The put/call ratio

Preview of the October 2011 S&C magazine

I started writing my first book near the end of the previous century. That sounds like such a long time ago! It was only published in Flemish, my native language. A small part was about fundamental analysis, the main part was about technical analysis, and there was an introduction to option strategies. In the part about option strategies, based on the put/call ratio and the open interest, I wrote about my idea of how these two parameters could be used as a leading indicator to predict the next index move. For a couple of years afterward, I published follow-up commentary and accompanying data from the European Options Exchange (EOE). Unfortunately, at some point this data stopped being offered anywhere I looked for it and I had to abandon that project, much to my regret.

Then in early 2010, I noticed that the put/call ratio of all the CBOE equity options is available at the CBOE website (http://www.cboe.com/data/PutCallRatio.aspx). There, you can find the CBOE equity put/call ratio data from October 21, 2003. That made me think about my earlier work. An indicator that uses the put/call ratio has an advantage in that it is not based on the usual price or volume data, and as such, it can be an interesting extra piece of independent price information. Looking at the figure below however, where you see a chart of the Standard & Poor's 500 at the top with the raw put/call ratio data at the bottom, it is evident that we will need some tricks to create a usable indicator.

Put/call ratio definition

You get the daily put/call ratio by dividing the sum of all put options by all call options traded on all individual CBOE equity option contracts. Important: Do not use the put/call ratio of the index itself; this will not give you a meaningful indicator. The result will be 1 if the number of puts and calls traded are equal. If you are using a linear scale for the indicator, you may have to do something with puts that move linearly from 1 to 10 and calls that only move from 0.1 to 1. But if you look at the CBOE equity option data from 2003 till now, the put/call ratio is rarely larger than 1 or smaller than 0.45. That means that using a linear scale is not a useful item, and that the ratio varies in reality between an equal number of calls and puts and about 2.5 times more calls than puts. Normally, you will see the index moving up while the put/call ratio is going down. More calls than puts are traded and the call option buyers believe in a further upside movement of the stock price. Conversely, you will see the index moving down with an upward moving put/call ratio. This means more puts are traded, and more put option traders are convinced of a continued move down of the stock price.

PUT/CALL RATIO AND PRICE CYCLES

Phase 1: The put/call ratio up turn warning.

In a normal short-term down move, the put/call ratio indicator will be moving up. In the following figure, where the indicator is plotted below the index, this price zone is marked in red. In a normal short-term up move, the put/call ratio indicator will move down. This is the green zone in the figure. The most interesting part here is the blue zone, where the short-term put/call ratio starts moving down while the index continues moving down or flat in the downtrend. This is an early warning for an upcoming price reversal. The downward move in the put/call ratio means that more calls than puts are being traded.

What is happening here is that private investors start selling stocks because they lose too much money in the downtrend. Stop-loss levels are broken, while others keep the stock and try to compensate for the loss by writing call options. They are convinced that the written call options will end up worthless as the downtrend continues. Finally, some investors buy put options to protect their stocks and/or simply try to profit from the downtrend. Others — let's call them professionals — are picking up the stocks at continuous lower prices and buying the call options written by private investors. They also write the put options bought by private investors. Sounds like the professionals know price is going to move up soon. If that is the case, they will profit by selling the stocks and call options at higher prices and they can buy back the written put options at a lower price, making money on stocks and more money with the options.

Phase 2: The up turn

The put/call ratio is moving down and the index is turning up after a downtrend. This area is marked green in Figure...

 

 

Read the complete article in the October 2011 issue of Stocks & Commodities magazine.

 

The PCRI Put/Call Ratio Indicator

Preview of the November 2011 S&C magazine

Starting from the raw put/call ratio data we will construct a "Put/Call Ratio Indicator" that would help us to recognize the six phases we talked about in part 1 of this article. We will first create a fast indicator and next a slow one that can be projected over the fast one. That way we have a short term and medium term view.

PCRI Fast

First we have to collect the data from the CBOE website and paste that data in a new security that I call "PCEQ" for put/call ratio of equities. You will have to note down the name of the folder this new equity is located. In my case it is on my C drive in a folder "C:\equis\data\specials\"

From part 1 we remember that if the put/call ratio varies from 10% calls and 100% puts and visa-versa, there is a scaling problem using a linear scale. However looking at the real put/call ratio data, we see that this data stays within a value of 0.45 to 0.9, 99% of the time. So, actually there is no problem. However to avoid those few extremes influencing the end result too much, I am limiting the put/call ratio value from 0.45 up to 0.90 with the following MetaStock statement after reading in the "PCEQ" put/call ratio data.

A first smoothing with almost no delay I am applying is with a short term TEMA average. The result of this smoothing is the base for the application of another smoothing technique we have used in previous articles.

To create the fast PCRI indicator I am using an RSI function and a weighted moving average on the RSI function. Finally to create a high and low reference line, I am using a 1.3 times standard deviation of the PCRI over a 200 day period, with a horizontal line in the middle at 50.

Let's have a look at the next figure with the PCRI_Fast indicator in the lower side of the chart and the S&P500 index in the upper part. Starting from left to right there is the index downtrend and the fast PCRI moving up. End 2005 we see a price reversal warning phase 1, with price still going down and the PCRI indicator turning down. This is followed by a phase 2 with an index up reversal and PCRI continuing down. Note this will most of the time be confirmed with some kind of trend break information as you can see half of February with price breaking a downtrend line. Now the index up move continues during phase 3 with PCRI continuing the down move. Phase 3 ends with a warning phase 4 with price still moving up and PCRI making an upturn. Next there is the PCRI phase 5 confirmation with the index starting the down move. Most of the time this is confirmed with a trend break information as you can see end of February with price breaking an uptrend line. The index continues the down move during phase 6. That ends a complete cycle and a new phase 1 is started when the PCRI turns down while the index is still moving down or flat.

Read the complete article in the November 2011 issue of Stocks & Commodities magazine.

 

Put/call trading examples and the smoothed inverse Fisher transform stochastic oscillator.

Preview of the December 2011 S&C magazine

The PCRI chart trading template

The next figure shows my charting template for trading based on the put/call ratio indicators. The window at the top holds the S&P500 daily data with 3 simple moving averages. A 50 (blue), 100 (red dashed) and 200 (red) moving average. These are typical averages useful as dynamic support and resistance levels. For the shorter term dynamic support and resistance I am using standard 20 periods Bollinger bands. Finally I will be using in this window support and resistance levels and trend lines to look for line breaks.

The second and third window hold the fast and slow put/call ratio indicator and the inverse Fisher transform of the slow PCRI. Read the first and second part of this article series to learn everything about these indicators. Finally in the fourth window I am using a standard stochastic 30 period oscillator with a 5 day slowing. And finally in the same window a smoothed inverse Fisher transform stochastic. This will help to eventually stay in a trade or ultimately to get you out of the trade if other signals fail.

Read the complete article in the December 2011 issue of Stocks & Commodities magazine

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