I don't understand how to read the put/call ratio. I cannot get it through my head how to interpret this. A solution would be greatly appreciated. (May 28, 2002)
The put/call ratio measures the number of puts traded versus the number of calls traded in a given session. First thing to understand is that the put/call ratio is a sentiment indicator. It is a super sentiment indicator so to speak as option traders, as a whole, tend to be speculators. They buy out of the money call and put options at low costs and low deltas, hoping to hit the home run. When speculation gets to an extreme it can clue us in on potential market direction. It is a measure of market sentiment that can help give you an idea if the market has potentially hit a bottom or if it is potentially topping. A sentiment indicator means two things: 1) it is secondary to primary indicators such as price and volume, breaking resistance levels, breakouts, and other indications of bullish or bearish action; and 2) it is a contrary indicator.
Because it is a measure of sentiment, we have to look at extremes for it to be of use. In a typical uptrending market (not what there is right now) the ratio ranges from 0.4 to 0.7 as a 'normal' range. It starts to get extreme in readings beyond those levels. On the down side, a reading below 0.4 indicates complacency. The closer to zero, the more complacent. That is bearish because markets that are complacent tend to be fully invested; there is no new money to come in and drive things higher.
A reading above 0.70 tends to indicate some fear in the market, i.e., there is concern the market could fall further (if already falling) or could be topping (if rallying to highs). When there is fear there is cash on the sidelines, i.e., the market is not fully invested. Thus, as the market continues to improve (as it should, e.g., if there is an economic recovery underway), it drags more of that sideline money into the market. That helps keep rallies alive. As far as predicting a rally after selling, however, you need to see a close over 1.0 on at least one, usually 2 or more occasions. That indicates an extreme level has been hit where option traders have switched from their typical bullish outlook to a bearish outlook.
When the majority of the speculators in the market are betting on further downside, that indicates an extreme indication. Speculators are typically wrong about market direction; as the saying goes, when the crowd thinks something is a sure bet, it is usually time to go the opposite way.
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