Thursday, February 25, 2010

Using the Intraday Equity Put/Call Ratio to Gauge Sentiment

The stock market opened sharply lower this morning and broke below important support in early trade. Although this looked quite bearish, the mixed sector performance and firmness among other asset classes suggested that we might be in more of a range environment. A number of traders apparently did not make this shift; by the end of the day, I heard from more than a few frustrated bears.

The intraday CBOE equity put/call ratio (above) helps us understand what was going on. Average put/call levels since the start of 2010 have been around .63. Notice how bearish sentiment grew through the morning, even as stocks were basing. Once the market broke out of its morning range on solid buying interest (NYSE TICK) and volume, put/call levels never dipped below average and indeed stayed elevated during the afternoon. This bearishness helped buoy the market through the afternoon trade.

Once we broke obvious support, it was obviously time to be short. Unfortunately, markets rarely reward what is readily apparent. A look below the surface at the put/call sentiment showed that the short side was crowded--and that set up a significant reversal.