Taking a contrarian view is often what trading (and investing) is all about. Contrarian is defined by the Merriam-Webster Online dictionary as “a person who takes a contrary position or attitude.” For our purposes, a secondary definition – “an investor who buys shares of stock when most others are selling and sells when others are buying” – is more to the point.
This approach is based on the idea that, at any given time, the majority of participants have an incorrect view of the markets in which they are involved. The adage “buy when there is blood in the streets” in another way to express this approach.
Contrarian analysis can take many forms, from buying in retracements to watching for overly bullish or bearish front page news – then taking the opposite view.
Another very popular method is what is known as the Put/Call Ratio. This indicator divides the total Puts purchased on a stock by the number of Calls. The idea is that when more people are bearish on a stock – and buying Puts – it’s probably oversold; and when more people are bullish on a stock – and buying Calls – it’s probably overbought.
A Put/Call ratio of 1.00 indicates that there are an equal number of Puts and Calls on the stock. A reading greater than 1 means there are more Puts than Calls, while a reading of less than 1 means there are more Calls than Puts.
It would be reasonable to assume that a reading of 1 is a neutral level or balance point for this indicator. However in most markets there are typically more Calls than Puts purchased. For this reason, the typical neutral level for this indicator is 0.75. Anything above 1 is regarded as potentially oversold and anything below 0.50 as overbought.
The chart below shows the Put/Call ratio of all equity options as reported on the Chicago Board of Options Exchange website - www.cboe.com. You can see that as the ratio approached 1 during the February/March dip, the SPX formed a low and moved higher.
Chart 1 – CBOE All Equity Put/Call Ratio
click chart for more detail
In a similar fashion, the ratio moving below 0.5 in early May warned that stocks were overbought and not long after that the recent sideways trading pattern followed.
For OptionGear users (www.optiongear.com), the Put/Call Ratio can be found on an individual stock or Index in the bottom left section of the Option Analysis Screen.
click chart for more detail
As shown above this certainly isn’t an indicator that can be used for direct entry and exit signals, however there are traders who have modified it to do so! Instead, we are looking at a very straightforward method of determining the probability of coming trend direction.
When the Put/Call ratio is close to or above 1.00, it’s time to look at tightening stops on bearish trades and/or search for bullish ones. When the Put/Call ratio is close to or below 0.50, it’s time to tighten stops on bullish trades and look for bearish ones. That’s as complicated as it needs to be!
Until next time…