Friday, June 6, 2008

Why You Need To Normalize The Put/Call Ratio

No time for research tonight. I spent the night at the Garden. Yeah Celts.

In lieu of a study, I instead prepared a chart of the CBOE Total Put/Call Ratio. One thing traders need to keep in mind when looking at certain indicators is that they may change over time. The put/call ratio is a prime example of that. The chart below is weekly. The green dots are the Friday closing prices of the put/call ratio and the brown line is a 40-week moving average.

Often times I hear traders refer to absolute levels in put/call ratios as if they are significant. What you can see by looking at the chart above is that “significant” has change over time. From ’97 to ’02 a “spike” in the ratio over 1.00 could have been viewed as significant. A trader seeing such a reading may conclude that fear among option traders was running high. Now a reading of 1.00 is below average. A reading of 0.5 would sure be significant, though. In 2000 it was about average. Strategies that may have been developed 7 or 8 years ago that looked for a move to a certain number are now likely obsolete. That doesn’t mean the put/call ratio has stopped working as an indicator, though.

The issue lies in the fact that the popularity and use of options for traders and institutions has changed over time. It will continue to change. To adjust for this you should normalize the readings over a certain time period and then compare the current readings to “normal”. There are a number of ways to do this. Comparing to a moving average using percentages is a simple and effective one. Another way to normalize the put/call ratios would be to use Bollinger Bands (try varying lengths). The specific method is not terribly important. The fact that it is done is important if you don’t want your strategy or study to become obsolete.

7 comments:

Scott said...

Hallelujah.

The targets are ALL moving. People are so schooled about contrarianism now that contrarian viewpoints are becoming contrarian indicators. Every bear-bull survey is supposed to show us that the majority are wrong. Then we react to the sentiment, then they do the survey again the next week. Ad nauseum.

People (not just institutions) are buying index puts to hedge their longs and calls.

All the while thestreet.com and CNBC commentators express their deep confusion about "how confusing these markets are". They're still looking for the same ratio benchmarks that were relevant 10 years ago.

Damian said...

Rob - not sure what you mean by comparing to a moving average using percentages - can you be more specific? Thanks1

Rob Hanna said...

Damien -

Rather than saying the P/C ratio spike up to 1.x compare it to a long-term moving average. An example:

On 3/14/07 the p/c ratio hit 1.66. The 200 ma was 0.97. That's more than a 70% spike over the norm.

On 4/14/00 the p/c ratio spiked up to 0.91. The 200ma was 0.55. That's about a 65% spike.

The 2000 spike on an abslute basis was less than the 2007 average, but when compared to "normal", they were actually similar.

Rob

Anonymous said...

I am curious about which pc ratio you were using for your chart and post about normmalizing.

Was it the $cpc overall ratio which includes index options ?

Woodshedder said...

Rob, would this also apply to volatility?

In other words, should a VIX reading from current time be compared to a reading ~7 years ago by the percentage of the value above or below the 200 dma?

Rob Hanna said...

The p/c ratio used was the CBOE Total Put/Call. It's the only one whose history is available back that far on the CBOE site.

Woodshedder,

The VIX is another indicator that seems more effective when "normalized". It is fairly common with the VIX, though. For instance, many traders will compare the VIX to it's 10ma. Others use Bollinger Bands. I tend to look at it in relation to short-term (10,20,50 days) rather than a 200. It is another good example of an index that should be normalized, though. Strategies that look at the VIX at certain static levels tend to be less effectve.

Rob

Anonymous said...

Back on May 8th i mentioned that his is a relative and not absolute indicator. a week later the equity P/C and cboe P/C avgs came close to hitting that relative low and it would have been a good time to heed their warning:

https://www.blogger.com/comment.g?blogID=2676650858658561710&postID=1584602395910049358

They have since rebounded, so the "easy" money may be off the table for now...

-mbs