Actions Speak Louder Than Words: Put To Call Ratio Signals No Major Correction In 2014

by: Derek Capo

Summary

Free tool gives investors insight when managers shift strategies at top and bottom of markets.

Ratio predicted crash of 2008 and bottom of 2009.

2013 and 2014 show no signs of a market top and we could see further upside.

Last week I read an article on Yahoo about a trader predicting that the market would correct 20% (with his proprietary model) within the next twelve months. Since I don't have my own proprietary model I do remember a free tool provided by the Chicago Board Options Exchange ((CBOE)) called the Put to Call ratio that would let me know if the market is extremely bearish or bullish.

The Put to Call Ratio calculates the number of puts divided by the number of calls purchased in the options exchange. The ratio is considered a contrarian indicator given the actions taken by portfolio managers and investors to protect from a correction or to position the portfolio for a rebound. The ratios have been tracked for decades, but the CBOE only provides free data for the past 14 years.

The put call ratio isn't perfect since it never precisely signals when to make a certain trade. However, the ratio does provide investors a general sense of when markets are too cheap or expensive (apart from just using P/E ratios). Some people criticize the value of the ratio because it only monitors the number of contracts not the total dollar value of the contracts. Although a valid point, I believe, that would only add more noise to the signals.

Disclosure

Before I go into the details of my observations, I would like to disclose to the public that I do not have a background or degree in advanced mathematics or statistics. All of the data and information I am writing is from my observations and opinion. Let's just keep in mind that investing is an art and science. As Warren Buffett says "It is better to be approximately right than precisely wrong."

Hypothesis and Considerations

I believe the ratio can provide investors enough information to estimate the possibility of a small (5%), medium (10%) and a large correction (20% or more) as well as very bullish signals to buy aggressively or to hold positions in their portfolio.

What I did to get to my hypothesis and conclusion

Step 1. Downloaded the data from CBOE website.

Step 2. Got all of the data from 2003 to today of the Exchange traded volume.

Step 3. Analyzed the S&P 500 chart from 2004 to 2013 to determine any signals before a correction, or a bounce would occur.

There were 2709 trading days in the data. If you want you can visit my website download the data I worked on.

Step 4. Break down the data into 4 sets.

a. Less than 0.70 was marked "Green" given the bullish bias of more calls than puts.

b. 1.0 to 1.49 was marked "Yellow" given the moderate negative bias due to more puts than calls.

c. 1.50 and higher I marked "Red" given a significant amount of puts was purchased vs. calls.

d. 9.71 to 0.99 I didn't color code given it was an overwhelming amount of the data points provided and concluded that since investors tend to have a more bullish bias it would be best not to pay too much attention vs. the other ranges.

Step 5. Put in performance over 1 week, 1, 3, 6, 9, 12, 15 and 18 months.

Step 6. Analyzed patterns of signals with correlation of the performance over the time periods.

Observation #1: A Put/Call Ratio of less than 0.70 signaled a strong buy or hold. If in a specific period of time a lot of "Green" with "Yellow" signals were showing, it is a sign that we were close to the bottom. For example, investing on the first "Green" could be misleading because on February 9th 2009 a ratio of 0.66 was being registered but by March 11th 2009 the index declined further 13%.

Here is a table to show what happened after the Put/Call ratio signaled 0.66 on February 9th, 2009 and results from 1 week to 15 months.

Duration

1 Week

1 Month

3 Months

6 Months

9 Months

12 Months

15 Months

S&P 500(%)

-9.28%

-13.70%

4.52%

15.77%

22.92%

23.06%

32.20%

Click to enlarge

One thing to note is that for 14 months before February 9th, 2009 there was no other "Green" signal thus signaling a bottom or close to one.

Observation #2: The ratio of 1.5 or higher would register a "Red" signal and would warn of a looming correction of more than 20% over the next 1 to 2 years and a sign of a market top. This ratio has to hit a few times over a period of time, 3 to 9 months, to be validated.

What led me to this Observation?

a. From February 27th, 2007 to March 16th, 2007 we hit the "Red" signal 3 times and over a period of 18 months or more the market declined 11%.

b. Then from March 2007 to late July 2007 there were never any "Green" signals but a lot of "Yellow" which was saying that investors were concerned that we were approaching frothy levels. In fact, the market went up from February so even with "Yellow" and "Red" signals the market was still going higher.

c. On July 26th 2007 to August 16th, 2007 the ratio registered two more "Red" signals at 1.52 and 1.50, respectively. If one were to have just paid attention to the August 16th signal you would have avoided a 38% drop in your portfolio within an 18 month time period. So, over an 11-month period (February 2007 to January 2008) the ratio was effectively telling us 6 times to get out or become short yet throughout this time the market still kept going up until October 2007.

Observation #3. "Yellow" signals that registered ratios of 1.00 to 1.4 on consistent basis (example 10 days in a row) signaled an upcoming small or medium correction.

If you look at the July 24th to August 17th 2007 there were 19 consecutive days of the ratio hitting more than 1.00 mixed with "red" signals and if you were to observe the 6-month period the market was down more than 10%.

In 2011, from June 1 to the 18th, the ratio was showing "Yellow" the entire time and within 3 months the market was down more than 10% thus correctly predicting a medium sized correction.

So, what happened in 2013 and so far in 2014?

  1. No "Red" signals have been registered in both years.
  2. In 2014, we have seen a mix of "Yellow" and "Green" signals.
  3. From January to July 24th there are 141 trading days yet the ratio registered 14 "Yellow," 7 "Green" and NO "Red." Even after the market dropping about 4% to 5% last week the ratio still hasn't registered any "Red" signals.

Conclusion

According to the ratio and past observations, investors' actions show they are currently not bearish enough to warrant a major correction for 2014.

Disclosure: The author is long YUME, TRMR, GME. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.