V.8:1 (14-16): Put-call sentiment indicator by Robert R. Prechter and David A. Allman

V.8:1 (14-16): Put-call sentiment indicator by Robert R. Prechter and David A. Allman
Item# \V08\C01\PUTCALL.PDF
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Put-call sentiment indicator by Robert R. Prechter and David A. Allman

Put/call ratios based on volume and dollar value have been widely used by technicians (see "Option premiums," Stocks & Commodities, December 1989). A third approach has been substantially overlooked. Since the Standard & Poor's 100-Stock Index (OEX) was introduced in March 1983 for the purpose of trading options on a market index, we have kept a ratio of the open interest on OEX puts vs. calls. We have found that a 10-day moving average of that ratio appears to be a substantive market indicator. It produces less erratic behavior than other types of put/call ratios, making it valuable in assessing the intermediate-term, as opposed to the short-term, outlook.

Briefly stated, investors are more willing to write (create and sell) call contracts when their outlook is bearish. Conversely, they sell put contracts when they feel bullish. Data since 1983 indicate that this OEX put/call open interest ratio appears to define extremes in aggregate investor sentiment. A 10-day reading near a 2:1 ratio in either direction is rare and has coincided with important turning points in the market. Such ratios have tended to occur in the weeks of option expiration, as writers on the wrong side of the market apparently delay covering until the last week, while simultaneously choosing not to write options for later expiration.

With regard to bottoms, there have been only three instances over the past six years when the 10-day ratio has dropped below 0.50 (Figure 1). The first such extreme was 0.42 in February 1984. Stocks underwent another five months of base building before ultimately bottoming just 5% lower. The next extreme was a reading of 0.43 in December 1984, as the secondary stock indices tested their summer lows. In that case, there was no lag time, as the market jumped 12% to new all-time highs over the next two months. More significantly, the two extremes in the 10-day ratio that year marked a severely negative sentiment from which prices increased an additional 130% during the next 2-1/2 years.

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