How To Use The Put Call Ratio To Help Predict Market Direction

by | May 10, 2020 | Editorial | 0 comments

Let me ask you this question….do you usually follow or bet against the crowd? 

For me, it really depends on what is happening that day!  

You, see I don’t blindly jump in and follow the trend… 

Instead, I closely monitor the market internals for clues and try to decipher which way the markets want to head after the bell.

And this has been working great for me  – I only had a single losing day all month!

Allow me to share with you these key market internal indicators… which can give you a heads up to what the street is thinking.

 

The Put/Call Ratio

 

One way to gauge short-term investor sentiment in the stock market is the put/call ratio (P/C ratio).

 It’s an indicator that measures the amount of put activity relative to call activity in the options market.

Investor sentiment tends to matter more when certain indicators are hitting extremes. 

Those readings typically don’t last long, but when they do happen, price reversals can occur.

When everyone seems upbeat, optimistic, and bullish, they can’t all possibly be right. Right? 

Well, that’s where contrarians come into the picture.

Contrarians are those who typically sell against the overall market trend in an uptrend or buy in a downtrend.

And contrarians are also the ones who make the terms “to catch a falling knife” and “stepping in front of a train” a real thing that happens.

These terms are used to describe those traders who buy stocks that are falling, and sell stocks that are rallying.  

But what if you are able to find when the buying momentum is running out of steam?  Or maybe it’s a signal to start to peel off a trade you might be in and tighten up the rest of the stops.

And on the other hand, what about if I am holding a short position and the sentiment is extremely negative and starting to turn around?  This could mean that either it’s time to start buying shares in the stock because it will be turning around or to decrease your exposure if you are holding a short trade.

Unfortunately, this contrarian thinking is not easy.  This type of trading really requires information to gauge whether sentiment is bullish or bearish. 

The P/C ratio is an indicator that measures total put options volume relative to call options volume.  

 

Reading the Put/Call Ratio

 

Before we discuss the ratio, let’s break it down into its two components.

What is a put and a call?

A put gives the holder the right to sell a specified amount of the underlying security at a specified price and date.

A call gives the holder the right to buy a specified amount of the underlying security at a specified price and date.

How to calculate the Put Call Ratio.

 

     Total number of puts 

PCR = —————————–

     Total number of calls

The Put-Call Ratio can be calculated on a single stock or the entire market as well.

Here is a sample plot of the Put Call Ratio

 

Source: Tradingview

 

As we can see from this image above, that when the puts become a larger value the stock takes a swing in the opposite direction.

So… how do you decipher the PCR values?

Let’s assume 9.82, puts and 8.47 calls traded, meaning that the PCR was 1.159, or (9.82/8.47).  

The 3 zones of the Put-Call Ratio:

  • Values below 0.75 signals high levels of bullish sentiment.  This means that it’s considered bearish from a contrarian viewpoint. 
  • Values between 0.75 and 1.00 are neutral and usually ignored.
  • Values above 1.00 indicate a high level of bearishness and considered a bullish signal by contrarians.

As a trader, a value of 1.159 is a high level that signals extreme bearishness.  This also means that a spike in the put/call ratio may warn that this is an extreme viewpoint and that the market could be running out of sellers.

And this also works for when the market is trading higher.  The lower the PCR the greater the possibility that the market is overbought and headed for a move lower.

But remember this is just an indicator and not a holy grail indicator.  So it’s important to consider other factors as well, such as global and economic data that are impacting the trading of the SPY.   

Pro Tip:  The Put-Call ratio can be applied to individual stocks, sectors, and any other ETF as well.  If you want to gauge sentiment towards how technology stock is doing, for example, you would want to look at the PCR of any of the NASDAQ ETF, QQQ.

That said, the PCR can potentially be another tool in your box or just something to keep on your radar as you assess market direction.

If you want to apply the Put-Call Ratio (PCR) to your trading strategy, you should keep these 4 tips in mind.

 

  • Focus on liquid stocks and markets.  The PCR can be misleading and even manipulated by traders and should be only used on stocks and markets that are extremely liquid. Since Daily Deposits is focused on trading the SPY, this should not be an issue.
  • Consider market action.  If a stock or market ETF is rallying to new highs this may cause the Put-Call Ratio to spike and is actually not a sign of bearishness.  
  • Hedging is not a market direction.  As each market or stock is different, there may be different “normals” that each one has.  It’s important to understand the “norm” or average readings of every market you trade to understand how this ratio works every day.
  • This is not a “holy grail” indicator PCR’s are indicators, just like a MACD or Moving Average is.  Meaning that the markets can continue in their original direction and not reverse, regardless of the value of the PCR.  The PCR is typically best used with other sentiment data, fundamental analysis of the market, or technical studies of price action and chart trends.

Conclusion

 

The Put Call Ratio is an extremely powerful sentiment indicator for traders and investors.  

This indicator may be used to help a trader to identify when a market that is trending higher and lower may run out of steam and reverse its direction.

So, if being able to accurately determine when the markets might reverse direction is valuable, then learning to read the Put Call Ratio correctly is of utmost importance.

To learn more about the market internals and how I use them to form the momentum ETF trading strategy – Click here to learn more!

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