The put/call ratio, a favourite contrarian indicator of options market sentiment is showing the most bullishness in 20 years. Is a big market correction coming or is this time different?
The put-call ratio shows the relative trading volumes of put options and call options in an underlying security. High levels of puts relative to calls shows bearish sentiment while high levels of calls relative to puts shows bullish sentiment. Traders use extreme values in the ratio as a contrarian indicator and a pre-cursor to a possible turning point.
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- The total put/call volume on US individual equities has reached a value of 0.39
- That is the lowest since the year 2000 when the dotcom bubble burst, marking the beginning of a major bear market.
- The US put/call ratio 5-day average has hit a 20-year low
- In March the ratio had reached its highest (most bearish) since the 2008 financial crisis
- Does it work? We look at the put-call ratio and the S&P 500 stock index
- How to use it - We contrast taking early signals versus waiting for confirmation.
- Does the pandemic make it different this time?! Ironically, the biggest reason to ignore the put-call ratio is the ‘Fed Put’.
Various readings of investor sentiment are looking extreme, including the ratio of the volume of put to call options on US individual equities.
It can be seen above that the 5-day moving average of the put-call ratio, which smooths out one-off extreme daily readings is at the lowest it has been since the year 2000 when the internet stock bubble of the 1990s finally burst.
The same 5-day average was at its most bearish since the 08’ financial crisis in March of this year. The turnaround in sentiment in the options market matches the impressive rebound in stock markets that erased 30-40% declines to reach record highs within the same year.
Does the put-call indicator work?
Let’s look at recent history with the chart below of the S&P 500 contrasted with the put-call ratio. It can be clearly seen that tops in the put-call ratio tend to correspond with bottoms in the S&P 500, while bottoms in the put-call ratio tend to match tops in the S&P 500.
David Larew at Thinktankcharts has highlighted 0.60 and 0.71 as levels with which to ride the trend of bullishness or bearishness respectively in the market. At the same time the chart shows that above 0.75 shows excessive bearishness and 0.45 as showing extreme bullishness. These extremes are what have coincided with reversals in the stock market.
Interestingly, it can be noted that over the course of the bull market of 2019, sentiment remained overall quite cautious. The put-call ratio fluctuated in a narrow range between what has been termed a ‘topping level’ and ‘bottoming level’. With the benefit of hindsight, and perhaps the use of a moving average at the time, the best signals were to buy the dips at the bottoming levels in line with the major bull trend.
This contrasts with the ratio readings today, which have become extremely low on four occasions that coincided with short term tops and its current reading is the lowest in 20 years.
How to use the put-call ratio
While the put-call ratio can be used a ‘trend confirmation’ tool by going with the bullish or bearish crowd, what we are interested in here is how to use it as a contrarian indicator. We want to use the indicator to know if the market has gotten too bullish, and the ratio is ‘too low’ - offering an opportunity to sell at the highs.
Here lies the problem with any so-called ‘leading indicator’. The signal to buy or sell can ‘lead’ the market by a long time, and can in fact be misleading. Put another way, the signal is often early and sometimes wrong.
The choice is either to
- Get in early and get ready to absorb unknown losses for the period in between the signal and the time the market reverses OR
- Wait for a confirmation that the signal is right by the put/call ratio coming off the extreme level, which will likely coincide with the market coming off its high or low.
Getting in early is simple enough. When the put-call ratio reaches an extreme, start to position your portfolio or your trades more bearish.
Waiting for confirmation has some more nuance. Going back to the work of Thinktankcharts, Larew has given the example of applying a Bollinger band to the put-call ratio.
Here you can watch for the put-call ratio to move 2 standard deviations away from its 20-day average (as represented by the top and bottom bands) and then wait for it to move back inside the band again to offer a more finetuned but ‘later’ entry.
Different this time?
As we will note once again, there is no silver bullet and using the put-call ratio is not always useful for timing your investments. What are some of the reasons to think that it may not work this time?
Ironically, the biggest reason to ignore the put-call ratio is the ‘Fed Put’. One can make the argument- and many are -that while unprecedented levels of liquidity is being added into financial markets via interest rates at zero (ZIRP) and quantitative easing, it is illogical to sell financial assets, no matter how far they have come already.
Here we will revert back to the same conclusion we reached in our blog The CAPE ratio has surpassed the roaring 20s! Is value investing dead?
If your trading style is shorter term and you are looking for growth and momentum, this very low put-call ratio is a sign of a very strong market. Sentiment statistics can remain ‘stretched’ for a long time. However, if your timeframe is a little longer term, this two-decade extreme reading is another reason to turn more cautious about your expected future returns.
Remember, the ratio is not a ‘market timing’ indicator because as Keynes said ‘markets can remain irrational longer than you can stay solvent’.
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