The Put Call Ratio

Besides being an outstanding vehicle for hedging investments or speculation, options offer a number of ways to act as a barometer for market sentiment. We have discussed the volatility skew as an indicator of complacency (8/26/13) and the volatility index, VIX (7/25/13) as an indicator of market excesses. Today I want to discuss the Put Call Ratio.

This ratio is simply the number of puts traded divided by the number of calls. This ratio is above 1 when  put volume exceeds call volume and below 1 when call volume exceeds put volume. Normally, the ratio is about 1.2 because puts are bought not only as a bearish speculation but as a hedge against long stock. When this ratio goes below 1 it suggests that there is a great deal of speculation on the upside and insufficient downside hedging. For this reason the Put Call Ratio is seen as a contrarian indicator.  A history of this ratio can be found at the CBOE website.

While this ratio is not a perfect indicator it can be a valuable tool for the active trader in determining imminent market tops and bottoms.

At the moment the put call ratio is at record lows which certainly suggests a great deal of froth in the market and that an October pullback is likely. For a more detailed examination of why this may be so I would like to refer you to a fine column on a site where I am also a contributor.