Wednesday, December 06, 2006

What We Can Learn From The Equity Put/Call Ratio

If you take a look at today's Weblog entry, you'll notice a chart of the equity put/call ratio for yesterday, December 5th, on a five-minute basis. That chart, which I was unfortunately unable to post here due to some technical difficulties, is worth a bit of study.

We opened with the put/call ratio at about .59, well below the 100-day average ratio of .78. That tells us right away that call buyers are being more aggressive than put buyers in relative terms. When we also see, from the NYSE TICK, that traders are lifting offers in more stocks than they're hitting bids, it clearly tells us that the market's initial sentiment is bullish.

By tracking the TICK and the equity put/call ratio through the day, we can determine whether or not bullish sentiment is increasing or reversing during the session. The Weblog chart shows us clearly that, as the afternoon wore on, call buyers continued to be more aggressive than put buyers. Indeed, we saw a downward move in the put/call ratio leading the market's afternoon rise toward its highs.

When bullish sentiment is sustained--and especially when it's expanding--during the day, fading market moves can be costly.

The 1-5 day market forecast when we have put/call sentiment extremes, however, suggests that we should fade those extremes. Since 2004 (N = 733), when we have a relative put/call ratio (i.e., the ratio of the current put/call reading to the 100-day average) that is below .70 (N = 26), the next five days in SPY average a loss of -.18% (11 up, 15 down). When the relative put/call ratio has been above 1.4 (N = 31), the next five days in SPY have averaged a gain of .21% (18 up, 13 down).

Indeed, when the relative put/call ratio is above 1.0, the next day in SPY averages a gain of .07%. When the relative ratio is below 1.0, the next day in SPY averages a loss of -.01%. All other things being equal, bullish sentiment tends not to carry over to the next day's trading.

As my research with options and stock market trading patterns continues, I will be reporting on further results.