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December 1986 buy signal) gave a sell signal in July 1987 (Figure4.26). You may not think that’s so bad, since the market actuallypeaked in August; but the index ratio began to climb back toward the100 level by September 1987 and actually gave a buy signal at thatpoint (September 1987). Thus, if you were only paying attention tothe index put–call ratio, you were long going into the crash of 1987.The saving grace was that the equity-only put–call ratio also gavea sell in July and remained on that sell signal through the crash andon into early 1988. So even though the equity put–call ratio sell signal was early, it was correct; and it did not reverse before the crash(see Figure 4.28).Nevertheless, the index signal was a disaster. What had gonewrong? Had the public actually been right? Did they really buy somany puts during the July–September period of 1987 and, therefore, correctly anticipate the crash? I think any one who survived thecrash or even read about it knows that the public most certainly didFigure 4.2855-DAY EQUITY PUT–CALL RATIO
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not anticipate it. Therefore, the public was not buying puts beforethe crash (in fact, you may recall our comments in Chapter 2 concerning how many public customers were actually selling naked putsjust before the crash).If you think about it logically, a rising market should always culminate with lots of call buying. The public will always chase a trend, notfight it. That’s why contrary indicators work. At the exact top of amarket, the public will be displaying its most bullish sentiment. Inoption terms, that means the public will be buying calls heavily at thetop of a bull market. By logical extension, then, you would not expectto see put buying increase heavily while a market is rising; rather, putbuying should increase while a market is falling. Thus, if you do seeput buying increasing during a rising market, you should suspect thatsomething besides speculation is behind that increase in put volume.So why did the put–call ratio shoot up that summer? There isonly one plausible answer: institutions were buying puts in order toprotect their stock holdings.* In Chapter 3, we discussed how portfolio insurance played a role in the crash. Those money managerswere (theoretically) using futures to hedge their stock positions, butmany others were buying index options as protection. So, during thesummer of 1987, as the market drove into what was considered bymany to be overvalued territory, some institutions took the precaution of buying puts. This is what caused the index put–call ratio toaccelerate to the upside. Apparently, by late September (see Figure4.26), the institutional put buying slacked off, and the index put–callratio began to trend down—a buy signal.The institutions tend to buy index puts more readily than individual equity puts, because with one large buy order in OEX puts, theycan acquire a lot of protection. It would be much more work to buyputs on each stock that they own, to say nothing of the fact thatmany of the individual equity puts would be so illiquid that the institutions could not even purchase the quantity of puts they need.*Some analysts may offer another explanation: that the public was selling nakedindex puts and thus inflating the volume. True, there was some of that going on, andthe losses subsequently suffered by those put sellers made front-page news in thefinancial section. But, in reality, there wasn’t enough naked put selling to make areal dent in the overall volume figures. Institutional put buying, however, was significant in terms of volume.
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We will never know what happened to all those puts that werebought, of course, but it wouldn’t be too shocking to discover thatthey were puts expiring in October or earlier. Of course, those puts,while useful, expired on October 16, 1987, just before the actualcrash on October 19. A less cynical view, of course, would allow thatthe institutions bought puts expiring in November or December.As a further example of a put–call ratio giving an erroneous signal to the unseasoned observer, consider what happened in QQQoptions in February 2000—at the top of the biggest technology bubble in history. Nothing symbolized the bubble more than QQQ andits options. They were the object of all kinds of speculators. Theput–call ratio chart overlaid with the QQQ chart is shown in Figure4.29. Refer to this during this example.QQQ was trading up rapidly during the first two months of2000 and had reached a price of 114 by early March. At the sametime, the QQQ standard put–call ratios had risen to an astoundinglevel: it was at 750, which means 750 puts were trading for every100 calls. To some observers, this was a wildly bullish sign—thatthat many puts were trading in comparison to calls. However, tothe experienced put–call ratio analyst, this was a signal not to bebelieved; for when the put–call ratio and the underlying instrumentare both rising rapidly, something is wrong. What was happeninghere was that the institutions were very worried about the lofty levels of the Nasdaq stocks they owned, and so they bought QQQputs as a hedge.If any institution is buying puts and buying stocks and buyingputs, are they bullish or bearish? No one knows, but we do know thatsuch hedging distorts any true contrarian signal we might discern;and so the put–call ratio should be ignored in that case.To this day, QQQ options remain a favorite hedging vehicle, andso the standard QQQ put–call ratio is not a useful indicator. However, the weighted ratio is useful.Earlier, we stated that, during the early days of listed indexoptions, the index put–call ratio was considered to be the best measure of speculative activity because there was very little use of putsfor protection. Obviously, that situation changed during the summerof 1987. Index puts suddenly became a very popular item amonginstitutions, which tend to have a herd mentality about such things.
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Put–Call Ratio
Figure 4.2921-DAY QQQ PUT–CALL RATIO WITH QQQ OVERLAYIncorrect tosay that thisis bullish
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As the theoreticians were convincing some money managers of theviability of using puts, the word was spreading; and many managersrushed in to buy these puts. During the years since then, even moremoney managers routinely use index puts as a form of protection.This is why the average put–call ratio readings of index options havemoved from the 60 –100 range in the 1980s up to the 100 –130range in the 1990s and beyond.Interpreting the put–call ratio as strictly a contrary indicatorresults from the tacit assumption that most option buying is speculative and can therefore be interpreted by the contrary-opiniontheory. In reality, there are other factors at work besides speculation. Index options at first were mostly pure speculation, but thenthey became speculation mixed with protective put buying. Ironically, equity option volume in the early 1980s contained a lot ofarbitrage activity. That arbitrage activity was so prevalent that iteven distorted the NYSE short-interest figures, and technicianshad to basically give up on short interest as a means of measuringmarket sentiment. The equity arbitrage that was so prevalent inthe early 1980s has disappeared (because of competitive pressures). Equity-only put–call ratios today are clearly a superior measure of sentiment. In fact, the index (OEX) ratio is not reliable atall in today’s environment where institutional hedging with indexputs is so prevalent.Consider the quandary that arises when hedging enters the picture. When we see a lot of index puts being bought while the marketis rising, are we to interpret this as bullish because the public is looking for a top in a rising market; or should we figure that the put volume is due to institutional put buying? Almost certainly, it’s the latter,for reasons already discussed—the public doesn’t get bearish at tops,they get bullish. But, even though he knows the put volume isincreasing from institutional activity, the contrarian is still in a difficultsituation. What is the institutional manager’s true bias? Is he bullishbecause he still owns stocks, or is he bearish because he is buyingputs? This is the bane of contrary analysis—attempting to accuratelyinterpret the data being received.Before getting to more recent examples, one more historicalfootnote might be helpful. In the 1980s, the put–call ratios weremore or less static, ranging between the same highs and lows. How-
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ever, as noted earlier, with the more prominent use of puts for protection, the ratios have crept higher over the ensuing years. Thismeans that a static interpretation (such as “buy when the index ratiogets to 100, and sell when it falls to 60”) is irrelevant. In the late1980s and early 1990s, however, some technicians were still tryingto stick with their old, static measures and were especially hurt by theminibear market of 1990. In that year, the ratios were trendinghigher, so static interpreters bought the market when the ratiosreached their old, (un)reliable buy zones. This got them long too earlyand created even more bad publicity for the put–call ratio as a technical indicator. Feature articles were written about the fact that theput–call ratios just didn’t work anymore.They still work, but you must interpret them dynamically—looking for local maxima and minima as buy and sell points—and not relyon fixed numbers. In fact, a true contrarian likes to see a poor signalpublicized from time to time. It keeps the average “Joe” away fromcontrary analysis. If everyone became contrarians, then what wouldhappen? Contrary analysis would cease to work, of course. By thevery nature of the market, what the majority is doing at extremes iswrong. If the majority is behaving as contrarians, then the market willadjust for that and make them wrong. So I like it when people try topoint out that contrary analysis doesn’t work (it does, of course, butdon’t tell too many people).You will never again see the 50-day moving average of the indexput–call ratio down to 60, even if the market goes straight to themoon. The following charts contain several examples of buys andsells occurring at differing levels; however, each of those buys andsells is a turning point in the trend of the ratio (a peak or a valley).This, then, is the proper way to interpret the put–call ratios.In the next few pages, we will look at two detailed examples ofusing the equity-only put–call ratios—both standard and weighted—to predict intermediate-term trends in the broad market. The firstexample begins in the summer of 1999. Figure 4.31 shows the OEXduring this time period. At that time, the broad market had rallied tonew highs in July, fell back during a rather sharp decline into October, then rallied in two stages to the market’s all-time high in March2000 before succumbing to ferocious selling in April, which lead to abottom in May 2000.
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We will examine how the equity-only put–call ratios performed asbroad market indicators during this time. On each of these charts,the letters “a” through “e” represent buy signals, while the numbers“1” through “4” are sell signals.First, consider the standard ratio, shown in Figure 4.30. Thefirst marked signal is denoted by the letter “a” in the middle of June1999. This is a buy signal because the put–call ratio formed a peakat that time. Even though it comes at a fairly low level on the chart—about 44 (meaning 44 puts traded for every 100 calls)—it is still avalid signal. Prior to that, the trend of the put–call ratio had beenupward. Then the trend reversed—to downward. That is the dynamicdefinition of a buy signal. At the end of this chapter, we will discusshow to spot these trend changes at the time they are occurring.From Figure 4.31, you can see that the buy signal, “a,” occurred atapproximately the 660 level on OEX. A substantial 70-point rally followed in OEX, taking it up to 730. So even though the signal camefrom a level that was not extreme, it was still a powerful signal.Figure 4.30STANDARD PUT–CALL RATIO
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THE PREDICTIVE POWER OF OPTIONSFigure 4.31$OEX: 1999–200079.040 78.000
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As the market moved higher, call buying followed, driving thestandard put–call ratio down to point “1” (Figure 4.30) in July 1999.At that point, the call buyers ran out of steam, and the ratio reversedupward. This is the definition of a sell signal. You can see from theOEX chart (Figure 4.31) that it was well-timed and identified adecline in OEX from about 730 to 670—another worthwhile trade.During that decline, put buying started to accelerate, and thestandard put–call ratio rose all the way to about the 52 level beforepeaking in late August 1999—another buy signal (“b” on the charts).This signal was a little late, and the ensuing OEX rally was rathermodest but still tradeable.After this buy signal occurred, the put–call ratio began to decline,as it should. However, it wasn’t long before the put–call ratioreversed again and gave a sell signal (point “2” on the charts). Once
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again, this was a signal that did not come from an extreme level onthe chart (extreme-level sell signals would occur at the bottom of thechart). Yet once again, it was an excellent signal, as it foreshadoweda decline all the way down to the 650 level of OEX.This steeper decline came during October 1999—and traderswere mindful of the disastrous Octobers of the two previous years—so a put buying panic of sorts set in, driving the standard put–callratio all the way up to point “c” at the 55 level (Figure 4.30). Carefulobservers will notice that there was a little “wiggle” in the put–callratio in early October. That might have been considered a buy signalin real time, although it was quickly reversed. This is a good time,then, to discuss what is the equivalent of a “stop” for the put–callratio trader. If you take a signal and then the ratio subsequentlyreverses direction, you should stop yourself out of any position youhave taken. In this case, if you had bought calls when the put–callratio appeared to be turning down in early October, you would stopyourself out when it turned back up in mid-October. The ultimate buysignal came later, at point “c.”The buy signal generated at point “c” was a tremendous one, asOEX rallied nearly 150 points by December. While that was occurring, note that the standard put–call chart was declining rapidly allalong, as traders bought calls more and more heavily. During thistime, call buying was very extreme, but that does not matter to theinterpretation of the put–call ratio. One must wait for the call buyingto exhaust itself—for the trend to change. That finally occurred atpoint “3” after the ratio had fallen dramatically from 55 to 38.At that point (“3”) it reversed into another sell signal. This wasanother decent signal, as OEX fell about 80 points to 720 duringJanuary and February 2000 (Figure 4.31). Put buying didn’t reallyaccelerate much during that decline, though; and the ratio had onlyreached the 45 level (point “d”) before it reversed downward, generating another buy signal.Once again, it was important to trade this signal, even though itdidn’t occur at an extreme level. The buy signal at point “d” preceded the final, volatile run to all-time highs, with OEX exceeding the840 level in March. While that was occurring, the put–call ratio fellonce again to the 39 level and reversed, generating a sell signal(point “4”).
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At the time, of course, no one knew that this would be the top ofthe market for years to come. It is worth noting that the put–call ratiodidn’t fall to some ridiculous level, such as 10, at this important top.It did give a sell signal, of course, and that’s what’s important—notthe absolute level.No one really knew that the market was transitioning into a bearmarket at this point, but that’s what was happening. OEX began todecline modestly, and then disaster struck in mid-April as the Dowfell 700 points in one day and Nasdaq was down 500. It turns outthat George Soros had decided to dump his tech stocks, and that’swhat caused the massive decline. That was a prescient sell by Soros,of course, and it had a lot to do with changing the complexion of themarketplace. After that panic selling, the market rebounded somewhat, but traders continued to load up on puts. This heavy buying ofputs forced the put–call ratio all the way back up to 54, before a buysignal occurred at point “e” in late May.In the wake of the severe bear market that followed, most tradersdon’t remember that there was a substantial rally in the summer of2000— one that began at that May bottom and carried OEX all theway back up to 830, nearly back to its all-time highs.Thus, there were nine signals generated during this time periodby the standard equity-only put–call ratio, and all were well-timed andpreceded good-sized moves by OEX. Even if one didn’t pick up onthe signals at the exact time they occurred, OEX moved far enoughto allow for good profits anyway, since they were of intermediateterm length.The weighted equity-only put–call ratio is shown in Figure 4.32.Let’s now examine how this ratio behaved over the same timeperiod. Without going into as much detail, one can see that the firstfour signals—a, b, 1, and 2—all occurred at virtually the same timeas the standard ratio’s signals. When one is using these put–callratios as a trading guide, this is important confirmation—that boththe standard and weighted ratios agree.The next signal in Figure 4.32, “c,” occurred in early October onthe weighted chart. This was a little early, but it eventually workedout. The next signal, the sell signal at point “3,” was better timedthan the standard ratio’s signal; it came at virtually the end of the
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Figure 4.32WEIGHTED EQUITY-ONLY PUT–CALL RATIO: 1999–2000
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year, coincident with OEX topping out. Signals “d” and “4” weretimed about the same as the standard ratio.However, the next signal, “e,” shows the true worth of theweighted ratio. As was mentioned earlier, the weighted ratio oftenmoves to more extreme levels than the standard ratio does. This iswhat occurred in April and May of 2000. After Soros dumped hisstocks and panic set in, traders were not only buying a lot of puts(volume) but spending a lot of dollars on them, as they evidently wereno longer just buying deeply out-of-the-money puts as protection, buthad started buying more at-the-money puts as downside speculation.This heavy spending on puts drove the weighted ratio up to its highsin Figure 4.32— over the 100 level (which means more money wasbeing spent on puts than on calls). This extreme point on theweighted chart is definitely a wake-up call to make the trade.Not only that, but if one compares Figures 4.30 and 4.32closely, one can see that the weighted ratio’s buy signal at point “e”
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arrived in late May, whereas the standard ratio’s signal came earlierin May. The weighted signal was better timed. This is typical of theweighted ratio’s signals— often coming from more extreme signalsand often being better timed.It was briefly mentioned before that an at-the-money option isprobably the best choice for trading these signals. Of course, that is ageneral statement and could be refined in many ways. But it is essentially correct. Since put–call ratios are sentiment-based signals, theycan be wrong (as can any indicator), and they may not be perfectlytimed. We saw in the previous examples that sometimes the signaloccurred a couple of weeks early. So the best approach when tradingthese equity-only put–call ratio signals is to buy a broad-based indexoption that is at- or maybe just slightly in-the-money. It could be a callon OEX, SPX, or DJX. I wouldn’t recommend using any otherindices to trades these equity-only signals. Of course, now thatExchange Traded Funds (ETFs) are available,* one could trade thoseas well: SPY (S&P SPDRS), OEF (the ETF that mirrors OEX), or DIA(Diamonds, which mirror the Dow Jones industrials), or even theS&P or e-mini futures. The important point is to stick with thosemajor indices.I would like to include one more example— one that shows howthe put–call ratios behaved as the bear market of major proportionsset in. Figures 4.33 and 4.34 show the standard and weightedequity-only ratios, respectively, from about the middle of 2001through the middle of 2002. In both figures, an unscaled chart ofOEX is shown above the put–call ratio. This allows one to see howthe market was behaving at the time of the signals.This example won’t be discussed in much detail, but it will beused to make two very important points: (1) that the put–call ratioscan rise to extremely high levels during a bear market and (2) that atrader sometimes has to use some logic when interpreting the ratios.
*Exchange Traded Funds are created by holding in trust the actual shares of stockthat comprise an index or a sector index, thus creating a “fund.” Shares of the fundare listed on a major exchange—usually the NYSE or the American Stock Exchange(AMEX) —and the index can be traded in the same way that shares of individualstocks can be traded.
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Figure 4.34WEIGHTED EQUITY-ONLY PUT–CALL RATIO300$OEX Unscaled
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Figure 4.33STANDARD EQUITY-ONLY PUT–CALL RATIO
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Both figures begin with the summer of 2001. The market (OEX)declined slowly in June and was rather flat in July. Bullish analyststhought that this dull period was positive—that the market wouldsoon turn upward. However, as you can see, the put–call ratios weremoving higher during this time. The standard ratio finally blastedthrough the bull market highs at 55 and reached 70 by mid-July. Atthat point, around July 1, there was actually a short-lived buy signal,but it turned back to a sell signal in early August. About that time, themarket began to fall steadily, and the put–call ratios resumed theirupward march. By September 1, the standard ratio was up to 75,and both ratios were seeing heavy increases—heavy put volume anddollar volume.A week and half later, the terrorist attack occurred on September11. In the aftermath, the market collapsed, and the put–call ratio ballooned to all-time highs (the standard ratio eventually exceeded thosehighs later in 2002 and again in 2003, but the weighted ratio neverhas been that high again). The put–call ratios gave accurate buy signals right near the bottom of one of the most panic-filled declines inhistory.After that, there were repeated sell signals during the fall of 2001and spring of 2002. But skip forward to July 2002, for that is wheresomething very unusual occurred—but it is something that we wereable to discern while it was happening, and it could happen again. InFigures 4.33 and 4.34, you can see that both equity-only put–callratios gave buy signals right about July 1, 2002. These were woefullypremature, as the market plunged that July, in one of the largest selling waves in memory. What had happened? Why were these signalsso wrong?First, let me point out a general rule that will always serve youwell when interpreting put–call ratio charts of any type: don’t fight aprice trend just because the put–call ratio gives a signal. Wait forsome technical confirmation from the underlying: perhaps just ahigher-high, lower-low sort of pattern or an upward penetration ofthe 20-day moving average—anything to indicate that a steep downtrend might be ended. In this case, since the market was virtually collapsing in July 2002, we did not actually buy anything, even thoughthe put–call ratios gave buy signals.
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But the bigger of the two questions is, “Why?” To answer thatquestion, think about what causes a put–call ratio to decline—and,thus, give a buy signal. Typically, the ratio is high because put buyingis rampant; and then when the put buying wanes, the ratio begins tofall and a buy signal is issued. However, since the put–call ratio is afraction, there is another way that the put–call ratio could decline:call volume could increase (call volume is in the denominator of thefraction and would thus cause the ratio to decline). It is rare for this tohappen because the public would not be thinking about buying callsas the market was in the midst of a major panic decline, as it was inJuly 2002.So what did happen? As it turns out, option premiums were skyhigh at the time, which—as we’ve already seen earlier in this chapter—is what happens when the market declines rapidly. However,the decline in the summer of 2002, coming after more than twoyears of bear market, had changed the fabric of investors. Severallarge investment houses began telling their clients to sell covered callsbecause the calls were so expensive. And so they did. Thus, call volume increased and made the put–call ratio fall. Hence, the premature buy signals occurred.We were able to discern what was happening within a week orso. On detailed examination, we saw that both put volume and callvolume were increasing during early July 2002—put volume becausetraders were panicking and buying puts; call volume because stockowners were selling expensive calls against their stock. Armed withthat information, we decided to watch put volume only as a criterionfor the buy signal. Sure enough, put volume itself peaked near theend of July, which was the actual market bottom. So, in the future,when you have a rapidly declining market and an apparent buy signalemanates from the put–call ratios while the market is still plummeting, use put volume as an aid in selecting the actual buy point. Whenput volume decreases, that should mark the bottom.Finally, in concluding this section on index put–call ratios, itshould be noted that there are other broad-based index put–callratios that can be useful in trading the market—although they are notas reliable nor as important as the equity-only ratios. These includethe OEX weighted ratio (not the standard), the QQQ weighted ratio
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(again, not the standard), and the S&P 500 futures put–call ratios(both standard and weighted are good in this market). Occasionally, Iwill also look at things like the NDX weighted ratio, the SPX ratio,the DJX ratio, the DIA ratio, and so forth; but those are very minorratios, and I would not use those as primary indicators.
Sector Index Options Put–Call RatiosPut–call ratios can be used in a similar manner for the more liquidsector options. Since sector options are quite a bit less liquid thanOEX options, you would expect the signals to be less accurate—andthey are—but they are still quite useful most of the time. At the timethis book was written, the following sectors were responding best toput–call ratio signals. The index symbol is given in parentheses (weuse a dollar sign to