Leavitt Brothers: Forget the Fundamentals

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Put/Call Ratio

The Put/Call ratio (P/C) was developed by Martin Zweig to determine the general market sentiment and expectations. It is a ratio of the number of calls and puts traded on the Chicago Board Options Exchange (CBOE).

The CBOE widely advertises that 85% of all options expire worthless, and this is at the heart of the P/C's effectiveness. Most of the options volume is due to buying, not selling. And unlike stocks where for every buyer there is a seller and for every seller there is a buyer, the options market is very one-sided. The exchange itself acts as a buyer to all sellers and a seller to all buyers.

Those who buy call options expect the market to rally while those who buy puts expect it to fall. Since most options traders are wrong, one can get a clue as to the future move of the market by studying the action in the options market. One could say the P/C is a contrarian indicator.

When the Put/Call ratio spikes up, it indicates most traders belief that the market will fall. Since most options traders are wrong, one can use this as a clue that perhaps bearishness has reached an extreme level and higher prices are coming.

Since the market has a general bullish bias to begin with, this type of extreme put/call reading is not equally effective on the downside.

But remember, this is only one indicator the astute trader should use , among others. Never solely rely on it .

Here is a typical Put/Call line. It fluctuates wildly, and as you can see it spends most of its time below 1.0. This indicates call option volume usually beats put option volume. Spikes to the downside are not very useful, but spikes to the upside can indicate a panic by the bulls (they are buying puts to protect their holdings), and a bounce can occur.

Here is the NYSE chart during this same time period. The spike in the Put/Call line did indeed signal an end to the small pullback with an otherwise uptrending market.

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