Can traders discount put-call ratios ?
By Jared Woodward
Ratios of put and call option volume are among the most popular sentiment indicators, and are widely quoted in the financial media. One rationale behind the use of put-call ratios is that they represent the preferences of above-average investors — that is, the behavior of the “smart money” is observable in the number of put options traded relative to calls.
The first problem with this hypothesis is that such a group might not exist. And even if there were such a group of informed investors, there’s no reason to expect its trading activity would be expressed in a constant long-term relationship to equity, index, or VIX options, such that a high ratio today would signal the same sort of behavior it did in 1980, or that a ratio with some predictive value today would be informative in the years ahead. Trader preferences for hedging products change over time.
An alternative economic rationale for the value of put-call ratios is that they signal instances of extreme broad-based sentiment. For example, a preponderance of put volume should be a positive sign for equities since it indicates too much negative sentiment among investors, including uninformed investors.
However, existing research on both equity and index put-call ratios suggests these indicators have limited predictive power. Here, examining the predictive power of the VIX call-put ratio shows equity, index, and CBOE Volatility Index (VIX) option-volume ratios do not appear to provide information beyond what can already be learned from asset prices.For the complete article, see the September 2013 issue of Active Trader magazine. Click here to subscribe.