Panic Sign: Put/Call Ratio

In this installment of the Panic Signs series, we delve into the fascinating world of the Put-Call Ratio (PCR). Often glanced at by traders, the Put-Call Ratio is more significant than meets the eye. However, few really understand how to use the PCR to their advantage.

While I don’t claim to have a foolproof solution, I have gathered insights from seasoned traders on how to effectively navigate the PCR and turn it into a valuable tool in your trading arsenal. Join me as we uncover the nuances of the Put-Call Ratio and explore how it can help us spot panic.

The Put/Call Ratio

First, we need to understand how many puts and calls are traded on any given day. For this analysis, we turn our attention to the CBOE (Chicago Board Options Exchange), a hub of options trading activity. By examining the trading data, we can take the pulse of the market and analyze how much interest there is in both puts and calls.

Calculate the Put/Call Ratio

The process involves a simple calculation. For example, let’s say that 100 puts and 50 calls were traded on a particular day. In this scenario, the Put-Call Ratio (PCR) would be 2 (100 puts divided by 50 calls). Conversely, if 50 calls and 100 puts were traded, the ratio would be 0.5 (50 calls divided by 100 puts).

Interpreting the Put/Call Ratio

Let’s interpret these numbers. A PCR above 1 indicates a bearish sentiment – more puts are traded than calls – a sign of potential negativity in the market. Conversely, a PCR below 1 indicates bullish sentiment, with more calls traded than puts, indicating optimism.

Examples for the Put/Call Ratio

Let’s break it down further. A PCR of 2 signals a particularly negative sentiment, while a ratio of 0.5 suggests a very positive outlook. In essence, any ratio above 1 tends to be bearish, while ratios below 1 tend to be bullish.

Detecting Panic with the Put/Call Ratio

However, when we thoroughly investigate whether there is any real benefit to this, we find that values above and below one don’t provide any substantial insight. Similar to our exploration of previous panic indicators, extreme values are crucial. In the case of the Put-Call Ratio (PCR), it’s worth noting that only bearish extremes make sense – indicating a scenario where significantly more puts are being traded than calls.

For example, with a benchmark of 1.40, if 140 puts are traded for every 100 calls, creating an excess of 40 puts, it signals an extreme negative reading. This indicates a high level of fear in the market and triggers our contrarian signal. This is when we actively look for opportunities as it suggests a potential market bottom.

It’s worth noting that put/call ratios are often only measured at the end of the trading day. However, we’ve found that this method tends to miss extreme values. Consider a day of heavy selling; the market opens weak, investors panic and buy puts, causing a significant spike in the put/call ratio. Towards the end of the day, large institutional buyers enter the market and push it up from its potential low. As a result, the put/call ratio falls, potentially settling at 1.2 or even 1.05.

Interestingly, we’ve noticed that such extremes often manifest themselves in the early trading hours – the first half hour before the market opens or the first two trading hours, especially on panic days.

Our target ratio for extreme values is 1.4. When we see a ratio of 1.4, we evaluate whether there’s an opportunity to enter the market, always in conjunction with other factors. As you can see in the chart we’ve included, instances of extreme put/call ratios, sometimes exceeding 2, are relatively rare but highly significant.

Summary

In our latest Panic Signs blog post, we delve into the often overlooked, yet crucial metric of the Put-Call Ratio (PCR). Despite its importance, many traders remain unsure of how to use it effectively.

With an emphasis on identifying panic as the key takeaway, only extremes matter, specifically bearish extremes such as a PCR of 1.40 or higher, provide significant insight. These extremes, which indicate a significant increase in puts relative to calls, serve as powerful contrarian signals for potential market bottoms, signaling heightened fear.

One noteworthy aspect is the timing of the put/call ratio measurement. Extreme values often manifest themselves in the early trading hours.

If you find this helpful, you may also be interested in other signs of market panic. In this article you will find 4 more panic signals like this one.