Follow the Put/Call Ratio for Market Turns
The Put/Call Ratio (PCR) is a useful tool for highlighting potential areas where the market may turn up or down. The PCR compares the volume of put options to call options, and the indicator is used as a gauge of market sentiment. The PCR should always be used in the context of price and not a sole indicator. The Put/Call Ratio can be found at the CBOE website under daily market statistics, and it is also available as an indicator on many charting platforms.
When the Put/Call Ratio is above 1.0, more puts are being bought and the sentiment is more bearish; when the PCR is below 1.0, more calls are being bought and the sentiment is more bullish. The PCR works best at extreme readings where it highlights a high degree of pessimism or optimism. The basic rule for the PCR is that a buy environment exists when the ratio is relatively high and a sell environment when the ratio is relatively low.
In the chart of the S&P 500, once can see where spikes in the PCR gave insight into the fear factor. From left to right, the first arrow was a good buy point. The second arrow was a buy point, but it led to a range period. The third arrow was another good buy point occurring on a higher low at the 50-period moving average (blue). The fourth arrow shows the heavy buying of puts as the market was in a range pattern; in this case, the sentiment was well-founded since the market subsequently entered a correction.
It is important to understand that the PCR measures sentiment and not price direction. Sentiment often runs counter to price, but sometimes sentiment supports price. To make sense of the PCR, look at the trend condition (trending, range) and assess whether or not the fear (or optimism) is supported by the technical analysis.
If the PCR spikes while price makes a higher low in an uptrend, it is a potential buying opportunity. If the PCR spikes during a range period, it could mean that puts are being bought just to be safe, but it could also mean that the market is perceived as high risk for a correction (this was the case in late January 2014).
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