Put-Call Ratios

The ratio of put option volume to call option volume, called the put-call ratio, is the major sentiment index for listed options. It too is used for its contrary value. The interpretation of extreme levels of the put-call ratios (in particular, the index option) points out a problem that may reflect on the proper use of all contrary indicators.`
Prior to 1986, the market was considered ready for an upturn when the total put volume exceeded 65% of the total call volume. Similarly, when the put volume fell to 35% of the call volume it was a bearish indication. In the volatile markets of 1986 and 1987 these levels proved to he far too close, and as McMillan said, “Not surprisingly, the put-call ratios fell into some disfavor at that point.” This could easily happen with a contrary indicator, or any indicator that rarely reaches its extreme values. Because contrary opinion is a valuable addition to analysis, use of these indicators now focuses on relative highs and lows. This can be accomplished by smoothing the ratio using a standard moving average or momentum indicator (a simple difference over ndays). When the ratio moves over 65% and turns down it is time to sell. Such an approach gives up a timing edge but greatly reduces risk and increases reliability.