TRC Technical Insight 1
The Put/Call Ratio (and other scary indicators)
Back to School
On Friday 4/22 the put/call ratio—tracked by the Chicago Board Options Exchange (CBOE)—reached its highest level since the beginning of the COVID-19 pandemic—indicating bearish sentiment among investors. With the recent market selloff, I think that it is a good idea to dive deeper into the put/call ratio (and other technical indicators) to help attain a better understanding of where the market could be heading.
The Ratio
So, what is the put/call ratio, what does it indicate, and how can it be used to our advantage? The calculation of the put/call ratio is quite straightforward, actually, as it is the total number of put options divided by the total number of call options in the market. Simply, a put option is the right (but not the obligation) to sell an asset at a predetermined price, while a call is option is the right to buy an asset at a predetermined price. In a market where traders and firms are purchasing more puts than calls (put/call ratio > 1) the market sentiment is bearish as the owners of these puts expect market (or individual stock) declines to increase the value of their contract(s).
Sentimental Trading
As seen in the chart above, the current put/call ratio is 1.30, its highest level since reaching 1.80 corresponding with the market crash in 2020. There are two potential ways to interpret the current put/call data, which lead to opposing conclusions. The first possible interpretation is to follow the market sentiment and use the indicator as as a proxy representation of what it depicts. Paired with other sentiment indicators—such as the AAII Investor Sentiment Survey and the Fear and Greed Index—along with current macroeconomic trends, one could easily view the market through a bearish lens. This interpretation may be intact as, clearly, the put/call ratio is nowhere near its all time high and the possibility of a crash still looms over our head given current global macroeconomic conditions. The second possible interpretation of the put/call data is through a contrarian lens that recognizes that organic market timing is futile and investors are typically incorrect in their analysis of future market directions. Investors with a contrarian mindset would theorize that the data is actually bullish, as the majority of the market is currently bearish. However, as famed investor Peter Lynch articulated, contrarianism has become a widely accepted view—so who is to say how the true contrarian mind would interpret the put/call ratio.
Concluding Thoughts
While the put/call ratio does in essence track market sentiment, it is not an anywhere near an indication of where the market is heading. As we know, timing the market is nearly impossible and most investors tend to be bearish or bullish at the wrong time. However, using the put/call ratio, paired with a plethora of other indicators, could be useful in a top-down investing/trading framework. Given the current market characteristics and forecasts, conserving capital is essential, and the put/call ratio may give insight into how to do that successfully. But, for those focused on long-term value investing, using the put/call ratio (and other sentiment and technical indicators) is useless.
Quote of the Day
“Some have fancied themselves contrarians, believing that they can profit by zigging when the rest of the world is zagging, but it didn't occur to them to become contrarian until that idea had already gotten so popular that contrarianism became the accepted view. The true contrarian is not the investor who takes the opposite side of a popular hot issue. The true contrarian waits for things to cool down and buys stocks that nobody cares about, and especially those that make Wall Street yawn.”
- Peter Lynch
Thunder Road Capital