Put/Call Ratio Suggests Going Short

Yesterday's interweb surf-o-rama led me to the comments section of Barry Ritholtz' blog post on $1.17 gasoline in Wyoming. (If you don't find cheap gas in the middle of nowhere a compelling topic, then why are you reading, of all things, a post on the Put/Call ratio?) The following unrelated comment caught my eye:

Steve Barry Says:
December 30th, 2008 at 4:24 pm

@KJ:
With 10 day put call MA at 2 year lows…21 day at 2 year lows…and 10 day nicely below the 21 day (indicating it likely will rise in the short-term) you probably have a great short opportunity now. The other times in the last 2 years put/call was close to this were Oct 07 and May 08 (check what the market did those times). Right after the new year, we'll get tons of earnings warnings.

Before I follow Steve Barry's suggestion to check the market history in Oct07 and May08, I should figure out what is the Put/Call Ratio and why is it suggesting to go short?

Forget Investopedia's simplistic definition.

Here's a better one from Stockcharts.com:

Put/Call Ratio: Based on CBOE statistics, the Put/Call Ratio equals the total number of puts divided by the total number of calls. When more puts are traded than calls, the ratio will exceed 1. As an indicator, the Put/Call Ratio is used to measure market sentiment. When the ratio gets too low, it indicates that call volume is high relative to put volume and the market may be overly bullish or complacent. When the ratio gets too high, it indicates that put volume is high relative to call volume and the market may be overly bearish or in panic. StockCharts.com charts the Put/Call ratio under the symbol $CPC

And here's an annotated chart of the Put/Call ratio:



According to this $CPC chart and others I've created with additional layers of visually-cluttered data that I'm keeping off of the blog, the 10DMA is 0.83, the 20DMA is 0.89, and the 50DMA is 0.97.

Back-checking the charts, the 10DMA fell at or below 0.90. on 13May08 and broke back above 0.90 on 21May08. On 5Oct07, the 10DMA fell below 0.90, hitting ~0.83 on 16Oct07 before returning above 0.90 on 22Oct07.

Before this period, the 10DMA falling below 0.90 seems quite common. It happened during long stretches of 2006, and several times throughout 2007.

My major concern with cherry-picking/data-mining the two most recent drops in the put/call ratio, and matching them to declines in the market is: correlation without causation.

I looked at the 250DMA for the put/call ratio at the beginning of each year starting in 2001. A quick look at the following table will show you that we've moved from almost two calls traded for every put at the outset of 2001 to slightly more puts than calls traded in 2008:

First Day of Trading in Each Year - (Put/Call Ratio 250DMA):
2001 - 0.56
2002 - 0.70
2003 - 0.81
2004 - 0.79
2005 - 0.83
2006 - 0.90
2007 - 0.92
2008 - 1.01
End of 2008 - 1.03

Now the put/call ratio as a tool is starting to make more sense to me.

0.90 isn't a static magic number. The potential trading signal arises when the short-term put/call ratio (10DMA) strays far from the longer-term put/call ratio (50DMA or better, 250DMA).

It's another variety of the overbought/oversold oscillators I favor, like the RSI.

The 10DMA reading of 0.82 would be thoroughly ho-hum in 2005, as it would be just about at the long-term 250DMA. 0.82 would have been a screaming call to go long in 2001. Right now, 0.82 says the market is a bit too optimistic and ready to fall.