Thursday, December 28, 2006

Assessing Stock Market Sentiment: A First Look At Equity and Index Option Indicators

It's natural to look toward the option markets to assess sentiment toward stocks: by separating put activity and call activity, we can see who is more active at any given period of time. If we think of puts as bets that traders are placing on the market's decline and calls as the bets traders are placing on the market's rise, the relative movements of put and call volume reveal the shifts in speculative sentiment among those traders.

Of course, options are also used for hedging purposes, which could greatly diminish their value as sentiment indicators. A large trader could be selling both puts and calls in anticipation of a flat market, for example.

Despite the hedging caveat, it does appear that equity put/call indicators have value as sentiment measures. Indeed, we may even derive benefit from considering puts and calls as different pieces of information, rather than joining them in a single ratio. My initial look at such relative put ratios and relative call ratios showed some promise as measures of stock market psychology.

To this point, I have focused on the put and call activity of individual stocks (equity puts and calls). With this post, I'll add another data series: the put and call volume for the stock indices. As it turns out, index put/call activity differs greatly from equity put/call data.

One outstanding difference is that the index put/call ratio is skewed toward put volume, whereas the equity ratio is slanted toward calls. Specifically, since 2004 (N = 753 trading days), the average equity put/call ratio has been .73. The average index put/call ratio has been 1.49.

Interestingly, the total volume of equity puts and calls each day since 2004 correlates with the total volume of index puts and calls by a sizable .80. That means that when equity options traders are active in the market, so are index options traders. The daily correlation between the equity and index put/call ratios, however, over that same period has been only .12. In other words, equity and index options traders appear to be responding to the same market events, but they are responding differently.

What this suggests is that the equity put/call ratio may be tapping more into the universe of options speculators and the index put/call ratio may be tapping more into the universe of options hedgers. This might help to account for why the equity ratio is skewed toward calls in a bull market, but the index ratio is skewed toward puts. If this is the case, both might reflect market sentiment, but in different ways--and in ways that might be synergistic. My upcoming posts will explore the value of these indicators.

Blog Links and Market Update for Thursday

7 comments:

davidino said...

Hi Doctor,

Great perspectives. Can you tell us that who are usually writing(sell) out big volume of option contracts,especially the index options? Are the dealers(market makers) doing the writing mostly or hedge funds?

Thanks.
Davidino

Brett Steenbarger, Ph.D. said...

Hi Davidino,

Thanks; at this juncture I don't have information specific re: who is writing the majority of index option contracts.

Brett

ProtectProfit$ said...

Always enjoy reading your analysis Brett. I've often wondered as a lover of bullish put spreads because of the enhanced aspect of time decay while puts though typically looked at as a defensive move aren't also considered from a bullish angle. Same with selling call spreads as a bearish strategy. How can one really know which way its being used?

ProtectProfit$ said...

Brett - on another note, you may already know of this site, but in case not...

http://www.moneychimp.com/features/monthly_returns.htm

And best wishes for a happy 2007!

Shelley :)

Brett Steenbarger, Ph.D. said...

Hi ProtectProfit$,

I'm sure that the different uses of options do muddy the waters with respect to analyzing the put/call data, but I'm not sure it's necessary to tease out what the various participants are doing. By treating put and call volume as separate time series and examining when volume is relatively elevated, we can see not only if there is a directional bias, but whether or not the bias is more attributable to puts or calls. It's a fascinating area for analysis; thanks for your comment and your link--

Brett

justin said...

I am quite new to investing, especially in the options arena but I am curious about what I expect will be received as an elementary question, so please be patient. What would be the norm for a put call ratio? I would expect maybe one, no higher than two? If so, isn't Friday's ratio of above three excessive? What would be the cause for that?

Brett Steenbarger, Ph.D. said...

Hi Justin,

The average equity put/call ratio is certainly under 1.0. A ratio of 3, such as I observed early on the day of the big February sell off, is an indication of *very* bearish sentiment.

Brett