The Option Premium Ratio And The DJIA by Christopher Cadbury
The discussion on the option premium ratio continues, with more examples on forecasting short-term movements in the DJIA.
Previously, I introduced the option premium ratio, which is the ratio of price premiums on puts versus calls. If it seems familiar, there's a good reason: It's the fifth psychological variable on the General Markets Indicators page in Investor's Business Daily. The premium ratio, in my opinion, is the best of all the sentiment indicators. Let me explain one of the ratio's truly outstanding characteristics, the way that it leads to rallies and declines, depending on the level of two of the same daily readings. Two of the same daily readings arise frequently, indicating that the sentiment toward the stock market is constant.
The daily values for the option premium ratio have extended from 0.03 to 1.74 since 1986; values under 0.29 are only associated with bear markets, while values of more than 1.18 are seen exclusively during rampaging bull market legs. Most of the time, values for the premium ratio range from 0.29 to l.18. Over the years, the median values for the premium ratio have been far less than the ratio's mean. The median value has remained in the low to mid-0.60s. Two of the same daily readings at levels well below the median, from 0.40 to 0.54, generally produce rallies. Two of the same readings at levels well above the median, from 0.78 to 0.88, usually result in declines. At two of the same values very near the median, from 0.6l to 0.67, the direction of the underlying market over the period of the two readings normally forewarns of the market's future course. A rising market will continue to rally, while a declining market will continue to fall.