Remember this when studying stock market direction: Investor sentiment can provide some of the most reliable signals.
Sentiment works in a peculiar way, and the put-call volume ratio has become a valuable tool in identifying market tops and bottoms. With this gauge, options traders act collectively as a market indicator.
The ratio consists of totaling up each day’s volume of call options and the volume of put options. Call options are bullish bets, purchased if you expect a stock or index to rise. Puts are bearish bets. Normally, the volume of calls is higher than puts. When it flips and more puts are purchased, the options crowd is bearish.
You would think the stock market tops when there’s an excessive amount of bearish put volume, but it’s actually the opposite. History shows it is precisely when options traders are most fearful that the stock market bottoms.
Specifically, pay attention when the put-call volume ratio spikes above 1.15. This level of investors sentiment has repeatedly marked market bottoms over time.
Investor Sentiment Flags Bear Market Lows
In the throes of last year’s coronavirus bear market, the ratio climbed above 1.15 in early March then eased back. Then, multiple times later in March, the ratio registered readings above 1.2. The Nasdaq and S&P 500 bottomed on March 23. Shortly later, on April 2, the new market uptrend was confirmed with a follow-through signal.
It’s important to note that in this major bottoming period, the ratio spent many days above 1.15 until the market bottomed for good. So the timing of the signal and actual bottom can differ quite a bit.
You can go back further in time to find other examples. In 2019, the market bottoms of early June, August and October shared the same signal: The put-call ratio spiked above 1.15 and even 1.2.
The put-call volume ratio also gives topping signals. If it falls below 0.6, consider it a warning. But the ratio’s topping signals haven’t been so accurate. Last June and August, for example, there were false signals. But a drop to 0.5 on Sept. 1 did coincide with the start of a market decline.
Investors should not make market-timing decisions solely on the put-call ratio or any single indicator. The follow-through is still the best bottoming signal. A high number of distribution days can flag market tops.
The put-call volume ratio is updated each day in the Psychological Market Indicators page of Investors.com.
Juan Carlos Arancibia is the Markets Editor of IBD and oversees our market coverage. Follow him at @IBD_jarancibia
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