- 1999: Volume 8, No. 5 Put/Call Ratio Indicates Market Sentiment

Let's face it. Options often scare people. I can't tell you how many times people have come up to me after an options lecture to say, "All fine and good. I understand a bit more about options now. But, I'd rather eat ground glass than trade those things!"

Far be it from me to second-guess any investor's risk tolerance. I make a point, however, to offer investors the opportunity to look over the shoulders of those who do trade these instruments. Even if one doesn't want to trade calls and puts themselves, the option marketplace can offer helpful clues for trading the underlying instruments. The June/ July Puts & Calls column (CRB Trader Volume 8, Number 4), for example, illustrated how option implied volatility gauges the market's view of a stock's future price potential. Yet another useful indicator of market sentiment offered by the option marketplace is the put/call ratio.

Long favored by contrarian investors, a put/call ratio monitors the relative volume of put trading as a function of call trading. The ratio is derived by dividing the volume of puts in an option class by the class call volume. For example, if 1,000 puts were traded on a given stock, while call volume totalled 2,000 contracts, the resulting ratio would be .50 (1,000 / 2,000). Changes in the ratio are a bellwether for shifts in investor sentiment about the underlying instrument. Put/call ratios for equity options will typically run below .50, reflecting investors' greater proclivity towards call trading. Index option put/call ratios tend to be higher. It's not at all unusual to see index option put/call ratios approaching or even exceeding 1.00 since professional portfolio managers can dominate these markets with massive short hedges.

Put/call ratios may fluctuate widely from one day to the next, so moving averages are often constructed to smooth out "noise" and to make trends easier to track. Put/call ratios are inverse indicators since contrarians view surges in the average put/call ratio i.e., put volume rising relative to call volume, as bullish while declines in the ratio portend sell-offs. Faster moving averages, i.e., those covering relatively fewer trading days, tend to generate more trading signals than slower averages.

Aggregated equity put/call ratios can be useful gauges of market-wide investor sentiment. For example, trading in technology issues has traditionally dominated the Pacific Exchange's option market because of heavy volume in such issues as Microsoft, Compaq, 3Com, and Sun Microsystems. As such, the Pacific Exchange put/call ratio has been used as a proxy for technology sector investor sentiment. Typically, the Pacific Exchange's put/call ratio ranges between .30 and .70 on a daily basis. Changes in the technology sector, especially as measured by the Pacific Stock Exchange Technology 100 Index (PSE), have often been presaged by significant shifts in the Pacific Exchange put/call ratio. Knowledge of such shifts could have certainly proved useful for sector investors this year, especially when technology performance diverged from general market measures.

One doesn't have to actually trade options to capitalize upon the ratio's clues either. While ratio signals can be used to trade PSE index options, for instance, action could alternatively be undertaken in PSE index futures, or in the mutual fund based upon the PSE index, depending upon one's risk tolerance and investment horizon. Neither does usage of put/call ratios require one to be a contrarian. For example, a commonly-used technical indicator, the moving average crossover, can be readily employed using put/call ratios. Oddly enough, even though put/call ratios are themselves inverse indicators, crossovers of a fast moving average above a slower average are still considered bullish signals, while bearish crossovers are those in which a faster average crosses below that of a slow ratio.

As an example, let's examine how the Pacific Exchange put/call ratio could have been used by technology investors this year. We'll use the PSE index as a yardstick for technology sector performance as well as our trading vehicle. Keep in mind that a direct investment in PSE isn't possible as it's an unmanaged index. To capture the PSE's performance characteristics, one would have to invest in the instruments based on the index i.e., options, futures or mutual funds, each having unique risk characteristics and costs.

For the first eight months of 1999, PSE, rising from 450.95 to 629.38, gained 40 percent. As illustrated in Figure 1, the index marched steadily upward this year, save for a "spring swoon" in early March. But even with that, PSE stayed in positive territory through August. The "bogey" for any trader is outperformance of a buy-and-hold position. For PSE this year, that's a tough benchmark indeed. Let's see how a crossover system's results stacked up against those of a buy-and-hold investor.

Figure 1

A simple crossover system can be constructed with a "fast" 10-day moving average of the put/call ratio and a "slow" 50-day average. The averages can be plotted graphically to note trends, but most especially to look for crossovers. A trading signal is generated whenever the fast average crosses the slow average. When the 10-day average crosses the 50-day ratio to the upside (a "positive crossover") a bull move is heralded. "Negative crossovers" signal selling opportunities as the fast average crosses below the slow ratio. Figure 2 graphically represents how such a crossover system would apply to the Pacific Exchange put/call ratio.

Figure 2

Now let's set some ground rules for our test. We'll assume that you'll be invested, short or long, one "share" of the PSE Technology 100 Index at all times. During a bull market this dictum sets a pretty level playing field. Keep in mind, though, that a bear market fairly well excludes the buy-and-hold investor who won't short a market. We'll also assume crossovers to be stop-and-reverse signals. When presented with a trading signal, you'll liquidate any existing share position with a closing sale or covering purchase, and enter the market in the opposite direction for another share. In other words, if you were long and a negative crossover occurs, you'll sell two PSE shares-one to close out your existing long share and the other to establish a new short position. For simplicity's sake, we'll assume all transactions take place at the day's closing price with no commissions and no slippage. Finally, we'll assume that you'll flatten out your position by no later than September 1 in order to tally cumulative realized profits and losses.

Figure 3 illustrates how 10 crossover signals would have been generated since the start of the year using this rather simple system.

Figure 3

Basic Put/Call Ratio Crossover
	PSE	10-Day P/C Ratio	50-Day P/C Ratio	Crossover	Signal
04-Jan-99	450.95
01-Feb-99	511.0	0.39	0.36	0.03	Buy
26-Mar-99	486.67	0.42	0.43	-0.01	Sell
15-Apr-99	503.05	0.45	0.44	0.01	Buy
26-Apr-99	536.54	0.42	0.43	-0.01	Sell
25-May-99	511.97	0.41	0.40	0.01	Buy
17-Jun-99	568.49	0.40	0.41	-0.01	Sell
24-Jun-99	568.19	0.42	0.40	0.02	Buy
09-Jul-99	621.75	0.38	0.40	-0.02	Sell
28-Jul-99	605.97	0.42	0.41	0.01	Buy
31-Aug-99	626.87	0.42	0.43	-0.01	Sell
01-Sep-99	629.38

Simple is not always better, though. In this instance, this system would have proven problematic in a couple of significant areas. Most important, the system's volatile-there's no discrimination for the quality of the signal. These cues, while eventually producing profits, would have generated inferior results compared with a buy and hold strategy as illustrated in Figure 4.

Figure 4

With only a 29 percent return generated by the end of August and a drawdown of better than 60 index points suffered during the spring swoon, you might be tempted to think put/call ratio trading is an expensive waste of time. Keep in mind, however, that we've not optimized our system. Systems traders have long appreciated the necessity of optimizing analysis in order to discover the methodology that produces the greatest profit. Optimization often takes expensive and complex analytical software packages. However, we can impose a relatively simple filter of our own without investing substantial resources or time.

Suppose, for example, you only accept signals if the crossover difference is at least 10 percent of the fast moving average's value. Thus, nine trading signals would have been generated as shown in Figure 5.

Figure 5

10 Percent Crossover
	PSE	10-Day P/C Ratio	50-Day P/C Ratio	Crossover	Crossover Percent	Signal
04-Jan-99	450.95
11-Jan-99	492.84	0.34	0.38	-0.04	-11.76%	Sell
03-Feb-99	512.18	0.43	0.37	0.06	13.95%	Buy
03-Apr-99	523.77	0.39	0.43	-0.04	-10.26%	Sell
20-Apr-99	482.52	0.50	0.44	0.06	12.00%	Buy
30-Apr-99	514.89	0.37	0.42	-0.05	-13.51	Sell
01-Jun-99	520.94	0.45	0.40	0.05	11.11%	Buy
14-Jul-99	631.34	0.34	0.40	-0.06	-17.65	Sell
30-Jul-99	596.26	0.47	0.42	0.05	10.64%	Buy
01-Sep-99	629.38	0.39	0.43	-0.04	-10.26	Sell

Figure 6 illustrates that results superior to both the basic crossover and the buy-and-hold strategies are obtained with the overlay of a simple 10 percent filter. Cumulative profits generated nearly a 53 percent return. Still, as with the basic system, you have to be willing to suffer through some drawdown. By application of the filter, however, relative risk is nearly halved. (See Figure 7.)

Figure 6

Figure 7

	Basic Crossover	10% Crossover
Maximum Drawdown Cumulative Realised Profit	61.43 points 132.25 points	66.29 points 238.24 points
Risk/Reward Ratio	46.4%	27.8%

So, this is a panacea for technology sector investors, right? Of course not. First of all, there's no guarantee that the results shown here can be replicated in the future. Second, these signals have to be acted upon in a dynamic marketplace. It's unlikely that you'd be able make use of the signal data until the following market day. By then, overnight buying or selling pressure could cause gap openings. Third, you have to translate these signals into trades with the three PSE-based instruments available. Options typically carry a volatility premium which must be taken into account. Futures have basis risk. And mutual funds can only be bought and redeemed on the basis of "next day pricing."

Still, this discourse does rather simply illustrate how the behavior of options traders can render useful clues for other investors. Even if you're not already an options user, put/call ratios may be another tool you can employ when analyzing a market.

And who knows, once you dip your toe in the options waters, you just might want to take the plunge yourself.

Brad Zigler is the Managing Director, Options Marketing, Research & Education for the Pacific Exchange (PCX) in San Francisco. He can be reached at . The PCX Web site is www.pacificex.com. Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. The examples presented do not take into consideration commissions, tax considerations or other transaction costs which may significantly affect the economic consequences of a given strategy. Options involve risk and are not for everyone.