Utilizing the CBOE Equity Put/Call Ratio

I recently read one of the excellent Q & A posts over at The Kirk Report with Jason Goepfert and was surprised that he singled out the Equity Put/Call Ratio as one of his favorite indicators. I’ve found some success in utilizing the indicator when it hits extreme levels, but I’ve never really examined it as a general market timing tool. Too bad, because it seems to be quite effective in that regard. Rather than look for extreme readings from the indicator as a contrarian signal, I’ve found monitoring the ebb and flow of a moving average of the ratio to be much more useful in terms of gauging investor sentiment. When the put/call ratio moving average is rising, fear is increasing and the market is a sell until the average begins falling, at which point greed is taking over and the market is a buy until the average begins rising again. With the application of a few simple rules, a moving average of the put/call ratio becomes an effective means of monitoring the steady shift from fear to greed (and back). I’ll have more on this topic shortly.

Since I’ve been conducting research on this indicator the past few days and had the data handy, I ran a quick study tonight that yielded some interesting results. In keeping with the theme that a rising put/call ratio has bearish implications, and noting that the 10-day moving average is still rising as of Tuesday’s close, I wanted to see how the S&P fared when it rallied 1%+ and the 10-day moving averege of the equity put/call ratio was climbing. In theory, such a rally would be in danger of failing given the bearish backdrop. Over the past thirty occurrences, that’s definitely been the case…

S&P500 +1%, Equity Put/Call Ratio 10d Avg Rising
02/24/09…
01/21/09… Lower S&P close three sessions later
01/02/09… Lower S&P close three sessions later
12/10/08… Lower S&P close three sessions later
11/21/08… No lower close 3 or 5 sessions later
11/13/08… Lower S&P close three sessions later
10/16/08… Lower S&P close five sessions later
09/18/08… Lower S&P close three sessions later
09/16/08… Lower S&P close five sessions later
09/11/08… Lower S&P close three sessions later
09/08/08… Lower S&P close three sessions later
08/28/08… Lower S&P close three sessions later
07/22/08… Lower S&P close three sessions later
07/17/08… Lower S&P close five sessions later
07/08/08… Lower S&P close three sessions later
06/13/08… Lower S&P close three sessions later
05/15/08… Lower S&P close three sessions later
03/11/08… Lower S&P close three sessions later
02/13/08… Lower S&P close three sessions later
01/14/08… Lower S&P close three sessions later
01/09/08… Lower S&P close five sessions later
12/21/07… Lower S&P close three sessions later
11/13/07… Lower S&P close three sessions later
11/06/07… Lower S&P close three sessions later
09/18/07… Lower S&P close five sessions later
09/11/07… No lower close 3 or 5 sessions later
08/24/07… Lower S&P close three sessions later
08/22/07… Lower S&P close five sessions later
08/06/07… Lower S&P close three sessions later
07/30/07… Lower S&P close three sessions later
03/06/07… Lower S&P close five sessions later

Note that in 28 out of the last 30 cases, or 93% of the time, the S&P500 closed at a lower level three or five trading days later. While you might call the past two years a relatively easy time to take a shot on the short side, the at-any-time odds for a lower S&P three or five trading days later (since March ’07) is only 62%, meaning this setup has performed much better than random the last two years. It should be noted that prior to 2007, performance wasn’t as reliable, with only about two-thirds of signals leading to a lower S&P three or five trading days later.

Categories : Archived EOD Commentary, End-of-Day Commentary

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