Puts and calls are derivative securities that let traders make bets on the short-term direction of stocks. Puts bet on falling prices and calls profit if stocks go up. If you are actively trading stocks, any signal for the next directional move in the market is a handy tool. An intraday put/call ratio indicator can be used to show market sentiment and often leads turns in the stock market from up to down or the other way around. Since the published intraday put/ratios update every half hour, you can check in every 30 minutes to see if the outlook of active traders is changing.
Puts and Calls
Puts and calls are option contracts that let traders make a leveraged bet on the direction of stock prices or stock index values. Puts go up if prices drop, so puts are purchased with the expectation of lower prices. Calls profit if prices rise, so call buyers are looking for higher prices. The Chicago Board Options Exchange tracks the number of puts and calls traded during the day and publishes three volume-based intraday put/call ratios. One covers options on stocks, another on stock indexes and the third is a combined ratio covering stocks and indexes. If more puts than calls have been traded, the ratio will be above 1.00. More calls pushes the ratio below 1.00.
The put/call ratio shows what traders think about the direction of stocks. As a result, the ratio is classified as a sentiment indicator. If it moves well above 1.00, a lot of traders are buying puts, which shows a belief that stock prices will soon decline. When the ratio drops well below the 1.00 level, the call buyers are in the majority and these traders are looking for higher prices. The put/call indicator will cycle above and below the 1.00 level as trader sentiment shifts.
If a lot of traders think the market is going down and buy puts, you might assume that a high put/call ratio would indicate the market is about to drop. However, historical data show that the ratio is actually a contrarian indicator. At the extremes, when the put/call ratio is high, view the peak as a signal that stock prices will go up. So if the put/call ratio drops well below 1.00, this is a sign the market is about to drop. For you as a day or swing trader, a high ratio is a sign to buy and a low ratio means you should sell.
Just an Indicator
If you want to add the intraday put/call ratio to your trading toolbox, you need to spend some time with your new tool and determine for yourself what levels of the indicator are good signals for your trading strategy. Take a look at all three intraday ratios published by the CBOE to determine which one best supports your trading. Remember that any indicator will not be 100 percent accurate, and you should fill your trading toolbox with several signals or indicators to help with your trading decisions.
Tim Plaehn has been writing financial, investment and trading articles and blogs since 2007. His work has appeared online at Seeking Alpha, Marketwatch.com and various other websites. Plaehn has a bachelor's degree in mathematics from the U.S. Air Force Academy.