Interpreting the Put/Call Ratio & What Many Misunderstand

When something unusual develops in the market, especially when it relates to sentiment, we see FinTwit and financial media jump all over it. Sometimes this can be a good thing but most of the time it’s done without a true understanding of what it is or what it means. The topic du jour? The very low CBOE put/call ratio. The ratio fell last week under 0.45, meaning there were less than half as many puts purchased as calls. This level was previously breached back in 2014 and 2011, each time appears on a chart to have been purely noise as the equity market didn’t ‘react’ to the (what was and is thought to be) froth in option activity sentiment. The put/call ratio can be a useful tool but it’s often misunderstood.

The put/call ratio is something I do pay attention to and reference quite a bit in my Thrasher Analytics letter, but not in the way that appears much more popular – in its raw form. I prefer to look at the daily ratio smoothed by various moving averages, providing a clearer picture in the overall trend in option sentiment. The specifics of the MAs I use aren’t important, in fact I originally showed them in the charts below but have sense gone back and taken them out to prevent the focus being on replicating the charts instead of the concept.

The put/call ratio typically moves inversely to the equity market. Which makes sense, as price moves higher, sentiment does too and with it more interest in call options vs. put options. Just like many other gauges of investor sentiment rise and fall along with price (margin debt, AAII, NAAIM, II, DSI, whatever alphabet soup indicator you’d like). Higher prices >>> more bulls. About this time, you’re probably think, “but when sentiment gets too high is when markets peak!!!” Is it? Let’s look at the last ten years….

There’s been four major declines in the equity since 2009: 2010, 2011, 2015, and 2018. AAII % Bulls peaked in August 2009, equities peaked in April ’10; sentiment peaked in December ’10, equities in April ’11; sentiment in November ’14 and equities in May ’15; sentiment in January ’18 and equities in September ’18. Sentiment often (not always!) peaks BEFORE price does. Which should theoretically make sense – sentiment tops out and with less bullish traders to sustain the up trend, price peaks and turns lower.

So why should option sentiment be any different? It’s not. At least not in my opinion. When correlation changes is what catches my attention. If something has a negative correlation to equities and that relationship hasn’t changed, then where’s the need for alarm bells?

The same idea applies to volatility. In November I wrote a post titled, “How Often Does The VIX Spike From a 3-Month Low?”, showing that it’s not when volatility is declining that preceding spikes higher but when volatility has begun to rise, simplistically explained/caused by less bullish S&P 500 option activity. Look at one of the largest spikes in recent history: January 2018. The VIX began rising since January 4th, several weeks before the February 5th spike. I’ll touch more on this at the end of this post.

Back to the put/call ratio, let’s look at some examples…

The chart below shows 2010 and 2011. Notice the black line at the bottom, a smoothed put/call ratio hits a low (red dotted lines) before the equity index hits a peak (green dotted line). The smoothed ratio made a higher-low by the time equities made their final thrust higher.

Next is 2014 and 2015. Same type of action – option sentiment correlation begins to rise – as more puts are purchased than calls  along with a rising equity index – ahead of any material decline in the index.

What about quick drops like in January 2018? Same story. The ratio bottomed ahead of the drop in stocks. It happened again before the Q4 ’18 drop and the brief dips over the last years. Which takes us to today, correlation remains negative between the smoothed ratio and the S&P 500. As I discuss in my Thrasher Analytics newsletter, I look for changes in this relationship, specifically when the sentiment shifts and a greater interest for puts brings the ratio higher, signaling the potential for less bullish price action.

With that said, while the put/call ratio can be a useful tool, it’s not a holly grail. A rising ratio doesn’t mean the market will crash. In fact, we saw a slight rise in November of this year that was ‘fixed’ by the 3-day dip in stocks which was quickly recovered over the last month. The point I’m here to make is to evaluate the WHY. Why is the indicator or data doing something? Is this normal? What’s history say when this indicator or data has done this in the past? Critical thinking can be a wonderful skill.

Back to volatility….

If you’ve been a reader of mine for any period of time you know volatility is something I spend a great deal of time on. So, I’d hate to not leave you with a VIX chart that fits snugly into the topic discussed above. Just like the put/call ratio, the VIX typically has a negative correlation to the equity market. Which is why, as I wrote back in November, the VIX declining is normal, it should go lower when stocks are going higher, that fits its historical correlation picture.

But that picture has recently changed. Over the last two weeks as stocks have been rising, so has the VIX. Just eleven previous times has the VIX had a ten-day correlation over 0.4 while itself being positive over the last week (I add this second criteria to focus on when VIX is rising with the market, excluding when volatility is declining with SPX).  Does this suggest an immediate expectation for equities to fall? No. But it does raise a yellow flag as a change in character for the market. An indicator, this time the VIX, has experienced a shift in its historical relationship with the market. The work doesn’t end there but I will leave it there for today.

If you’d like to receive more research and commentary like this, I’d suggest checking out my weekly letter I send to subscribers at www.thrasheranalytics.com

Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.