The CBOE Index Put-Call Ratio (PCR) on Friday November 19th, 2010 was 0.77. More index calls were traded than index puts – a rarely observed event. On the average, a PCR this low has occurred only one in every 200 trading days since 2003 (0.5% of the time). Said differently, the PCR has been higher than Friday’s level for 99.5% of trading days over the last seven years.
The PCR has been used as a contrarian indicator for future equity returns. It is said that a low PCR (fewer put than call trades) portends a fall in equities. If this is true, Friday's value of 0.77 – fully 2.5 standard deviations below the 20d simple moving average – would instruct traders to be short the market.
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We have previously stated in SA that the PCR is, in fact, a poor predictive measure. But what does the historical data tell us about very low PCRs; say, below 1.00? See the figure below; each orange line signifies a trading day with PCR below 1.00 (more calls than puts), and the black line indicates the percent to trading days with PCR below 1.00 (50 days before or after the index day):
Between 2003 and today, the average equity market (SPX) daily return has been about +3 bps. A PCR of less than 1.00 has occurred 85 times since October 2003 (about 5% of the time, or once in every 20 trading days). Equities returned about -2 bps the day after a PCR of <1.00, compared with an overall average daily return of about +3 bps during the seven-year period. A -2 bps return is of course not very significant; even if it occurred each day for a year the annual return would be a modest -5%.
What about longer term returns? Maybe a low PCR doesn’t predict equity returns the following trading day, but what about the next 10, 20 or 100 trading days? This information is depicted in the table below:
Again, the PCR has very little trade signaling value. The highly positive SPX return of +78 bps on the days with PCR <1.00 merely corroborates the well-described observation that put volume decreases in a rising market and increases in a falling market. The mildly negative return of -4 bps the day following a PCR <1.00 likely relates to the negative autocorrelation of market returns; i.e. the mild reversal in SPX returns from one day to the next. There is little predictive value for 10-day and 20-day forward returns, but there is a mildly positive +7 bps average daily return over the 100 days following a PCR of less than 1.00; probably related to the concentration of low PCRs during the last part of the market downturn of late 2008.
In summary, the PCR appears to be reflective of that day’s SPX return, but is of little value as a trading signal for the next 1, 10, 20, or even 100 day period. Nevertheless, the high concentration of low PCR (diminished relative put volume) trading days at the end of the late 2008 market downturn is interesting. This is at least associated with the recovery of the equity markets, if not predictive of the rise. The single-day, extraordinarily low PCR of 0.77 on Friday November 19th is also interesting, but its significance remains obscure.