Over the past month or so, I’ve often referenced the trading signals from the CBOE Put/Call ratio (CPC). This is a ratio that compares the number of puts traded each day to the number of calls traded.
I use this information as a contrary indicator, so I tend to get more bullish as the CPC rallies (meaning investors are buying many more puts than calls). And I get more bearish as the CPC falls (meaning investors are buying many more calls than puts).
The CPC has been quite a reliable indicator over the past several weeks. And that prompted the following question from a reader…
Jeff, I went to the CBOE website and I see there are numerous put/call ratios, i.e. index put/call ratio, exchange-traded products put/call ratio, total put/call ratio and equity put/call ratio. As of 7/31/18 the equity put/call ratio is .69, extreme optimism; however, the exchange-traded products put/call ratio is at 1.38, extreme pessimism. The index put/call ratio is 1.21, extreme pessimism, and the total put/call ratio is 1. These are giving contradictory signals. Who’s to say which one is correct?
– Edward
This is a great question, Edward. The short answer is that I follow the total put/call ratio because it has the most consistent trading range and it is the most reliable contrary indicator.
Here’s the long answer…
It is probably helpful to know what type of investor typically trades which type of option. For example, institutional investors tend to trade index options as opposed to options on individual equities. Institutions often buy index puts to hedge their entire portfolios, or they sell covered calls on an index in order to generate income on their portfolios.
Since institutions are often seen as the “smart money” in the stock market, we can’t really use the index put/call ratio as a contrary indicator.
Individual investors (aka the “dumb money”) tend to trade individual equity options. These trades are usually speculative option purchases. That’s what makes this ratio a good contrary indicator.
Both institutions and individuals trade options on exchange-traded products. So, both the smart money and the dumb money are involved here.
Given this information, perhaps we ought to be paying more attention to the equity-only put/call ratio (CPCE) as a contrary indicator. In my experience, though, I’ve found that the trading signals from the total put/call ratio (CPC) are more consistent.
For example, I know that whenever the CPC pops above 1.20, investors are getting quite bearish and the market is likely to bounce. And when the CPC dips below 0.80, investors are too optimistic. The market is likely to decline.
I’ve followed the CPC for more than 20 years. So, I’m comfortable with interpreting the signals from this ratio.
The equity-only put/call ratio (CPCE) has only been around for about half as long. And the trading range seems to contract just a little every year. In other words, the trading range for the ratio gets smaller and smaller. So, it’s harder to define exactly what an “extreme” level on the CPCE looks like.
Keep in mind, though, I don’t rely solely on the CPC for trading decisions. It’s only one of maybe a dozen or so daily indicators I look at. When extreme readings on the CPC confirm extreme readings on other indicators, I tend to pay closer attention to its trading signals.
The bottom line is I prefer using the total put/call ratio because I can clearly define “extreme” levels on the ratio. And I’m comfortable with the reliability of the trading signals.
Other analysts might have the same level of comfort and reliability following the other put/call ratios. It’s a matter of personal preference and experience.
Best regards and good trading,
Jeff Clark
P.S. Regular Market Minute readers know that the CPC has recently come back in favor. And I’m excited for it to be back in my trading toolkit.
It’s only part of how I find trades each week for my Delta Report subscribers. Even better, another rare market anomaly just showed up on my radar… signaling a huge move ahead. And I’m planning on taking advantage of it early next week.
To learn more about my technique for the current market climate – and a subscription to the Delta Report – click here.
More Mailbag
Today, a response to Tuesday’s piece, “How One Bad Idea Bought an Early Retirement”…
I think it is about the fifth time I read this one. Every time I laugh out loud. We all went through something similar, in my case I am very happy I did not learn this lesson with options (so it was less painful for me, but I learned the hard way).
I am using your service more for the long term than the short term. How can that be? One day I will write a longer mail to you. Keep on your good work and please continue to be the gentleman you are.
– Alain
And another reader, reacting to yesterday’s essay, “Good News for Gold,” shares why they’re still holding on…
I hope so, I’m lugging a dead horse around. For a long time. I increased my silver and gold holdings to nosebleed levels because of Cassandra calls for disaster looming. The “disaster” is the lack of one… and the raging bull market since Trump took power. However I do see the very clear historical markers about debt and price-to-GDP and so forth. Thus I’m sanguine and feel my holdings will save my bacon someday. The problem is gold seems to follow the dollar and sometimes it follows the markets! Confounding everyone.
Will China blink first? Logic says yes. But China is a command economy and Xi doesn’t care about his people until they are in Tiananmen Square again. So maybe not.
I also see HUGE risk of ETF meltdowns and how 99% of investors think ETFs are safe and simple. Wrong! The selling will be brutal when it starts as those funds unload everything in size and margin clerks roam like packs of hyenas. When? Keeps being pushed back. Supposed to be already on us. Now they say next year or 2020. The Fed is going to raise rates in September and December, Killing the economy and consumers! Yikes! So I’m holding my gold and silver stocks.
– Patrick
Are you holding on to gold through this downturn?
As always, let us know – along with any other questions or comments – right here. We may print your letter in future editions of our Friday Mailbag…