Here I will talk about using put call ratio alone to develop a simple strategy; the annual return/performance beats the benchmark S&P 500 index return by 6% on average every year, furthermore it is extremely simple to implement. too good to be true?
Before we go into details, firstly let's review "put-call ratio". The put-call ratio is a tool specifically designed to gauge the overall sentiment (mood) of the stock market. The ratio is calculated by dividing the volume of traded put options by the volume of traded call options. As this ratio increases, it can be interpreted that investors are putting their money more into put options rather than call options. An increase in traded put options signals that investors are either starting to speculate that the market will move lower, or starting to hedge their equity portfolios in case of a sell-off.
The put-call ratio is primarily used by traders as a contrarian indicator when the values reach relatively extreme levels. This means that many traders will consider a large ratio a sign of a buying opportunity because they believe that the market holds an unjustly bearish outlook and that it will soon adjust, when those with short positions start looking for places to cover. There is no magic number that indicates that the market has created a bottom or a top, but generally traders will anticipate this by looking for spikes in the ratio or for when the ratio reaches levels that are outside of the normal trading range.
Can we use this for any investment strategy? I have observed that in most of cases, the put call ratio is larger than 1. What does this mean and why is it so? Put call ratio larger than 1 signals that most of time, the traders or investors buy more put options than call options. This could be because that institutional investors and traders normally have big equity exposures in their portfolio. By purchasing the put options, institutional investors are able to hedge their equity downside risk. If equity performs well, the put option will expire worthless, but it is fine for the investors as their equity portfolio has gain value substantially. On the other hand, if equity drops, the put option they purchased will be able to hedge their equity portfolio's losses. This is typically how institutional investors use equity put options to manage their equity exposures.
I have observed that the average put call ratio from 2006 to 2013 is around 1.8, which means that on average the put volume investors purchased is 80% more than the call option volume investor purchased. The lowest put call ratio during this period is around 0.8 and maximum reading is amazingly around 4.8, which indicates extremely fear in the market.
It is wise to avoid following the crowd when the put call ratio reading reaches the extreme level. When the put call ratio reach 4 or even higher, the sentiment must be very bad, and investors are buying put option at big volume and expensive prices to hedge their equity risk or speculate the equity price could go down further, under this situation, one could be a little bit contrarian and stop selling equity.
On the other hand, when put volume is small, investors are generally less concern of the equity risk, the risk appetite should be positive and stock market could be doing well and the stock index price have already priced in all the positive expectations, once there are any negative surprise, stock market will highly likely slides from here.
A simple strategy is developed to utilize this powerful tool for long term investment strategy.
• When put call ratio is smaller than 1.5, stay in cash as market price is almost fully priced in the positive expectations..
• Otherwise, fully invested in the stock index(ETF) all the way…
This investment strategy is extremely easy to implement for buy and hold long term investors, except one needs to monitor the put call ratio on the daily basis.
From 2007 to 2013, assume no dividend is included here, this simple investment strategy yields a 9.63% return annually. At the same time the S&P 500 Index will only have a return of 3.73%.
Beauty lies in simplicity!
Below chart is the performance of this simple investment strategy. With 100 invested in 2007, today it has grown to 182, while assume one buy and hold S&P 500 index, 100 has only grown to 127.