Thursday, December 28, 2006

Stock Market Psychology: Equity and Index Put/Call Ratios

In my most recent post, I showed that there is a near-zero correlation between the daily equity put/call ratio and the daily index ratio over the past several years. Whereas the equity ratio has shown more call than put activity over that period, the index ratio has been skewed toward puts. These factors lead me to believe that different groups of market participants are active in the equity and index options markets. Are they both accurate measures of market psychology, despite their differences? I decided to take an initial look.

Going back to 2004 (N = 748 trading days), I divided the sample in half based upon whether the five-day put/call ratios were relatively low (more bullish) or high (more bearish). I then looked to see how the S&P 500 Index (SPY) behaved over the following five days.

When the five-day equity put/call ratio was relatively low (N = 374), the next four days in SPY averaged a loss of -.03% (190 up, 187 down). When the five-day equity put/call ratio was relatively high (N = 374), the next four days in SPY averaged a gain of .29% (232 up, 142 down). This is quite a difference. It suggests that the common wisdom has held true: market returns are superior when equity options participants are relatively bearish and are subnormal when equity options participants are relatively bullish.

Now let's look at the index put/call ratio. When the five-day index put/call ratio was relatively low (N = 374), the next four days in SPY averaged a gain of .08% (197 up, 177 down). When the five-day index put/call ratio was relatively high (N = 374), the next four days in SPY averaged a gain of .19% (225 up, 149 down). Although the difference is not as dramatic, we see a similar pattern among the index option ratios: when relatively bullish, market returns have underperformed; when relatively bearish, market returns have been superior.

Interestingly, five-day index put/call ratios have correlated with five-day equity ratios by only .05--meaning that they are essentially independent of one another. My best interpretation of the data is that both are measuring sentiment, but among different market participants. The equity put/call ratio is assessing the psychology of speculative traders; the index ratio is tapping the psychology of those using index vehicles for hedging purposes. While there are obviously other uses of the options to be considered, it does appear that the sentiment of these groups is worth tracking for the short-term trader. In my next post, I will examine these ratios on a relative basis (i.e., when they are elevated or depressed relative to their moving averages).

8 comments:

NO DooDahs said...

You might be interested in this.

http://marketthoughts.com/z20050728.html

From July 2005.

Brett Steenbarger, Ph.D. said...

That's an excellent article, Bill; hats off to you and thanks for the link!

Brett

yinTrader said...

Hi Brett

Beginning to learn about puts and calls from your posts.

Also thanks to Nodoodahs for his link which I find relevant although posted in July 2005.

Puts and Calls will be another field of study to add for next year as I progress from trading Indices and FX.

Counting down to 2007.....cheers

Anonymous said...

Dr. Brett - I think that option activity follows rather than leads especially in the equity area. I.E. market's going down got to buy puts - sell calls and so on. But I contend that that is a small percentage of what is actually going on.

There is a huge amount of trade selling puts into dips and selling calls into rallys. These are absolute contrarian investments with high success probability and are making the big houses even more wealthy.

I know that for years and years the conventional wisdom has been that excesses in the PCR suggest peaks and valleys in the market and I know (Bill) that the math somewhat supports the proposition. But once again the elephant in the tent are the 8000+ funds with their not necessarily "smarter" but absolutely "more" money with which they can easily hedge their hedges.

So within all of this activity that is largely becoming business as usual we see that implied volatilities are ever more decreasing.

That, of course, is an option sellers dream because no IV and guess what - no activity - option expires worthless. So what are they going to do? - Sell more options of course. And because there are 8000+ well heeled funds at large there are always willing buyers. Because these guys have to stay cheaply hedged. And the IV keeps the options cheap. This is "snake eats tail" time.

Bottom line - while it might have meant something as little as four or five years ago - does puts and calls activity really mean anything today?

Brett Steenbarger, Ph.D. said...

Hi Marlyn Trades,

Yes, the data I've analyzed from 2004 to the present would agree with you: there is selling/buying of calls on rallies and selling/buying of puts on declines. That is particularly the case among equity options. What you're pointing out is the vantage point of the option seller, whereas the contrarian interpretation emphasizes the perspective of the option buyer. Nevertheless, we see that when call option volume is elevated relative to put option volume among individual equities, the near-term market returns are subnormal and vice versa. I suspect you're right: the smarter money is selling the options at those turning points; the dumber money is the more speculative traders buying from the sellers after a run up or down. Thanks for the perspective--

Brett

NO DooDahs said...

Ah, but if all we want is an "edge" then we ignore EPCR signals that are in the "middle" and look for extremes, and leverage that moment …

Brett Steenbarger, Ph.D. said...

Hi NO DooDahs,

I think your strategy works well with a variety of indicators, where extreme values possess far more market information than moderate levels, which represent noise around a mean. Great observation--

Brett

1984 said...

That's why I love CFDs - the Don of the notorious derivative's family
Wouldn't touch options with a 10-foot-pole ...