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June 13, 2003

Trading the Put/Call Ratio 2
by Adam Hamilton

Six months ago I wrote an essay called "Trading the Put/Call Ratio" that explored the potential benefits to index speculators of carefully monitoring and sometimes trading on this renowned sentiment indicator.

With the benefit of another half-year of observations and insights, this week I would like to take another look at the Put/Call Ratio as a primary index-speculation indicator. It has proven true to historical form most of the time since then but has recently been behaving quite anomalously, which is perplexing and fascinating.

As I outlined in my original essay's background on the PCR, it is computed by dividing the total put-options volume by the total call-options volume traded on the Chicago Board Options Exchange on any given trading day. The CBOE is the most important options exchange on the planet as around 90% of all index options trading runs through it.

You can see the latest headline PCR for yourself an hour or so after the markets close each day by surfing to the CBOE's homepage and clicking on the "Market Data" tab on top of the page. The first number you will see on the CBOE's "Market Statistics Summary" page is the daily headline PCR number. This grand summary Put/Call Ratio represents the PCR for all the options contracts traded on the CBOE on a particular day.

While all the graphs in this essay show this headline PCR number, individual PCRs can also be calculated for specific options contracts, like the QQQ NASDAQ 100 tracking stock for example. One of our research projects in progress at Zeal right now involves exploring the potential usefulness to speculators of using specialized narrow PCRs for individual securities rather than the all-encompassing headline PCR number.

It will be most interesting to see whether pure narrow PCRs produce tradable indicators superior to the headline PCR. When we get closer to finishing this project I will probably write some future essays showcasing the results. If the specialized PCRs appear tradable, we will launch new index-options trades for our wonderful subscribers as appropriate in our private Zeal Intelligence and Zeal Speculator newsletters.

For now though, the headline PCR itself continues to offer a great deal of food for thought, especially in light of the current major rally in the US equity markets. I am going to skip a lot of the background and jump right into PCR analysis this week, but if you wish you can skim the original "Trading the Put/Call Ratio" essay to get up to speed.

As always, I still prefer to use a short moving-average of the PCR rather than the raw indicator itself. Day-to-day volatility in the PCR is mind-blowing and can be ridiculously erratic. By using a moving average, the signal-to-noise ratio of the indicator is vastly increased and it is much easier to interpret.

Just as six months ago, I still prefer the 21-day moving average of the Put/Call Ratio, or the PCR 21dma, as the primary flavor in which to digest the PCR. 21 days may seem like an odd number at first glance, but as there happens to be an average of 21 trading days in each month, the PCR 21dma is essentially simply a one-month moving average of the daily headline PCR, quite logical.

Our trio of charts this week starts with the strategic long-term big picture and zooms down to the short-term tactical scene today. Larger, more-detailed versions of a couple of these graphs that we built for internal research purposes have been posted on the Web at www.zealllc.com/charts/pcr.htm if you are interested.

We'll begin with a long-term view of the PCR 21dma with the S&P 500 superimposed on top. I'm indebted to a brilliant financial analyst from the Netherlands for pointing out these fascinating long-term PCR trends across Great Bull and Great Bear markets to me. The collective activities of options speculators and hedgers change quite dramatically as major secular trend shifts occur.

The long-term PCR 21dma presented above is fascinating from both strategic and tactical perspectives. Viewed over the long-term it offers some great insights into the collective psyche and activity of options traders as a whole across a massive secular trend change in the equity markets.

During the Great Bull, the PCR 21dma tended to trend lower. The yellow support and resistance lines above mark this rough downtrend channel. It is interesting to note the gradual, and logical, change in the collective behavior of options speculators and hedgers as the Great Bull matured.

In the mid-1990s, not long after Alan Greenspan's infamous "Irrational Exuberance" speech, both options speculators and hedgers were fairly skeptical about the soaring US stock prices and tended to trade more call options than put options, but not much more. A PCR 21dma in mid-1996 approaching 0.90 shows that call-option activity wasn't significantly higher than put-option activity at the time.

But as the US markets continued to soar and the Great Bull stampeded higher, options players gradually began to trust the bull. Options speculators realized that, in general, buying puts for speculation in a massive bull market was a great way to throw away capital, so overall relative put volume gradually declined. Options hedgers, those folks buying puts to protect their long positions in actual stock owned, also realized that they didn't need to pay the expensive price for "puts insurance" on their long positions since the bull was so powerful.

Faith in and popular acceptance of the Great Bull in options players continued to increase until the 2000 top, just as in the general public. Some rare anomalous events like the Long-Term Capital Management hedge-fund implosion of 1998 sparked huge buying in put options, but for the most part the number of puts traded relative to calls continued to decline throughout the Great Bull.

By the end of the Great Bull in early 2000, in 21dma terms the number of calls traded more than doubled the number of puts as mania psychology ran rampant! I find it fascinating as a contrarian investor to observe how precisely that popular option psychology marked the long-term stock-market top. At almost the very moment when the vast majority of options players were convinced that buying puts was a useless endeavor, the contrarian way to play was to back up the dump truck and load it up with puts until its tires burst!

The Great Bear stealthily began its vicious work when everyone and their dog were buying call options betting on higher prices for stocks and the indices in early 2000. As the chart above shows, the strategic trend of the PCR 21dma reversed upward right when the stock-market bubble tops were carved. The inherent symmetry between the Great Bull PCR 21dma downtrend and the Great Bear PCR 21dma uptrend is remarkable!

As the markets continued to grind lower over months and years following the stock-market tops and PCR 21dma trend reversal, the exact opposite psychological reaction began to manifest itself in the hearts of options players. The longer the Great Bear lingers, the more folks believe in its incredible power. Popular interest in puts, both by speculators and hedgers, has gradually grown in recent years.

Speculators have watched bear rally after bear rally shatter itself against the primary Great Bear downtrend, so they are gradually wising up to the inherent wisdom of betting with the primary downtrend by using puts. Hedgers have seen their long stock positions eviscerated by the Great Bear, so they are more and more willing to buy puts to hedge their long exposure in case another major downleg snowballs.

Even though the PCR 21dma uptrend in this secular bear has been fairly steep compared to its downtrend in the secular bull of last decade, I find it extremely provocative that to this point the PCR 21dma has never exceeded 1.00. This means that call volume has always been higher than put volume on a 21dma basis, even during the dark depths of bearish despair that rocked the markets at the interim lows of last July and October.

I strongly suspect that before this Great Bear fully runs its course that the PCR 21dma will exceed 1.00, that over at least one 21-trading-day period the average put volume will be higher than the average call volume. It is hard to imagine a Great Bear ending without the majority of market players, including the options folks, waxing overwhelmingly bearish and extensively trafficking in put options accordingly. A PCR 21dma over 1.00 will be necessary to mark those fateful days when options bears finally outnumber options bulls.

So, even if you are a long-term investor and not a gun-slinging speculator, the long-term PCR 21dma trends are worth watching to help identify early any major stock-market sentiment trend changes manifested in popular options-market psychology.

For speculators who are trading over time horizons of under one year, this long-term PCR 21dma chart also offers some fantastic insights. Like all sentiment indicators, the PCR 21dma is a contrarian indicator. As a contrarian speculator you want to aggressively buy puts when most other folks are buying calls (low PCR) and buy calls when everyone else is devouring puts (high PCR).

Consistently playing against the crowd is the surest way to win over the long-term. This truth never changes for short-term speculators, regardless of whether or not the markets happen to be galloping in a major secular bull or plunging in a major secular bear. If you examine any short-term period on the graph above, high or low PCR 21dma extremes near their trend-channel boundaries generally marked great entry points for short-term contrarian speculations.

When the PCR 21dma was high near the top of its trend channel, it indicated widespread fear as too many folks were buying puts. These were the moments to buy calls and bet on a major rally. Conversely, when the PCR 21dma headed towards the bottom of its trend channel indicating extreme bullishness as folks loaded up on calls, these were the very moments when contrarian speculators ought to have bought puts for short-term trades.

While this phenomenon is somewhat tedious to spot with all the years crammed into this chart, it is very apparent on the larger charts at www.zealllc.com/charts/pcr.htm and also in this Great Bear chart zoomed in below.

The PCR 21dma performs best as an indicator for shorting purposes, as it tends to mark interim tops in the stock markets remarkably well. Major interim market tops tend to linger for a week or two which gives the 21dma's inherent 10-day lag time enough time to catch up with and mark the top and signal speculators to buy put options in anticipation of an imminent decline. For indicator purposes, it is important to remember that moving averages always tend to have a signal lag time of around one-half of their entire duration.

As I explained in "Trading the NASDAQ Bust 2" however, the PCR 21dma doesn't tend to be precise and quick enough to flag major bottoms in the markets for speculators to catch. The sharp V-bounces above that mark major interim bounce points often unfold with blistering speed, so by the time the PCR 21dma catches up 10 trading days later and fully reflects the options trading activity surrounding the V-bounce the markets have often already run up dramatically.

Amazingly, often 50% of the entire gains in a major bear-market rally are made within the first 10 trading days after a V-bottom! Since the smoothed PCR is much too slow to catch these events in real-time, major long signals for speculators are best obtained from daily volatility measures that immediately reflect extreme fear like the VIX and Relative VIX.

But for short-term market-topping signals, the PCR 21dma's track record, through both Great Bull and Great Bear markets, is exquisitely excellent. In the graph above every major interim top in the entire Great Bear is marked with a yellow line, and all these tops, the time to start buying puts, correspond to low PCR 21dma levels near the support line of its long-term uptrend channel.

This low PCR 21dma signal worked perfectly until March 21st, which brings us to the PCR 21dma anomaly I have been pondering in recent months. Friday March 21st marked the top of the initial blistering surge in the current rally, which at the time was a war rally based on early positive tidings surrounding Washington's annexation of Iraq. This fateful day is marked above by the rightmost vertical yellow line.

The S&P 500 had surged up a phenomenal 12% in only 8 trading days ending Friday March 21st! That Friday the markets were euphoric as US-taxpayer-financed bombs destroyed Baghdad live on international television. A quick war victory was widely expected to end general uncertainty, terminate the Great Bear, lead to vastly lower energy prices, and unleash a flood of consumer spending and booming economic growth.

Yet, even in the midst of all this manic euphoria, the PCR 21dma tumbled to the bottom of its trend channel and flashed a stock-market topping signal for speculators to aggressively buy puts in anticipation of a coming fall in the stock markets. I personally purchased index puts on this signal as did many of our clients, but so far this amazing rally has defied the PCR 21dma short signal and bludgeoned our puts positions along with all the other shorts out there.

As is quite evident now, this particular PCR 21dma topping signal failed for some reason. This anomaly ruined the perfect 100% track record of this indicator in the Great Bear so it warrants some serious study. Is the PCR 21dma obsolete as a sentiment indicator now? Has the PCR 21dma primary trend subtly changed back to Great Bull mode? What is the PCR 21dma telling us about this rally today?

Our final graph zooms in even farther to offer some insights into these important questions for speculators.

The March anomaly in the PCR 21dma is readily apparent at this scale. Normally major PCR 21dma lows near the lower support line of its uptrend mark major interim tops in the stock markets. As highlighted by the first three yellow arrows above, this happened in August, November (another time we deployed extensive puts based on this signal), and January. After each of these PCR 21dma topping signals, the markets fell substantially in the following weeks and months.

On March 21st this same topping signal flashed, but instead of the markets falling substantially a short 6-day reversal ensued and then the war rally continued soaring higher blasting through resistance. The March 21st event marks the first enigma of this PCR 21dma anomaly.

A second facet of this anomaly has emerged in the past few months since March 21st. You will note above that the PCR 21dma tends to move in the opposite direction of the stock markets. When the S&P 500 is soaring during a major bear-market rally, the PCR 21dma falls as relatively more folks buy calls to try to chase the ongoing rally while interest in buying puts drops dramatically since few people choose to be contrarians and consistently bet against the thundering herd.

The red and blue arrows above highlight this phenomenon since last July. This pattern, an old and respected one, held until March. But after March 21st the stock markets have continued rallying dramatically while the PCR 21dma has mysteriously flat-lined around 0.80 or so. During a normal bear-market rally like the ones that launched in July and October, the PCR 21dma plunges down to new interim lows as the bullish short-term market behavior severely limits the pool of people willing to buy puts for speculative or hedging purposes.

A third facet of this anomaly in the PCR 21dma is also evident in hindsight. Normally major interim market troughs, V-bounces, are marked by high PCR 21dma levels reflecting widespread fear. These PCR 21dma tops tend to lag 10 days or so after bottoms, but they do a nice job of marking them in hindsight. There was a relatively modest PCR 21dma top following the February interim lows, but when the pre-war March interim lows rolled around there was oddly no fear as measured by the PCR 21dma.

Just as the VIX and volatility sentiment indicators also noted, our current rally didn't erupt out of fear as rallies almost always do. All these strange circumstances conspire to make for a very peculiar scene. The PCR 21dma anomaly, along with this entire rally that caught so many experienced speculators the wrong way, is definitely one of the weirdest things to happen in the stock markets from a sentiment perspective in recent market history!

Interpreting this anomaly is difficult. Since we are all trapped within the physical dimensionality of time and cannot see the future like God, neither you or I have any way of knowing yet whether the PCR 21dma is broken or whether this is a one-time event surrounding Washington's annexation of Iraq.

My gut feeling, a carefully considered guess, is that the PCR 21dma is not broken.

My working theory explaining the war rally, which may certainly be wrong, involves a geopolitically-spawned rogue sentiment wave stoking fantastic popular greed followed by a frantic game of catch-up by some massive institutional players. These two factors together apparently managed to bludgeon the major US stock indices higher even against a howling headwind of greed when sentiment indicators were virtually unanimous in saying they should sink.

When Washington annexed Iraq, the stunning military victories early on removed a lot of uncertainty. Since most folks sadly still don't understand the core valuation nature of this Great Bear, there has been a widespread rumor for a long time that anticipation over Iraq was holding down the equity markets. Once that Iraq uncertainty waned, believers in the Iraq Great Bear theory, mostly speculators, flooded into the old market darlings of the 2000 bubble once again with reckless abandon.

The initial violent upsurge in mid-March ending on the 21st may have been spawned by overwhelming relief that Iraq didn't turn into a WMD holocaust, mixed with some usual speculator greed surrounding the resolution of the invasion uncertainty. Without the Iraq psychology rogue wave, I believe the rally would have failed on March 21st just as the sentiment indicators like the PCR 21dma predicted it ought to have.

In early April as the rally traded sideways and the S&P 500's 200dma continued pressing down on it, persistent rumors of major pension-fund purchases of stocks began to surface. Apparently a significant number of private and public (state) pension funds decided to shift tens of billions of dollars out of the red-hot bond market and back into stocks to chase the war rally. This heavy marginal demand for stocks overwhelmed the light selling interest and propelled the stock markets higher smashing key technical resistance levels and sending the shorts running to cover, farther fueling this rally.

Yet, even in the face of the largest rally in this entire Great Bear to date, many options players, like me, remain skeptical of the rally. The PCR 21dma never plunged significantly below 0.80 after March 21st, showing that put volume remains 80% as high as call volume. This happens to be right on the long-term support line of the PCR 21dma uptrend as well, probably suggesting that a PCR 21dma ratio running 0.80 or so is about as high as greedy sentiment can run three years into today's brutal supercycle Great Bear market.

While only time will tell if the PCR 21dma has shattered and is no longer useful, which I am certain is not the case, or whether a new bull market was born in March, which is incredibly doubtful in light of today's stellar overvaluations, I still have faith in this indicator in light of its long and distinguished track record before March 21st.

Short-term market movements will always be primarily driven by greed and fear warring within the hearts of speculators. These speculators often prefer to make their leveraged bets with put options and call options, so the ratio of these two grand classes of derivatives ought to continue to be highly valuable for contrarian speculators to monitor as they seek to bet against the majority of other speculators and hedgers.

When the PCR 21dma is vindicated in the coming months, it will soar as stocks plunge. As it tracks its bottom trendline today exposing extreme greed and complacency, the PCR 21dma continues to call for a major fall in the stock markets as it seeks to redeem itself as an elite sentiment indicator.

Adam Hamilton, CPA
Zeal LLC.com

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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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