denote that it’s an index):Banking ($BKX)Japan ($JPN)Morgan Stanley High Tech ($MSH)Nasdaq-100 ($NDX)Oil Service ($OSX)Pharmaceutical ($DRG)
Russell 2000 ($RUT)Semiconductor ($SOX)Utility ($UTY)Gold & Silver ($XAU)Natural Gas ($XNG)Oil & Gas ($XOI)
The categories represented in the preceding list are fairly selfexplanatory. Specific details of the components of each sector indexcan be obtained from the web site of the exchange where they aretraded— generally the CBOE (www.cboe.com) or the AMEX (www.amex.com). These sector indices are similar to the broad marketindices in that they don’t actually exist—an investor can’t buy sharesof $SPX any more than he can buy shares of $SOX. However, hecan buy options on these indices. He can also, in many cases, buyETFs, which mirror the performance of the index.Exchange-traded funds, in fact, may have listed options of theirown. This is particularly true of HOLDRS (which trade on the AMEXand are unit trusts comprised of shares of stocks in a similar sector)and many iShares (ETFs listed by Barclay’s Global Investors(www.ishares.com), which can be found on a large variety of indicesand sectors. For example, many of the Russell or Wilshire indices
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(Russell 2000 Growth or Value, for example) are exchange-listed inthe form of iShares, and many have listed options. While the liquidityof the options on most of these ETFs is small, they are useful in trading signals from the index options themselves.Let’s say that you spot a put–call ratio buy signal on the MorganStanley High-Tech Index ($MSH). The index itself might be traded at500, and an at-the-money option might cost 20 points ($2,000) ormore. For more volatile indices, like the $SOX, at-the-moneyoptions have sometimes cost 50 or 60 points during highly volatiletimes. For most ordinary investors, these options are too expensive—in terms of price, not necessarily in terms of implied volatility—to be useful trading vehicles. The bid–asked spreads are wide onthem, and it’s hard to buy a large enough quantity to be able to manage the position properly (by taking partial profits, for example).However, the sector options do give good signals. Consider Figure 4.35, the graph of the $MSH put–call ratio overlaid with anFigure 4.35$MSH PUT–CALL RATIO1300$MSH Unscaled
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unscaled chart of the $MSH itself. You can see that the put–callchart is interpreted in the same way—peaks in the put–call ratio arebuy signals for the underlying index, while valleys in the put–callchart are sell signals for $MSH. Two of each are marked on thechart in Figure 4.35.But how shall we trade these signals if we don’t have the kind ofmoney required to buy such high-priced at-the-money options? Usually, we can find an ETF that mirrors the behavior of the index andtrades at a much lower price, and that ETF may well have options,too. In this case, the Nasdaq-100 Tracking Stock (QQQ) behavesmuch like $MSH. Consider Figures 4.36 and 4.37 to verify that thetwo graphs have almost identical shapes.In fact, there is a companion ETF for any of the indices listed earlier and for many more as well. Following are the companions for theones we listed as the “best” sector put–call ratios to trade. We preferto use the weighted ratios when trading these, but the standard ratioshave been fairly successful as well.Sector/ Index
Companion ETF
Banking ($BKX)Japan ($JPN)Morgan Stanley HighTech ($MSH)Nasdaq-100 ($NDX)Oil Service ($OSX)Pharmaceutical ($DRG)Russell 2000 ($RUT)Semiconductor ($SOX)Utility ($UTY)Gold & Silver ($XAU)Natural Gas ($XNG)Oil & Gas ($XOI)
Regional Bank HOLDRS (RKH)(None)Nasdaq-100 Tracking Stock (QQQ)Nasdaq-100 Tracking Stock (QQQ)Oil Service HOLDRS (OIH)Pharmaceutical HOLDRS (PPH)Russell 2000 iShares (IWM)Semiconductor HOLDRS (SMH)Utility HOLDRS (UTH)(None necessary—$XAU is low-priced)(None)Oil iShares (IYE)
Figure 4.36$MSH WEIGHTED PUT–CALL RATIO64.920 61.260 63.590
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Figure 4.37NASDAQ-1OO TRADING STOCK (QQQ)52.125 48.875
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Using Put-Call Ratios to TradeIndividual StocksPut–call ratios can be used on individual stocks. This is a change inmy thinking since the first edition of this book was published; but Ihave come to the conclusion that as long as the stock is highly liquidand there are no takeover rumors (or other fundamental reasons thatwould influence the option volume), then the ratios can be used forprofitable sentiment-based trading. If weighted ratios are available,that would be even more preferable.Let’s begin by looking at one of the most liquid stocks, Microsoft(MSFT). In the spring of 2000, the Justice Department’s antitrustcase was being tried, and high-tech stocks were under great pressurefrom heavy selling by Soros and others. This action led to some goodtrades based on put–call ratios.Figure 4.38 shows the chart of MSFT stock from the summer of1999 to the summer of 2000. Figure 4.39 shows the standardput–call ratio at that same time. There are several buy and sell signalsmarked on the charts. The first two signals—a buy in June 1999 anda sell about a month later—weren’t particularly good signals. This ispar for the course where stock option put–call ratios are concerned:they have a lower winning percentage than, say, the equity-onlyput–call ratio does for predicting the broad market. However, a double or triple buy signal was generated at about the 80 level in theOctober–December 1999 time period. While it took the stock awhile to get moving, it did finally explode to the upside in December—making those most recent buy signals nicely profitable as MSFTmoved from 90 to 118.That December 1999 rally brought all the speculators back in,and the put–call ratio plummeted as they bought calls. Finally, rightaround the new year, the put–call ratio bottomed and generated asell signal. It was a profitable signal, too, as MSFT fell from 118 backto the low 90s. One would have probably been stopped out by a trailing stop or by the next buy signal that occurred on about February 1,2000. This buy signal came from a low level on the chart (about 50);but it was eventually a good one, as MSFT rallied once again—fromthe low 90s back up to 114. Note that this particular buy signal waspremature, as the stock really didn’t rally until March 1.
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Figure 4.38MSFT: 1999–200080.000 77.000 77.750
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In any case, the most important signals were about to occur.That March rally (while the Nasdaq Composite was making all-timehighs) brought in massive call buying; and the put–call ratio fell below30 in late March, before generating a sell signal. Actually, the sell signal missed the actual top by a little ways, but it did arrive when thestock was still at about 104. At that point, the freefall began, and thestock collapsed to 62.All the while, puts were being heavily bought, and the put–callratio rushed back up to the highest level on the chart, 90, in earlyJune 2000. So in just a matter of a couple of months, the public hadgone from being the most bullish they had ever been regardingMSFT to the most bearish. This is ideal action for contrarians, and itwas accurately reflected in the put–call ratios. At that point (June2000), the put–call ratio suddenly topped out, as wrong-way specu-
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THE PREDICTIVE POWER OF OPTIONSFigure 4.39STANDARD MSFT PUT–CALL RATIO
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lators had their fill of puts and a buy signal ensued—a buy signal thatsubsequently saw the stock jump from 62 to 82.Thus, the standard put–call ratio had delivered four excellent signals, one marginally profitable signal, and two that were probablyinsignificant (the first two). This is an excellent track record for astock’s put–call ratio. Now, let’s look at the same time frame for theweighted put–call ratio (Figure 4.39A).The one outstanding feature on the weighted chart is the buy signal near June 1, 2000. Bearish sentiment had grown so rampantthat the dollar-weighted ratio rose to 320—meaning $320 werebeing spent on puts for every $100 being spent on calls. This wastremendously pessimistic, and it was an alert to traders who followthese sentiment indicators that they should, indeed, pay attention tothe next buy signal. As we already know, that rally took MSFT fromabout 62 to 82.
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Ratio
Figure 4.39AWEIGHTED MSFT PUT–CALL RATIO32030028026024022020018016014012010080604020
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The huge spike in the weighted ratio reduced the previous signalson its chart to nearly meaningless gibberish, since they are allsquashed down near the bottom of the graph. In real time, several ofthem had been excellent signals in their own right; but from this viewof the situation, only the extreme nature of the last buy signal standsout. This is another excellent example of how weighted ratios cangive more extreme readings and, thus, highlight a tradeable situationmore clearly.These are the stocks that, as of the time of this writing, were thebest on which to utilize the put–call ratios for trading:America Online (AOL )Alliant Technology (ATK)American Express (AXP)Boeing (BA)Citigroup (C)
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Cigna (CI)Chevron-Texaco (CVX)Cisco (CSCO)Dell Computer (DELL)Walt Disney (DIS)Eastman Kodak (EK)General Electric (GE)General Motors (GM)Hewlett-Packard (HPQ)IBM (IBM)Intel (INTC)Johnson & Johnson (JNJ)Coca-Cola (KO)Lockheed-Martin (LMT)McDonald’s (MCD)3M Company (MMM)Merck (MRK)Microsoft (MSFT)Pfizer (PFE)United Technologies (UTX)Wal-Mart (WMT)Of course, other stocks respond well to signals from time to time,but these are the ones that have consistently seen a good trackrecord of signals, especially from the weighted ratios.One good rule of thumb to follow before making any put–calltrade is to look at the signals over the past year and see how manyhave been profitable. If most have, then that’s a good sign to goahead and trade the next signal. However, there will sometimes beoccasions when most of the signals have not been good at all. In thatcase, I would avoid taking a trade in that issue. Poor signals are oftencaused by hedging or arbitrage, but they might also be caused byoccasional heavy option volume in an issue whose options are normally lightly traded. Any of these can produce bad signals, and theyshould be readily available when you look at the past year’s action.Let’s conclude this section on stock option put–call ratios bylooking at another chart to illustrate how the weighted ratio can
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sometimes clear up a murky picture by eliminating a lot of “noise”(i.e., bad signals). For this purpose, let’s look at some Intel (INTC)charts from the 1999–2000 period. Figure 4.40 shows the standardINTC put–call chart. Note how many signals there are—too many totrade, really, because one would be lagging each signal slightly. Andwhen there are that many signals grouped so close together, it isapparent that whipsaws and losses would result.Figure 4.41 is the weighted put–call chart of INTC over the exactsame time period. Note how much smoother the graph is. There areonly a few signals, as opposed to the helter-skelter nature of the standard ratio. As might be expected, these signals were clearer and produced much better results.
Figure 4.40STANDARD INTC PUT–CALL RATIO
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THE PREDICTIVE POWER OF OPTIONSFigure 4.41WEIGHTED INTC PUT–CALL RATIO
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To summarize, put–call ratios can be profitably used on stocks,but you should be mindful of the fact that extraneous factors cancause large volume to occur in stock options and that volume is generally not conducive to contrarian analysis. It is hedging or arbitrage,but is not sentiment-based. Ideally, it would be good to be able to isolate the trading activities of small speculators alone, but that data isnot forthcoming; so it is necessary to make adjustments, to see howprevious signals have done, and to generally scrutinize the signalsbefore acting on them.
Futures Options Put–Call RatiosPut–call ratios can also be calculated for futures options. As statedpreviously, though, it only makes sense to compute such a ratio for
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one commodity or set of futures contracts at a time. Thus, to compute the gold futures options put–call ratio, add the put volume for allof the existing gold contracts (February gold futures puts, April, June,August, October, and December, for example). That total would thenbe divided by the call option volume totaled over the same contracts.The result would be the gold put–call ratio for the day. The numberof puts and calls traded is reported, subtotaled by commodity, in thedaily newspaper listing of futures option prices.Since the total volume of gold options traded in a given day is avery small number compared to OEX options or total equityoptions, you must be a little careful in interpreting the indicator.One or two large orders can distort the gold put–call ratio dailybecause volume is relatively thin. Thus, rather than interpretingeach local maximum and local minimum as a sell or a buy signal,respectively, you may be better served by looking for extreme maxima and minima as signals.Figure 4.42 is a chart of gold’s put–call ratio extending from January 1994 through August 1995. You can see that the ratio had anFigure 4.4221-DAY GOLD PUT–CALL RATIO
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THE PREDICTIVE POWER OF OPTIONS
extreme peak near 100 (point A) in August 1994. That was a goodbuy signal, as gold rallied from about 385 to 410 over the next twomonths. See the chart of continuous gold futures, Figure 4.43, toverify this.The continuous charts shown in the remainder of this chapterare constructed by sequentially linking futures contracts and eliminating the gap that occurs between them. For this gold chart, for example, during April and May, the price is that of the nearest Junefutures. Then during June and July, the continuous price uses thenearest August futures, and so forth. However, the price of eachsequential contract is adjusted to eliminate the gap that exists(between June and August futures, for example). Essentially, thischart represents the actual results a trader would have experiencedhad he bought gold futures in August 1993 and continually rolled tothe nearest contract about a month before expiration. The October
Figure 4.43CONTINUOUS GOLD FUTURES
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1995 prices (on the right side of the chart) are lower than the actualDecember 1995 gold futures prices. This is reflective of the fact thata trader would have lost some ground each time he rolled forward,since the longer-term contracts trade at a premium to the currentcontract. In a situation where the longer-term contracts trade at a discount to current contracts (T-bonds, for example), the continuousprice chart would have a higher price in October 1995 than theactual December T-bond futures. We use this continuous price chartto evaluate the signals because it reflects how a trader would havedone at any time by trading the most liquid contract over the lengthof the chart, without artificial gaps in prices.Back to our example. In May 1995, the put–call ratio reached anextreme low, getting all the way down to 20 (point B). That meansthat there were five calls traded for every put that traded, on average.That low level is certainly reflective of an extreme bullish opinion ongold. Therefore, by contrary-opinion theory, a sell signal was issued.Gold was much less volatile at that time, but it did manage to declineabout $20.So, using the extremes seems to work fairly well. But what aboutthe other two significant turning points in the gold put–call ratio(points C and D on the chart in Figure 4.42)? It turns out that thesewere good signals, also. Point C identifies a sell signal in October1994. Look again at the chart of continuous gold (Figure 4.43), andyou can see that it declined from about 390 to about 355 in January.Point D on the put–call ratio chart in Figure 4.42 is a localmaximum—a buy signal. It worked pretty well, also. Gold ralliedfrom that January buy signal to a high in April (355 to 378, approximately). Then, shortly thereafter, the extreme sell signal of May1995 occurred.Gold options trade between about 5,000 and 20,000 contracts aday normally, but occasionally volume is above that range. As optionsgo, that’s not a lot of contracts. In fact, a large wholesaler or institutional account could probably dominate the volume on any given day.Whether they would be active enough to dominate it for 21 days (thelength of the moving average that we are using) is unlikely, but stillpossible. That’s why we usually prefer to stick with only extreme readings as signals. However, you can see from the preceding charts thateven the intermediate readings (points C and D) can also present
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good trading opportunities. However, I would still caution you to be alittle more careful with the intermediate readings.Since each futures option market is more or less a separateentity, we have taken extensive looks at each one over time in orderto determine whether the put–call ratio is a useful indicator. The lowvolume markets are the easiest to eliminate. These include cocoa,the U.S. Dollar Index, copper, orange juice, the CRB Index, and Tbills. Avoid these contracts, as far as the put–call ratio indicatorgoes, because the volume is just too low to give meaningful signals. If volume should increase in any of these contracts in the coming years, then that assessment may change.There are other contracts where the put–call ratio seems to haveno correlation to the price movement of the underlying futures.These should be avoided as well. Avoid corn, soybeans, wheat, crudeoil, heating oil, and unleaded gas. For whatever reason, the maximaand minima on the put–call ratio—even at the extremes—do notcorrespond very well at all with buy and sell points for these futures.Perhaps the option volume is dominated by true hedgers; that’s usually what distorts the put–call ratio. In any case, we would not recommend trading these contracts with put–call ratio signals.Now that we’ve eliminated those, let’s discuss more profitableones. As noted earlier, gold futures can be profitably traded with theput–call ratio. Another of the best is live cattle. Figures 4.44 and4.45, respectively, show a composite chart of live-cattle futures overthat same time and the put–call ratio for live cattle over the past couple of years.Note how well the local maxima and minima—marked as buys(B) and sells (S)—correspond with the similar points marked on theprice chart. At least over this time period, the put–call ratios seem toremain fairly stable. Buys have originated with the ratio in the 110to-130 area, and sells in the 75-to-85 neighborhood.Another very good futures contract to watch for put–call ratiosignals is T-bonds. The charts of T-bond (continuous) futures pricesand put–call ratio are shown in Figures 4.46 and 4.47. The buys andsells are marked on both charts, so that you can see how they correspond. Note that this is another futures contract where all the localmaxima and minima can be used as sell and buy signals.
Figure 4.44CONTINUOUS LIVE-CATTLE FUTURES
Figure 4.4521-DAY LIVE-CATTLE PUT–CALL RATIO
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Over the time period shown, the sell signals generally originatedwith the put–call ratio in the 110-to-130 area, and the buy signals inthe 70-to-80 area. Not every signal was a winning trade, but the vastmajority of them were winners.Another contract that can be traded well using the put–call ratiosis the S&P 500 futures contract (see Figure 4.48). This is somethingof a duplication of the index put–call ratio signals given by OEXoptions, but the two can be used as a confirmation of each other.The put–call ratios for S&P 500 futures options are much higherthan the ratios for OEX options, indicating that more puts routinelytrade in this market. Nevertheless, the signals have been reliable.The next group of futures contracts that we look at have less reliable signals than those just presented. These include sugar, coffee,cotton, live hogs, and natural gas. In general, the put–call ratios on
Figure 4.4721-DAY T-BOND PUT–CALL RATIO
Figure 4.4821-DAY S&P PUT–CALL RATIO
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these five give pretty reliable signals. But the percent of winningsignals is lower than gold, cattle, S&Ps, or T-bonds.The only signals in sugar that are worth using are the extremes:either buys with the ratio well over 100 or sells with the ratio under50. Local maxima and minima at intermediate levels have notproved to be reliable in sugar over the length of time shown in Figures 4.49 and 4.50. The best signal was the buy signal in October1994, when the put–call ratio had risen to its highest point on thechart—110. Anytime the sugar put–call ratio exceeds 100, youshould be looking for it to roll over and give a buy signal. The varyingsell signals were much more modest in nature, but each was somewhat profitable.Coffee is another commodity that has had some very profitablemoves on the back of put–call ratio signals. The put–call ratios
Figure 4.49CONTINUOUS SUGAR FUTURES
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Figure 4.5021-DAY SUGAR PUT–CALL RATIO
reached a peak in March 1994. That was an excellent buy point, ascoffee exploded over the next few months (Figures 4.51 and 4.52).A sell signal then followed in July 1994, and it was a good one, too.The other buy signal—near November 1, 1994—wasn’t quite sosuccessful. The only other extreme in the put–call ratio came as a sellsignal near September 1, 1995; and that was a very profitable signalas well. Clearly, not all the moves in coffee are captured by theput–call ratio; but some very good ones are—enough to make itworth your while to keep track of the ratio.Cotton has also been very tradeable using the put–call ratios. Thefirst signal shown in Figures 4.53 and 4.54—a sell occurring in midFebruary 1994—wasn’t all that good. However, the next one was:the buy of October 1994 (Figure 4.54), which came with the put–callratio at nearly 200, was a spectacular buy and caught the beginningof the huge bull market. This buy signal is an extremely illustrativeone for another reason: it clearly shows the benefit of the dynamic
Figure 4.51CONTINUOUS COFFEE FUTURES
Figure 4.5221-DAY COFFEE PUT–CALL RATIO
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Figure 4.53CONTINUOUS COTTON FUTURES
Figure 4.5421-DAY COTTON PUT–CALL RATIO
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approach. By waiting until the put–call ratio rolled over and headeddown, a trader would have avoided getting in too early. The put–callratio was not anywhere near that extreme level at any other time inthe two years of data; and it may not be again for a long time.A poor sell signal occurred in February 1995, but the followingbuy signal in April 1995 was another excellent signal. Note that thisbuy signal came at a much lower level —160. Then, just to show thatthe cotton put–call ratio can issue a good sell signal, the sell of lateJune 1995 was a nice signal. Finally, the last buy signal—which camefrom a lower extreme when compared with the other two buy signals—near September 1, 1995, was a good one as well. Note that thesells generally emanate from the 50-to-60 range on the put–call chart.However, the buys all came from different levels; so while the staticapproach might have worked for the sells (which signals, by the way,were not as good as the buys), the dynamic approach is the only onethat would have gotten you in at the right time on the buy side.Sugar, coffee, and cotton are somewhat related. Futures traderswho trade one of these markets often trade all three. However, thefourth member of the group of “pretty good” put–call ratio signals islive hogs. Since live-cattle options have a useful put– call ratio, it isnot unusual to find that live hogs do as well.The first signal that we see in Figure 4.55 is in February 1994,when an extremely good sell signal was issued. Eventually, optiontraders switched sides, and the put–call ratio peaked, issuing a shortlived buy signal in June 1994. As you can see from Figure 4.55, thechart of continuous prices, a quick rally en