Put to Call ratio as a market Indicator

This morning I was doing some research and had a discovery that I wanted to share with my readers. It has to do with stock market indicators I track daily and what they mean to me. I am always open to hear other points of view on the same data so have at it if you like. The one I chose to focus on today was the much touted Put to Call ratio. Simply put, it is a ratio of the trading volume of put options to call options. It is used to gauge investor sentiment. For example, a high volume of puts compared to calls indicates a bearish sentiment in the market. I use the extremes of this indicator to help me determine market turning points and whether I should buy or sell stocks. In looking at the Put to Call ratio from 2004 to 2009, I discovered some interesting facts. First looking at the chart above, I have selected the most extreme values on the Index and plotted them as they occur over time on the Dow chart. You can see that most of the extreme point showed Bearish trends for most of 2007 and 2008, with the exception of a few low data extreme points such as 0.57 and 0.66. Most of the signals said to sell. You might want to double click on the chart to see it larger on a separate page.

The number of times the Put to Call ratio was at the highs of between 1.2 and 1.7 was 135 times out of 1400 data points. That's 9.6% of the time the sentiment was very pessimistic (Bearish). Interestingly, of those 135 times, here's the number of times by year:

2004 9
2005 9
2006 20
2007 33
2008 36
2009 0 (so far)

Here's a breakdown of these 36 signals by month for 2008
Jan 5
Feb 2
Mar 9
April 2
May 0
June 1
July 2
Aug 0
Sept 5
Oct 7
Nov 3
Dec 0

Remember it was Oct. 2008 that had the big drop from a Dow of 11,000 to about 7,800. The Put to Call ratio was screaming in March warning us of an impending drop in the market.

The number of times the Put to Call ratio was at the lows of between 0.69 to as low as 0.32, was 88 times out of 1400 data points. That's 6.3% of the time the sentiment was very optimistic (Bullish). Again, interestingly, of those 88 times, here's the number of times by year:

2004 51
2005 13
2006 15
2007 2
2008 0*
2009 6

* Notice that there were 0 Bullish signals in 2008 and also notice that for only the first 4 months of 2009 there has been 6 Bullish signals. It may be we are in line for about 18 for the year at this rate.

Here's what the Dow did in each of those years starting with the first number the opening price in January and the second number the December ending.

2004 10,425 10,800
2005 10,800 10,796
2006 10,796 12,500
2007 12,500 13,264
2008 13,264 8,483
2009 8,483 8,574 Closing price on May 8th

It is clear from the above data that there were many signals to sell and prevent the loss of capital by watching this Put to Call Indicator. The difficulty with using any single indicator to make a market decision is that you don't know if you are in a transition period within that indicator or not. So using the highs and lows as determination points can be misleading and costly, as I can tell you first hand. I don't use a single indicator, but try to use several. I happen to like this one but trends are more important as you can see from the above data, than isolated data points.

If any of you were recipients of my Newsletter and can remember back in 2000, I had used the indicator at its extreme to tell my readers I was going into 100% cash at that time because the extreme reading on the Put to Call ratio was at the most Bullish signal at 0.30. That extreme value of Bullishness could be a great tool to find a turning point while everyone is buying and selling into the rally. Conversely, when the Put to call ratio was at the extreme pessimistic value after 9/11, I used it to Buy back into the market, as did many others. So the take away is this from the Put to Call ratio, when the numbers start showing consistently a high or low value, believe the trend. If the numbers are staying low, it is a bullish sign and the market should rally. If the numbers are pointing higher, it is a bearish sign and the market will drop. However at both extremes they will reverse that trend.

Lately the market is signaling a Bullish, not bearish trend with the Put to Call closing on Friday at 0.86 and it has been as low os 0.65 recently (May 5th). We are close to testing this rally as we approach the 200 day Moving averages for the Dow and S&P 500. We have gone over the 200 day Moving average on the Nasdaq this past week but retreated below it. This next week is an important week. If I just use the Put to Call ratio as an indicator, it says the market will go higher. But if I consider the 200 day Moving average it gives me pause and has been the reason I have not sold my ETF Ultra Short, TZA. It has been painful to hold on to the shares given the big drop from about $31-$36/share purchase price to the close yesterday at $25/share. Luckily, my shares of other stocks like BCON rose significantly lately to minimize the paper loss. Here's an excerpt from the Dynamic Wealth Report on the 200 day Moving average from Feb 23rd, 2009 and is applicable today:

The 200-day moving average is still trending downward. This tells me to hold off. It’s not yet time to jump back into the markets. This is not the time to buy & hold… not yet. Believe me, I’m watching this indicator closely.

Once we start trending higher, it’ll be time to get reinvested in the markets - in a big way. Until then, continue hedging your positions… buy stocks very selectively, and stick to the strength of the markets. If you do decide to take positions, make them small… it’s a traders market right now.

One other piece of data I am watching is Insider trading. Insider Selling dollars amounts dominate the Buying and has for many months. If things are really go up a lot, someone should tell the Insiders, because they don't seem to think so!
Good luck this week. Don't forget to vote for May on my Mini Poll as to when you believe the recession will end.