The stock market selloff since the last new all-time high on July 26 has brought the bears out, and they have been trading a lot of put options. Some trade those as an outright bearish bet, and some as a hedge on portfolio risk. Whatever the motivation for those trades, it is a sign of a bottoming condition for prices when we see persistently higher trading of put options versus call options.
This week’s chart looks at a 21-day moving average of the daily CBOE Equity Put/Call Volume Ratio. 21 trading days is roughly one month, and so it can make for a useful lookback period for this purpose. It smooths out the daily spikes, and allows us to see what the Put/Call numbers have been doing more broadly. When it gets to an extended level, either high or low, it says that prices should be at a meaningful turning point.
Other lookback periods can also be useful. I like to use a 5-day MA for this purpose also.
One problem is identifying where “high” and “low” reading thresholds are. The horizontal dashed lines are arbitrarily placed on the chart, using the LAR method (Looks About Right). And there can be some drift over time, as some periods see generally higher or lower numbers than other periods.
To grapple with that, years ago I did some tinkering and came up with this next indicator. It involves a lot more computations, but it is based on the same raw data. Its formula is as follows:
21MA(calls) – 21MA(puts)
[21MA(calls) + 21MA(puts)]
Then I calculate a 50-day MA of that ratio. Finally I measure how far that ratio is away from its 50MA to get the indicator you see here:
By first averaging the numbers of calls and puts separately, it allows for greater volume days to not get washed out into just the daily ratios. By placing calls ahead of puts in the formula, instead of the normal Put/Call Ratio, I am flipping the orientation of the plot to better correlate with how prices behave. And by measuring the deviation from the 50MA, I am correcting for any drift over time in the normal levels of puts and calls, making for a nice clean oscillator with more well-defined boundaries of “normal” range behavior.
Interpretationally, the net result is the same in terms of showing us an extended condition right now. Once again, I have set the dashed horizontal lines using the LAR method, and that seems okay for this purpose. Someone else who might replicate this indicator could come up with a more scientific method of designating “high” and “low”, and I would not quibble with that.
The immediate message of this indicator now is that equity options traders have been a whole lot more interested in trading puts lately versus calls. That is a sign of trader pessimism, and when pessimism (or optimism) goes too far, it gives us a useful message.
Editor, The McClellan Market Report