Introduction
The technical analysis universe is filled with indicators that are lagging, relative to price action. Therefore, wouldn’t it be great if there was a way to gauge the risk appetite of the market? Or, wouldn’t it be great if we could see that a specific market is approaching an extreme level and take our measures before the reversal occurs? That’s what we’re going to dive into here. Welcome to the Put / Call Ratio as a contrarian indicator. We’re not going to waste time in theoretical aspects here, there are lots of resources in the Education section of this website. Instead, we’re going to look at how P/C Ratio can provide useful and early insights to traders looking for market reversals.
Put / Call Ratio: How Much Is Too Much?
At first, let’s try to identify some extreme levels in the P/C Ratio, if we can. Generally speaking, a Put / Call Ratio above 1.5 is considered a signs of extreme bearishness, indicating fear in the market. On the other hand, a Put / Call Ratio below 0.5 is considered a sign of extreme bullishness, signifying underlying greed. However, these levels are arbitrary to a large degree, as each market bears its own idiosyncracies.
For instance, it has been found that in the Treasury Bond market, a Put / Call Ratio of Treasury Bond Futures options greater than 1.1 meant extreme bullish sentiment, while when it fell below 0.7, it signified extreme bearish sentiment.
In the stock market, and particularly in the S&P 500, it has been found that an envelope, based on a 49 day moving average of the Put / Call Ratio, with extreme levels at 0.5 and -1.7 Standard Deviations respectively, works well as a contrarian indicator. In simpler terms, a long position is opened when the upper band is touched and a short position is opened when the lower band is touched.
Put / Call Ratio And RSI: A Strong Combination
As we’ve mentioned many times, the quest of profitable trading relies heavily on the interpretation of multiple indicators. It is very rare, and most often the result of luck, that a “signal” from a sole indicator will be profitable. If this happens every now and then, it certainly won’t happen in the long run. That’s why trading with the Put / Call Ratio in cooperation with the Relative Strength Index increases the effectiveness exponentially.
We’ve already talked about how Put / Call Ratio gauges the market sentiment. In our article “Relative Strength Index: Top 5 Mistakes Of The Novice Trader”, we argued that a common mistake novice traders make is to trade based on every overbought / oversold situation, as signaled by the RSI, no using additional tools for confirmation. However, if we combine RSI (14) oversold levels on a weekly chart with Put / Call Ratio bands at 1.5 Standard Deviations for the S&P500, the results are spectacular.
Created with TradingView, the chart listed above shows how effective a Buy – And – Hold strategy would be in the case of S&P500. However, we should bear in mind that the direction of the prevailing trend always plays a big part in such cases. As we can see by the plotted Moving Averages, the S&P500 is on a long term uptrend that makes trading in that direction much safer and more productive.
Bottom Line
The Put / Call Ratio is not some magic wand that reads behind the market lines. However, its extreme readings do provide traders with valuable information about upcoming reversals. The combination with other technical indicators is suggested, in order to extract more prediction value.
