Understanding the OEX Put/Call Strategy

This post is a follow-up to an S&P 500 swing trading strategy that I shared last week: the OEX Put/Call Strategy. (Warning: this post will get geeky. You’ve been warned.)

I’ve been running some numbers to understand just what it is that that makes this strategy so predictive. The strategy is a little difficult to wrap the head around, but I’m excited about it because (a) it’s worked so well, and (b) it’s using a data source unrelated to anything else I’m looking at on the State of the Market report.

A reminder, strategy results (red) and its inverse (green) versus the S&P 500 (blue) from 1985, frictionless with NO return on cash:

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[logarithmically-scaled]

The strategy is buying when a shorter (i.e. faster) moving average of the ratio of the S&P 500 over the OEX put/call ratio is below a longer (i.e. slower) moving average.

Thinking about that for a moment, the strategy is bullish when either the numerator of the fraction (the S&P 500) is falling or the denominator (the OEX put/call ratio) is rising, even though both of these would be (in traditional thinking) bearish.

Taking that logic a step further, the graph below of the S&P 500 (red, right axis) versus the OEX put/call ratio (blue, left axis) shows that the put/call ratio is much more volatile than the S&P 500. Because of that, the strategy is really driven not by the S&P 500 falling, but by the put/call ratio rising.

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Confirming this is the fact that about 88% of the time that the strategy has been long, the 21-day EMA of just the put/call ratio has been above the 42-day EMA.

So what this strategy is really measuring is an increasing put/call ratio in a market that might be oversold, might be neutral, and even might be a bit overbought…just not too overbought.

Put another way, the strategy is taking a contrarian position against the put/call ratio. A high put/call ratio would indicate that a large number of investors are betting on (or hedging against) the market falling. This strategy is buying into that bearishness except when the market is very overbought and due a pullback.

This all of course goes very much against conventional wisdom, but like most things in the stock market, conventional wisdom is usually not all that wise.

One last note: Because of how frequently this strategy changes positions, I’ve decided to count it as an intermediate-term indicator on the State of the Market report. I’m still in search of good unique long-term indicators to add to the report.