Study: Effect of High PC Ratio on Daily Market Action

[GCB]

Recently in the chat room I've called attention to the put/call ratio being high. (High defined as 1.0 or greater.) My theory has been that the a high pc ratio puts a "floor" under the market and keeps it from going down much, as it represents too much beariness. For the last three days the pc ratio has been over 1.0 for most of the sessions and, though the market tried to go down and had some early success doing so, all three time it reversed strongly to the upside.

I decided to study some historical data and so went back two years and observed the effect of a high pc ratio on the ER2 (Russell 2000). The results were as follows:

Of the 105 days which the pc ratio spent a large amount of time above 1.0, 10 of those days were up days, 24 were down days, and 71 were mixed/reversal days.

By up or down day I mean a day when there was really nothing that could be termed as a genuine reversal, rather they were days when most of the action was in clearly one direction or another.

This data is a bit surprising since there were 2.4 times as many down days as up days. So playing a high pc ratio day short is not unreasonable. There is almost always some down on high pc ratio days. This makes sense. The pc ratio is up for a reason.

Of the mixed/reversal days there were some choppy days, but there were many days when the prices reversed strongly, a few times from an up open to a down close. But there were many days when the price started down in the morning, then reversed strongly back up.

The lesson I think is to not be afraid to play a high pc ratio day short, particularly early, but be ready for a mid-morning, mid-day reversal on such days, as that is the norm.

However, keep in mind there were several pure bear-ugly selloff days when the pc ratio was over 1.0, so they can and do happen.

The bottom line is that pc ratio is at best a secondary indicator.

I'll post a related study on low pc ratio days soon.

[wsam29]

I myself don't really understand PC ratio, its not as clearly defined like the VIX index, which does have an inverse relationship to the stock indices.

Have you considered doing some VIX comparisons to PC ratio since they are both options related.

[GCB]

Might do that wsam.

This "study" of mine is based upon the recommendation of John Carter regarding the pc ratio. His rule is to not get short when the pc ratio is over 1.0 and not get long when it is under .6.

Although I found over 100 days in the last two years where the pc ratio spent significant time over 1.0 during the trading day. I found only 6 days in the last two years when it spent significant time under .6. So there are simply not enough samplings to draw any conclusions about this level and it's effect on market behavior.

My general view is that given a market that is turning up from a decline, the higher the pc ratio, and the VIX for that matter, the more likely the reversal is to take hold. And given a market that is turning down from an advance, the lower the pc ratio and the VIX, the more likely it is to take hold.

As for Carter's recomended levels, they are a bit arbitrary.

I do agree with this however, when the pc ratio (or VIX) is moving in the same direction as the market, i.e. folks are buying puts when the market is going up or calls when the market is going down, that is a great confirmation that the trend is likely to continue.

[dupaski]

Have you considered using a dollar weighted PC ratio? I've not had much time to test, but in theory it makes a lot of sense. I know some people that use it in their trading and they feel it's a better indicator of sentiment than the standard PC ratio.

Here is a link to an article by Fari Hamzei explaining the indicator:

Welcome to eSignal Learning! -- Better Trading. Smarter Investing.

Here is another one from Fari's site:

Put/Call Ratio in real time. Better Data. Better Trades. - Hamzei Analytics, LLC