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December 06, 2002

Trading The Put/Call Ratio
by Adam Hamilton

The Great Game of Speculation often reminds me of an ever-escalating arms race.

Each individual speculator trading deploys his scarce and precious capital into a vast, unforgiving marketplace. These speculators making bets pit their own emotional fortitude and raw intellect against countless other speculators in the modern financial equivalent of ancient Roman gladiatorial combat.

These capital gladiators willingly enter the financial-market arena fully realizing that only one winner will leave. Either a speculator will emerge victorious with a win or his counterparty will carry the day and vanquish the speculator. Unlike investing, in pure speculation only one side of a trade can be a winner. Only one gladiator remains standing when the dust clears from the battlefield and the trade is settled.

With this binary nature of speculation in mind, speculators are constantly searching for new weapons that might give them an edge. In today's financial gladiatorial combat the weapons of traders are not wickedly-sharp iron swords or spiked clubs, but superior information. In theory the speculator armed with the best information has the highest probability of victoriously riding out of a successful trade on a mighty white steed.

In reality it isn't really this simple though. A speculator can possess fantastic information, but if he lacks the courage and emotional fortitude necessary to execute the trade at the very contrarian moment when everyone else thinks it is a foolish idea, the speculator will fail. For example, pretty much every serious student of market history fully realized the NASDAQ was in unprecedented bubble territory in early March 2000, but how many had the raw guts to sell short at NASDAQ 5000? Not many.

The perpetually-escalating speculators' information arms-race does indeed equip prudent speculators with some powerful financial weapons, but they can only be wielded successfully by a speculator with the right training.

The best training is years of actual trading, as the markets are relentless at exposing every one of our own individual emotional weaknesses, ferreting out every chink in our armor. Only by winning and losing your own scarce capital in the brutal real world of speculation can you learn to suppress the inherent greed and fear warring deep within your own heart.

Not surprisingly it is their own painful battle scars that bring priceless wisdom to accomplished speculators!

While information research is admittedly no substitute for real-world trading experience, it is still important for speculators to be armed with the best trading tools available. Like all speculators, at Zeal we are constantly searching for new information arms to add to our own speculation arsenal. The more good, solid tools we can command, the higher our probability of executing successful trades.

One trading tool we have been discussing and monitoring for our clients in our Zeal Intelligence newsletter in recent months is the Put/Call Ratio (PCR). Like the venerable VIX implied volatility index we constantly watch like hawks, the PCR is a very useful addition to any speculator's quiver. While it is not perfect, when used in concert with other trading tools it can really help speculators buy low and sell high with greater consistency.

The Put/Call Ratio is simply the number of put options contracts traded in a given day divided by the number of call options contracts traded that same day. The put volume divided by the call volume yields the Put/Call Ratio.

As I discussed last week in "QQQ Options Trading 101", speculators use put options to bet a certain index or security is going down and call options to bet they are going up. Each day some speculators believe they can earn a profit betting on put options and others believe that the prudent bet at the moment is call options. At the end of each day all these individual trades are tallied up and collated.

The custodian of the Put/Call Ratio is the venerable Chicago Board Options Exchange. The CBOE was founded in April 1973 and revolutionized options trading by standardizing options so they could be traded on exchanges just like any other security. More options contracts are traded through the CBOE each day than on any other exchange on Earth. The CBOE claims that 51% of all options traded in the US and 91% of all index options trading volume runs through it.

At the end of each trading day the folks at the CBOE add up all the put options and call options traded on both specific stocks and broad stock indices. The total put volume is divided by the total call volume, and the Put/Call Ratio is reported.

You can see the PCR for yourself each day by visiting http://www.cboe.com/MktData/default.asp and then scrolling down halfway through the page to find and click on the small "Final volume and open interest can be found here" link. At the top of the new page that opens with a long list of interesting options stats the Put/Call Ratio is reported for the whole speculation world to see.

While the raw PCR data itself is usually phenomenally volatile day-to-day, seemingly random market noise, the PCR gets really fascinating when a moving average is applied to the raw data. Our first graph this week shows the elite S&P 500 stock index in blue superimposed over the chaotic raw daily PCR data in dark gray and a 21-day moving average of the PCR in red. The yellow trend-pipe of the PCR 21dma can be a very valuable weapon for speculators' arsenals.

Each bounce point of the PCR 21dma within its trend channel above is marked with a yellow arrowhead and a number, odd on the lower support line and even on the upper resistance line. The identifying number by each arrowhead corresponds to the same number on the blue S&P 500 line itself to make the two data series easier to visually compare.

For example arrowhead 1, the first time in the approximately two years shown above when the PCR 21dma bounced off its bottom support line, corresponds with the 1 far above on the blue S&P 500 line. Intriguingly, the very day the PCR 21dma bounced would not have been a bad moment at all to short the S&P 500, as it was on the verge of plummeting another 20% in the next 43 trading days!

If you examine arrowheads 3, 5, 7, and 9 you will note that they all also marked great, yet not perfect, moments in time to profitably short the S&P 500. Each time in the past two years the PCR 21dma has bounced near its bottom support line, the US stock markets have fallen in the following weeks or months, sometimes quite dramatically. Generally a low PCR 21dma within its trend pipe is a signal for speculators to short the US stock markets or sell calls and buy puts in anticipation of another downleg.

As I discussed in more depth in the new December issue of Zeal Intelligence just published for our subscribers, it is also quite provocative to note that today the PCR 21dma is once again hovering right on the bottom support line of its recent uptrend, arrowhead 11 above. This obvious short signal in the context of recent-past PCR 21dma behavior could have profound implications for speculators. It definitely merits careful consideration as speculators try to divine whether or not our current bear-market rally has already galloped far enough to run out of steam.

Conversely, if you look at the top resistance line of the PCR 21dma uptrend channel above, you will note that a bounce off these levels generally threw off a profitable buy signal for speculators. Arrowhead 2 above occurred only 3 days after the S&P 500 bounced in April 2001 on its way to a spectacular 19% bear-market rally in only 32 trading days! Going long on this PCR 21dma peak would have been a very profitable strategy.

Similarly, the PCR 21dma upper resistance line bounces 4, 6, and 10 above also proved to be excellent, yet not perfect, moments to go long. Generally a high PCR 21dma within its trend pipe is a signal for speculators to buy the US stock markets or sell puts and buy calls in anticipation of another bear-market rally.

While the PCR's short signal at the bottom is pretty solid, its long signal at the top is not quite as clear. Note above that there are a couple possible upper resistance lines for the PCR's uptrend channel. We drew the potential primary one in larger yellow dots and the secondary slightly lower one in smaller yellow dots. These dueling resistance lines significantly complicate the task of using the PCR in real-time for signaling long entries.

For instance, does a trader throw long the instant the lower top resistance line is breached or hold out for the upper one to be hit? Either decision could be right or wrong at any given moment and adds significant uncertainty to trading the PCR 21dma.

Farther complicating the PCR's long signals above is the vexing arrowhead 8. This short-term top of 0.92 occurred on June 24th, 2002 when the S&P 500 closed at 993. While a short-term PCR top is usually a long signal, a speculator who went long on this June 24th signal would have been slaughtered. The S&P 500 plunged another 20% in only 20 trading days right after arrowhead 8 above, not a pretty picture for anyone deployed long or in call options.

So just like most other weapons in speculators' arsenals, the Put/Call Ratio is very useful but not the Holy Grail of the art of trading. Most of the time in the past couple years it has worked really well, but it doesn't always throw off the correct signal, such as right before the surreal summer mini-panic we witnessed in July 2002.

Interestingly though, the PCR 21dma does seem to mark shorting entry points rather well, even if it is not always right on the long side. If you recall some of my recent discussions of the VIX in other essays, you may remember that the VIX marks long entry points extraordinarily well, but is not precise on shorting entry points. So perhaps the PCR 21dma and VIX can be married together to help speculators achieve superior timing for both their long and short trades!

Like any good marriage, the strengths of the PCR 21dma compliment the weaknesses of the VIX and the strengths of the VIX complement the weaknesses of the PCR 21dma. Maybe it is a match made in speculation heaven! This idea is definitely worthy of further exploration in future essays and newsletters.

Finally, it is worth taking a careful look at the dark-gray raw PCR data shown above. The daily PCR is incredibly volatile and great caution should be exercised when trying to interpret one daily number alone in isolation. For example, on August 17th, 2001 the PCR soared to 1.07 out of the blue, a very high level. Yet, on that same afternoon the smoother PCR 21dma at 0.72 wasn't even close to the top of its trend channel. The US markets wouldn't bounce until a month later on September 21st.

Daily raw PCR extremes certainly aren't worthy of much special attention.

A low daily PCR thus far in 2002 runs below 0.60 and a high daily PCR above 1.20. This oscillation between 0.60 and 1.20 seems to be about the general PCR range these days. These extremes can happen almost anytime, almost regardless of where the PCR 21dma happens to be at any given moment. In light of this observation please remember that daily PCR data in isolation is immensely volatile and it should be smoothed-out in some kind of moving average in order to render it a useful speculation tool.

How does the PCR 21dma stack up as a timing tool for tactical speculations in the ubiquitous and hyper-volatile QQQs? Pretty darned good!

As you can see above, every PCR 21dma short signal proved to be excellent for QQQ speculators. It remains to be seen whether our current arrowhead 11 today will mark a near-optimal time to short for the next few months, but I suspect the PCR 21dma's short signal will once again vindicate itself. It will be interesting to watch the markets unfold in the coming months and see if the PCR 21dma was right yet again.

Conversely, the PCR 21dma does throw out some excellent long signals for QQQ traders, but unfortunately they are more ambiguous with the double-vision of the hard-to-place top resistance line for the PCR 21dma's uptrend channel. Also, just like with the S&P 500 discussed above, arrowhead 8 was not the right time to go long the QQQs in the summer of 2002 as they still had quite a bit of short-term downside left ahead.

Nothing in speculation is ever a sure thing, so great caution must always be exercised. Perhaps QQQ speculators should consider using the VIX for their long entry signals and the PCR 21dma for their shorting entry signals. Just like the gladiators in ancient Rome, a speculator who has trained using more than one trading weapon is a fearsome and formidable opponent. One trading weapon can compensate for the weaknesses of another and vice versa.

Sure, the Put/Call Ratio is certainly interesting but why does it seem to work? In one word, emotion!

It never ceases to strike me as ironic, but in speculation all roads lead to emotion. We silly humans, and I too am personally a huge offender, spend tens of billions of dollars a year trying to figure out which way the markets will meander next. Whole corporations, incredibly intelligent people, and countless high-end computer time is dedicated to trying to forecast the markets as if they were mechanical and inherently predictable like some giant grandfather clock.

Yet, it is not fundamental realities that drive short-term market movements, but pure emotion. Warren Buffett continually declares that one doesn't have to be a rocket scientist to be blessed with success in the markets, all one has to do is understand herd psychology and investor emotion!

For speculators, emotion is both the boon and bane of their very existences. Everyone else's emotions are wonderful for speculators because they create gaping short-term market inefficiencies that speculators can exploit for great profits. Emotion is a sharp double-edged sword though. While speculators love others' emotional trading, if they emotionally trade themselves they are doomed. Greed and fear are lethal for an individual speculator if they are allowed to run free within the speculator's own heart.

The Put/Call Ratio is a useful contrarian speculation tool because it provides a proxy for herd psychology, general speculator emotion at any given moment in time.

When the majority of speculators get scared, they tend to buy many more put contracts in anticipation the markets will plummet even farther. The PCR rockets up on the heavy put buying, marking times of extreme general fear. As all contrarians know however, it is these very times of great fear when a bounce is imminent! When everyone else is scared is exactly when a speculator should be going long or buying calls. This is why high PCR 21dmas on the graphs above mark long entry points.

Conversely, when the markets have already been rallying for a while immense general greed and complacency sets in like a malignant cancer. Market participants somehow seem to magically forget all their past hardships and suddenly assume that trading is easy. Dollar signs cloud their eyes and they run out to buy call options aggressively betting the markets are going to soar even higher. As call options trading eclipses puts, the PCR plunges. This is why low PCR 21dmas on the graphs above mark excellent short entry points.

Once again, I defer to the great Oracle of Omaha Warren Buffett who wisely declares, "Be brave when others are afraid, and afraid when others are brave."

When the PCR 21dma soars, fight the terrified put-buying crowd and buy calls. When the PCR 21dma plummets, buck the frenzied call-buying herd and buy puts. Ruthlessly exploit your counterparty's own uncontrolled fear and greed!

The thundering herd is always wrong at the turning points as most people are blinded and enslaved by their own emotions. The prudent contrarian speculator actively suppresses his own emotions so he can capitalize on the emotional mistakes of the majority to earn large speculative profits.

The Put/Call Ratio helps speculators discern when general greed or general fear has become so great as to be unsustainable, and the speculator can then deploy capital to reap the big profits when the emotional pendulum inevitably swings back away from its current extreme in the opposite direction.

The Put/Call Ratio is yet another solid weapon within a speculator's arsenal to time trades to take advantage of unsustainable extremes in herd psychology.

Adam Hamilton, CPA
Zeal LLC.com

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If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

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Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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