Using The Put/Call Ratio To Locate Market Swings

by | Jun 23, 2020 | Editorial | 0 comments

Last night stock futures sold off steadily off a headline that the U.S. and China Trade deal fell apart

However, after further clarification…they recovered…and going into this morning’s session… stock futures were up.

If you’re waiting for the first 30-minutes of the trading day to figure out the overall trend of the market… you are probably too late. 

I’ve found that there’s a lot of edge which can be gained by examining the pre-market. 

In fact, my pre-market analysis is partly responsible for my 90% win-rate in my Daily Deposits trading service. 

What does my premarket routine consist of?

 

Daily Deposits

 

The core of Daily Deposits is based on determining the strength of the markets using premarket momentum analysis.

Daily Deposits is broken down into 3 main parts:

  1. US and global premarket analysis
  2. Identification of supporting trade information
  3. Executing the trade

These premarket indicators are then combined with other indicators that produce some of the most accurate trading signals!

Each of those three main parts are critical to the success of Daily Deposits!  

They are like the legs of a triangle… by removing any one of those key pieces of information, you risk collapsing the entire system!

But it’s more than just identifying macro economics.

And that’s where technical analysis and indicators come into action.

 

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.

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: Thinkorswim

 

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 if 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 find out!

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