Tuesday, May 16, 2006

VIX and Put/Call Ratio: How Are They Related?

Note: Thanks for the positive comments regarding the expanded Trading Psychology Weblog, which now includes links to the day's interesting news features, a summary of intermarket relationships, and daily measures of market strength, weakness, and trend.

I received a few emails regarding the relationship between the put/call ratio and the VIX as measures of sentiment. I decided to create relative versions of both indicators, by evaluating each as a proportion of its 20 day moving average. Interestingly, the correlation between the relative VIX and the relative put/call ratio since March, 2003 (N = 805 trading days) has only been .41. That means that about 16% of the variance in the relative put/call ratio is attributable to the relative VIX and vice versa. While the two indicators are related, they are not measuring the same thing.

What has made the recent time period significant--particularly this past Friday--is that the relative VIX was quite high (19% above its average) *and* the relative put/call ratio was quite elevated (54% above its average). Since March, 2003, we've had 33 occasions in which the VIX was 15% or more above its average. The next day, SPY averaged a gain of .35% (23 up, 10 down)--much stronger than the average one-day gain for SPY of .06% (448 up, 357 down).

A median split of the data based upon the relative put/call ratio was instructive. When the VIX was more than 15% above its average and the relative put/call ratio was high, the next day in SPY averaged a gain of .49% (13 up, 3 down). When the VIX was elevated and the put/call ratio was low, the next day in SPY averaged a gain of .21% (10 up, 7 down). Clearly, the upside edge is greatest when VIX *and* the put/call ratio are elevated, as we've seen recently. Enhanced volatility and enhanced pessimism, when they occur jointly, seem to offer superior near-term rewards.