Put Call Ratio for Options Trading

Topic: The Put/Call Ratio

Folks: This letter addresses a fundamental subject in option analysis - sentiment readings. Please read it carefully and write me if you need help in understanding it. A good grasp of the Put/Call Ratio is very important to your trading.

Dear Options Trading FAQ:

I have an options trading query for you to consider. Let me introduce it by copying to you a portion of a recent news article by a Reuters reporter, Medora Lee who often writes about options trading. She is writing of Bernard Schaeffer's bearish outlook on the tech sector due to the high number of calls being chased:

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Despite expected gains in broader U.S. stock indices and the Dow 30, Schaeffer warned that technology indices continued to look bearish. "I remain bearish on the semiconductor sector although bounces are certainly possible after the recent huge declines," Schaeffer said, adding, "both Applied Materials (AMAT) and Micron Technology (MU) continue to attract hordes of bottom-fishing call option speculators, and there is very muted put activity. This is classic bullish sentiment in a bear market that strongly suggests that the bottom is not at hand."
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Now, it seems to me that this comment on call option activity is not very insightful. At some point the market *will* turn around and at that point those that have been fortunate enough to predict it and time it will be correct in their bottom-fishing call speculation.

I'm personally not big on trying to time the market since I don't think it can be done, but to claim the bottom fishers are wrong because they are a reverse or contrarian indicator also seems problematic. But maybe there are some things I don't know about using put/call ratios as technical indicators of market direction.

Can you enlighten? Thanks again for your continued commentary on options trading.

Options Trader Confused by the Put/Call

Dear Put/Call Ratio Doubter:

Ah, the famous Put/Call Ratio. This is that demon contrarian indicator that *puts* (ha, ha, -very punny!) options traders into a tizzy. Option traders just can't stand being used as a wrong way signal! For those of you who need a review, it is the number of put option contracts traded divided by the number of call option contracts. In the abovementioned example, Mr. Schaeffer's eye was caught by the very low put/call ratio in the tech sector (very few puts traded as compared to calls). He reads this in the usual contrarian fashion - that the option trades represent dumb money. That is, speculative funds that usually prove to be ill invested. Therefore, he is situating himself opposite the call buyers and maintaining his bearish stance on techs.

Yes, use of the Put/Call Ratio can be problematic in that one must always take into account what the general market atmosphere is. Note that Schaeffer places the call option buying into context by referencing the bearish tech environment. This is important in that the Put/Call Ratio figures can go to different levels in different market scenarios in order to trigger a signal.

Had the same call buying occurred in a rising or flat market for AMAT and MU, Schaeffer's signals may not have been triggered. Proper use of the Put/Call Ratio comes with experience in watching it and in understanding just when certain amounts of put or call volume is allowed to increase or decrease without tripping an alarm. For instance, if MU was going straight up (instead of declining), one must allow for increased call volume caused by that rise and not go short against the natural increase in call buying.

You mention that in some cases, the market will turn and prove the fortunate bottom-fishers right. Yes, but I think you will agree that those folks were mostly just lucky guessers. That money does happen to represent purely speculative money as opposed to really smart money. By and by, one must use the Put/Call Ratio as a contrary indicator. There are exceptional times when other rules apply (I'll cover that subject in an upcoming letter), but stick with the classic interpretation as a general rule.

Bottom line for options traders? I think Mr. Schaeffer's analysis is sound and was reported well by the news service. Whether he'll turn out to be right in his market judgment is another matter. Only time will tell.

Keep an eye out for advanced Put/Call Ration interpretation techniques in future letters.

Good Luck!

PS. I have been working on my own proprietary option sentiment survey which I'll unveil in the very near future. I'll be collecting market opinion surveys from the Options Trading FAQ readership and compiling the data for distribution to the major media channels. The standard Wall Street sentiment studies (AAII, Consensus, Market Vane, Investor's Intelligence, etc.) have been getting a bit stale in their polling methods. It's time for a little shakeup!

The Options Trading FAQ Sentiment Survey (TM) will be the first electronic weekly sentiment polling of a very interesting demographic group. The average Options Trader FAQ reader is a well educated, solidly financed, internet savvy, private investor intensely interested in advanced trading techniques. Such a group certainly deserves to be tracked. Using the technology of the Internet to do so will allow for accurate and timely data gathering. I am very excited about this venture and hope the readership will be kind enough to contribute to this leading edge research project. Warning! As with the other sentiment surveys, we may find ourselves also to be a reliable contrary indicator. In that case, we'll just always place our orders opposite to our market opinion. It's certainly been working for myself since I started reversing my orders !!

Good luck and trade well! Remember, an educated options trader is the best options trader. Browse these books books on trading options.

Tags: Options Trading, Options Indicators, Options Put/Call Ratio

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