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.
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