Playing the Playing Field: Using the Put/Call Ratio to Grab Market Gains
You may have run across some of the put/call ratio articles on Benzinga — they date back more than a decade and represent timely, actionable commentary on those markets. But if you don’t know how to use that ratio, the data on those pages doesn’t translate. What does the ratio mean; where does it come from; and how can I use it?
This COVID market gives us a great opportunity to discuss exactly what the put/call ratio means, because, like everything else, it’s been literally turned upside down. Properly utilized, you may be able to use the ratio to give yourself a greater chance of profit than the average market trader.
What is the Put/Call Ratio?
The put/call ratio is a market indicator administered through the Chicago Board Options Exchange (CBOE). The CBOE is the world’s biggest exchange for options. It has originated a number of measurement proxies for market activity, the most famous being its volatility index (VIX).
Puts and calls are the two major option types. Each put or call is a contract that represents the control of 100 shares of a particular stock. Generally (not always), puts go up in value when the underlying stock value drops. Calls go up in value when the underlying stock value rises.
When the investor aggregate buys more puts than calls on a stock/on an index/in the market, it means that the market expects the value of that stock/that index/the market to fall. The opposite is true when investors buy more calls than puts. It doesn’t mean this will happen. There is always a chance that some disruptive piece of news will completely change short term market sentiment. Understanding the Ratio
The normal value of the put/call ratio is 0.7. 0.7, not 1.0, represents a neutral sentiment. Anything above 0.7 is bearish; anything below 0.7 is bullish. 0.7 represents market neutrality because of the Efficiency Assumption (not the Efficient Market Hypothesis; that’s different). The assumption is that all companies must improve business processes in order to keep pace with improving technology and consumer expectations. All else being equal, a company will reinvest profits into itself and deliver consistently more efficient solutions, which will add to its profitability, which will increase its ability to self-invest, etc., in a positive spiral.
As of this writing (market close July 27, 2020), the ratio is 0.44. The market is expecting the market to rise. Not just rise, but fly. News of extended stimulus, cheap money for business and Federal Reserve interest rate and corporate bond guarantees probably factor in here.
However, a second wave of COVID, if it’s serious enough, could reverse this market on a dime.
How can you participate in this strong trend and protect yourself from a sudden market reversal on bad news?
Playing the Ratio
Instead of waiting on the market to prove the put/call ratio correct, you can play the ratio itself.
Over the past 6 months, the ratio has been moving within a range of 1.28 to 0.37. This is quite volatile, which is good. It gives plenty of room to see market changes. The 1.28 high occurred in March when the market was at its 52-week pandemic lows.
Guess what? That was the best time to buy calls, not puts.
Since today’s 0.44 ratio is near its 6 month low, it actually isn’t a good time to buy calls. All else being equal, traders will likely begin to buy more puts in the near future. This doesn’t mean that the market will immediately reverse itself. If the ratio rises to 0.6 from 0.44, this means only that the market is less bullish, not bearish.
As the chart shows, the 1.28 reading is unlikely to happen again. That would likely mean a double bottom, and the Fed has already stated its intention to avoid this outcome. The 0.75 mark gets touched quite a few times, though. Based on this data, a turnaround to 0.75 might be a good time to buy calls. At 0.44, you might want to begin searching the short side of the market for overbought stocks. These are the most likely to fall should euphoria about an instant recovery slow down. Any bad news — a rise in COVID cases, a shift in Fed policy, an unexpected bad earnings report — will likely result in a pullback from euphoria and give you a chance to profit.
Using the Ratio
If you want to test strategies like the put/call ratio using historical data, TD Ameritrade offers one of the most sophisticated backtesting platforms on the market. It is always a good idea to test any strategy before putting real money on it. With TD Ameritrade, you can be sure that your test results are accurate. You can then seamlessly take your trade on their intuitive platform that also lets you quickly react to changes in the market.
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