Tuesday, April 28, 2015

The Equity Put/Call Ratio: Why Sentiment Matters

Lately I've seen a variety of observations about stock market sentiment, ranging from bullish to bearish to neutral.  My favorite measure of sentiment is the put/call ratio for all individual stocks with listed options.  This excludes index option volume.  Above we see a five-day moving average of the equity put/call ratio (red) plotted against the SPX.  (Raw data from e-Signal).

In general, we've tended to see elevations of the ratio at relative market lows.  Over the last few weeks, the ratio has dramatically declined as we've percolated to new highs.  We are currently in a zone where traders are bullish in their options-related behavior.

Since the start of 2014, sentiment has been an important tell for forward market returns.  If we simply conduct a median split of the daily data, we find that when traders have been relative bullish (N = 160), the next 10 days in SPX have averaged a loss of -.28%.  When traders have been relatively bearish (N = 160), the next 10 days in SPX have averaged a gain of 1.18%.  In other words, if you followed the sentiment herd and bought the market when traders were bullish and sold when they were bearish, you lost significant money.  Essentially all the market's returns have come from time periods when traders did not believe we were going to get good returns.

There's an important lesson there.

Further Reading:  The Index Put/Call Ratio