Tuesday, August 11, 2009

A Long-Term Look At Put/Call Ratios

In June of 2008 I posted a discussion on the importance of normalizing put/call ratios when considering whether their readings were significant. In that post I showed that the average put/call ratio had risen steadily and substantially from 2000 into mid-2008 when the post was done. I included a “starry night” graph where weekly closing levels of the CBOE Put/Call Ratio were seen as dots and the 40-week moving average was drawn with a line. I’ve reproduced that chart below updated through 8/7/09.

(click to enlarge)

What you’ll notice is that right around the time of the original post the put/call ratio began to decline. In fact the average put/call ratio is now about 20% lower than it was at its peak in ’08. A few thoughts on this:

1) A drop in the average put/call is not something you would expect during the worst bear market 70+ years. The 2000 – 2002 bear market is when the ratio began its 8-year ascension. Did traders actually become more complacent as the market cratered? The VIX action last year would suggest this was not the case. So why the drop in the put/call ratio? I suspect it has much to do with the emerging popularity of inverse ETF’s. With a new hedging tool at traders’ disposal, the demand for puts has waned.
2) “Why” really isn’t a big concern for me. What is important is that my analysis takes this information into account. Normalization remains just as important on the way down as it was on the way up. If last year you were viewing readings of 0.8 or 0.75 as possible complacence, then you need to realize that this year those readings aren’t much below average. And if the pace keeps up they’ll be average by the end of the year. Meanwhile readings that were just slightly above average last year are now fairly extreme.

Normalization can be done a number of different ways. Moving average envelopes around long-term moving averages is one simple way to do it. Another would be to use Bollinger Bands. The exact method is not what’s vital. What’s vital is that your strategies and analysis account for the fact that – like the market – the put/call ratio (and many other gauges) evolves over time.


Trader Kitteh said...

Agreed, there are two sides to every trade and I would guess that most players are not playing outright directional. In the run up, its quite possible that options were used to hedge say positions in CDO's and as those blew up, so did the need to hedge. Normalizing would take the slow changing dynamics into account.

Sentiment_Al said...

Good point about normalization, but you leave the mistaken impression that Bollinger bands or moving averages would have allowed the P/C ratio to trigger a buy signal in March 2009. It wouldn't. The March P/C was low even after adjustment, and this indicator simply didn't work at the beginning of one of the biggest rallies in history.