Long time readers of my articles will know that we often refer to something called the put/call ratio within our work. We refer to it in our analysis of individual stocks each month and almost always use it within our analysis of the indices. Put/call ratios are an excellent measure of investor sentiment and can help us identify imbalances that are likely to reverse soon and also trends that may last for some time. This ratio is merely the number of put contracts on a stock or index, divided by the number of calls. The resultant ratio helps us to see if there are a higher number of bearish or bullish investors on a particular stock. When there is an excessive amount of call buying (bullish bets) made on a stock that is rising, the chances increase that any future buying strength will have dramatically reduced and that a reversal is at hand. When there is an excessive amount of put buying (bearish bets) made on a stock that is falling, selling strength will have reduced and a rally could soon take place. When we see an extreme in one of these conditions, it is highly likely that a reversal is at hand. For example, if the majority of investors are bullish, there is little chance that any more money will come into a stock because most of the buying has already taken place. In the opposite case, when there has been an extremely high put/call ratio (high amount of puts), investors have already sold much of their stock positions and so any slight increase in buying strength will overwhelm the remaining sellers and start pushing the price up. A put/call ratio of 1 would tell us that for every one put buyer, there is a call buyer. Now although at first interpretation you could argue that this is surely an even match, it is in fact considered bearish. The reason for this is that investors are normally optimistic towards stocks and thus the ratio should be naturally more biased towards having more call buyers. Therefore, for most stocks a put/call ratio of 0.5 could be considered even. However, many Nasdaq stocks naturally tend to have a higher put/call ratio due to investors still being bearish on these stocks since the dot.com bubble burst. In order to really know what the average ratio is for a stock, you will need to take a look at its history. APPLYING THESE RATIOS Lets assume that a stock has been rising and that because of this, investors were increasing the numbers of calls they were buying in anticipation of even further price rises. You would need to look for a point when the ratio started to reverse. This could be at one of two points. The first reason could be that the ratio has reached a level that had previously marked a stock price high. The second reason could be that the stock is reaching a price level where there is a very high amount of open call interest. That could provide a natural resistance barrier for the stock as sellers of the options start short selling stock to ensure it doesn’t get above their optimal strike price. However, you could see a situation where a stock price is rising and yet the put/call ratio is rising i.e. although the stock is going up, investors are placing bearish bets against it. This is the classic analogy of a ‘market rising on a wall of worry’. So investors aren’t convinced that the stock will continue to rise. In this situation, investors will very often be disappointed and some of them will give up the game and join the party, thus providing more buying strength to the stock. It would only be once these bearish bets had subsided that the stock would then start to head lower. A classic example of this is with the Nasdaq exchange traded fund, the QQQQ after it had made its final lows in March of 2003. The put/call ratio was well over 2 which meant there were two put buyers for every one call buyer. But as the markets began to rally during the course of that year, the put/call ratio remained high on the QQQQ, helping to fuel the advance. It was only once optimism started creeping back into investors, that the ratio started to decline in 2004. And what happened? The market started to fall! A very recent example of the put/call ratio at work is again evident in the QQQQ. Over the past week, the stock has found price support at $36. From looking at the put/call ratio, we can see that the peak level of put open interest is right at the $36 strike price. So the stock found support just where the highest number of puts had been bought. So there are many ways in which you can use put/call ratios in your trading
You can track the ratio on a chart to see when it reaches an extreme that has previously marked a high or low in the stock price.
If it is falling as a stock is rising, then this is bearish for a stock as investors are too optimistic—watch for a reversal in the ratio.
If it is rising as a stock is rising, then this can be bullish for a stock as investors are too pessimistic.
Look at where the most number of puts and calls are bought as these strike prices will offer both support or resistance to a stock—as shown in the example with the QQQQ above.
You can get all of this information by going to www.schaeffersresearch.com and clicking on the quotes and tools tab. Darren Winters
Was this article helpful to you? Leave a Public Comment or
Question:
This Article has been viewed 700
times.
Article added to SearchWarp.com on Sunday, November 27, 2005 View other articles written by Darren Winters(269)
If you found this article interesting, you may want to check out:
Disclaimer: All information on this site is provided for informational purposes only! By no means is any
information presented herein intended to substitute for the advice provided to you by any health care or other professional
or organization.
