Put-call ratios are useful, sentiment-based, indicators. The put-call ratio is simply the volume of all puts that traded on a given day divided by the volume of calls that traded on that day. The ratio can be calculated for an individual stock, index, or futures underlying contract, or can be aggregated — for example, we often refer to the equity-only put-call ratio, which is the sum of all equity put options divided by all equity call options on any given day.
Once the ratios are calculated, a moving average is generally used to smooth them out. We prefer the day moving average for that purpose, although it is certainly acceptable to use moving averages of other lengths. The chart on the right above is a sample one — of IBM. Buy and sell points are marked on the chart. The chart on the left above is that of IBM common stock, with the put-call ratio buy and sell signals marked on it. You can see that, in general, the signals are good ones.
In reality, we couple technical analysis — using support and resistance levels — with the signals generated by the put-call ratios. The combining of the two methods normally produces better-timed entry and exit points in our trades. A dollar-weighted put-call ratio is constructed by using not only the volume of the various options, but their price as well.
The two are multiplied together, and the total of that product for all put options is divided by the total of that product for all call options. Formally stated, the weighted put-call ratio can be written mathematically as shown in the box below. The thinking is that it is more important to know how much total money is being spent on puts versus calls, than merely to know the volume.
This point has some validity. For example, a person who is merely hedging his position perhaps is not really all that bearish, but just wants to buy some puts as insurance. He might buy fairly deep out-of-the-money puts. Thus, his dollars would be spent on rather low-priced puts. On the other hand, a truly bearish speculator would most likely buy a put with a higher delta — something that is at-the-money, or perhaps slightly in-the-money.
That is, during bullish periods the weighted reading can dip down to 0. Furthermore, during extreme bearishness, the weighted ratio will easily rise above 2.
The buy and sell signals are marked on the charts. For these charts, the major buy and sell signals occur at relatively the same points in time. Get access to over put-call ratio charts on various stocks, futures and indices by subscribing to The Strategy Zone.
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You should be aware of all the risks associated with trading and investing, and seek advice from an independent financial advisor if you have any doubts. Past performance is not necessarily indicative of future results.
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