August 6, 2010, Newsletter Issue #168: Put / Call Ratio

Tip of the Week

Over the years, sentiment analysis and options have each become increasingly popular in the investment community. What was once relegated to the final chapters of investment books and the occasional mention in magazines or periodicals has become a sizable industry. The amount and availability of data providers and website analysts have grown as well. The sources that use or cover put/call ratios in one form or another have become too numerous to count. The phrase "put/call ratio" is no longer descriptive enough by itself to convey to the analyst what kind of indicator it is. Different firms and analysts use different methods to dissect put/call ratio data and often apply their own unique methodologies. However, there are three ways in which option data can be segregated - type, data, and method. Nearly all put/call ratios encountered will be constructed from a combination of the following themes. When there is an excessive amount of bullish bets (call buying) made on equities, the buying strength has probably depleted. The opposite is true when there is a large number of bearish bets (put buying). This generally means the selling strength has faded. When there is an exorbitantly large number of puts compared to calls (a high put/call ratio), there are many investors who have made leveraged bets that stocks will decline. At that point, these investors have already sold a great deal of their stock positions, which means there is a lack of selling strength. In such a scenario, even slightly more buying strength will overwhelm the remaining sellers and push the market back up. This is why the overall market tends to rally following high equity put/call ratios.

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