The Option Premium Ratio by Christopher Cadbury
Christopher Cadbury, member of the American Stock Exchange and book author, explains a sentiment indicator generated from the equity options market that identifies trading opportunities in the stock market.
Monitoring market sentiment data is a popular technique today because investors can use the data for market forecasting. One popular sentiment measure is derived from investment sentiment surveys, while another sentiment indicator is the ratio of put trading volume to call trading volume. A lesser-known measure of sentiment is the option premium ratio, which is the total equity put premiums divided by the total equity call premiums. This data is calculated and presented in each issue of the Investor's Business Daily on the General Market Indicators page, under the fifth psychological market indicator. I will present methods of using the option premium ratio, but before I do so let us review other sentiment indicators.
Investment surveys, which are conducted among investment advisors and the investing public, are used as a contrarian indicator. If survey respondents are very bullish, then money is considered to be already commited to the stock market, and so the available buying power is regarded as already depleted. When that occurs, the market is considered vulnerable to a decline because bullish leading advisors can only become less enthusiastic about the market. It is likely that those who follow these advisors will start selling when the advisors temper their outlook for the stock market.