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Put Call Ratios

and
How to Use Them
Christopher Carolan (2003)
The logic of put/call ratios is that too many puts trade at market lows and too many caIIs
trade at peaks. ln general this approach is true, but there's plenty of noise in the data, and
changes in option trading patterns over time have made interpreting put/call ratios more
difficult. Some analysts have abandoned put/call ratios altogether.
l have used my years of experience on the options trading floor to utilize those
characteristics of options trading that l observed first-hand in the development of better
put/call statistics.
Intra-day Data: l use intra-day data, based on the observation that the emotional burst in
options activity often last just a few hours, and as such may be drowned out in daily data
by hedging and arbitrage activity. All of my put/call moving averages are volume weighted,
meaning that a half hour with twice as much volume counts for twice as much in the ratio.
VoIume: Option volume is a key to the reliability of put/call ratios. lmportant market turns
occur on high option volume. Extreme put/call ratios without an accompanying surge in
volume should be discounted.
The ModeI: The put/call model issues a signal when the ratio is outside of the signal lines
AND the volume is above the signal line AND the volume turns down. Volume is naturally
high on expiration day, thus a higher signal point is used on those days. The Put/Call
Model is not a system. lt does not produce alternating buy and sell signals. lt is very good
at catching intermediate-term lows, and has caught some good tops in its history.
How to Use: A very good use for put/call ratios is for evaluating sentiment just AFTER a
market turn. The options ratio will tell you whether people believe in, or are skeptical of, the
new trend. Usually they are wrong and the put/call ratio can be a big help in separating the
important turns from the "head-fakes."
The chart below has arrows denoting the September and October lows of 1999. Notice
how there was no extreme put/call ratio at the September low. The rally off of that low
convinced many that the bottom was in, but the put/call model indicated that fear had just
not reached strong enough levels. Later in October, the Put/Call Model issued two buy
signals within three days, and the market immediately began a near vertical rally in the
NASDAQ issues.
Below's a similar case. The April 4 low was quickly retraced, though the Put/Call Model
was clear that no foundation of fear had been built on which to rally. The later April 14/17
low was accompanied by a buy signal, and the resulting rally was more lasting. The
strength of the Put/Call Model is its ability to pinpoint major lows, usually within 24 hours of
the bottom. A word of caution. In proIonged decIines, the modeI may give some
premature buy signaIs.
Weighted Indices: Some analysts have recently been quoted saying "the put/call ratio is
at its lowest point in x years!" lt's not appropriate to compare straight put/call ratios from the
late 90s with those of five or ten years ago. The percentage of options trading volume
devoted to indices (OEX, SPX, etc.) has fallen sharply in recent years. This fact distorts
comparisons between current and older data. To address that problem, l developed a
weighted put/call ratio where the index component is a fixed 25% of the ratio across time.
As shown here, this indicator has a good record of finding tops, though like most sentiment
based indicators, it finds more turns than actuaIIy occur.