Thursday, March 05, 2015

Measuring Stock Market Sentiment With the Index Put/Call Ratio

The recent post took a look at the Equity Put/Call Ratio (the ratio of put volume to call volume for all listed options of individual stocks across all exchanges) and what it tells us about the market.  Above we see a five-day moving average of the Index Put/Call Ratio (the ratio of put volume to call volume for all listed options of stock indexes; data from e-Signal).  Interestingly, the two ratios since 2014 have correlated only .25, which means that they share a little over 6% of total variance.  This suggests that the two measures function differently vis a vis sentiment.  If a portfolio manager has a long/short book and wants to quickly hedge a net long position, buying index puts could be a quick way of accomplishing that.  If that same manager wanted to express a view in a single name or hedge a directional exposure to that particular stock, the options for that stock would be the most effective expression, liquidity providing).  

Another interesting feature of the Index Put/Call Ratio is that it has varied wildly over recent years.  In 2007, we routinely saw 20-day averages above 1.70.  As you can see from the chart above, we have never seen such a high reading during the period since 2014 and indeed have not seen that kind of reading since 2010.  We even have an example of variation in the ratio in the recent data.  Note how, since the October 2014 drop, we have seen higher put/call ratios than earlier in the year.  In other words, money managers are doing more hedging now than earlier in 2014.

The absolute values of the Index Put/Call Ratio do contain information, but it's tricky given the wandering mean of the distribution and the correlation to concurrent price change.  Since 2014, the Index Put/Call ratio has correlated -.56 with the percentage of SPX stocks trading above their five-day moving averages.  This is what we saw with the Equity Put/Call Ratio:  there is a tendency to buy puts after short term declines and vice versa.  Sentiment is quite sensitive to recent price movement.

Since 2014, when the Index Put/Call Ratio has been above 1.0, the next five days in SPX have averaged a gain of +.68% vs. +.22% for the remainder of the sample.  When either the Index or Equity Ratio (or both) have been above 1.0 (87 trading days), the next five days in SPX have averaged a gain of +.82% vs. no change for the remainder of the sample.

In short, it does appear that options ratios tell us something about sentiment; that index options reflect different sentiment issues than equity options; and that teasing apart the ratios from recent price change might provide a purer measure of the value of options-based sentiment as a predictor of short-term price action.

Further Reading:  Measuring Sentiment Intraday