Blog - Investing Notes

June 22, 2007 - The Predictive Power of the Put-Call Ratio for Individual Stocks

In our blog entries of 5/8/07 and 5/9/07, we conclude that the aggregate put-call ratio is of little help in predicting the future direction of the overall stock market. How about put-call ratios for individual stocks? In their 2006 paper entitled "The Information in Option Volume for Future Stock Prices", published in The Review of Financial Studies, Jun Pan and Allen Poteshman investigate the predictive power of put-call ratios for the returns of individual stocks. They define the put-call ratio as put buy-to-open volume divided by the sum of put and call buy-to-open volumes. Using daily volumes for all Chicago Board Options Exchange (CBOE) listed options and associated stock price data during 1990-2001, they find that:

• The average put-call ratio is about 30%, with the lowest (highest) quintile averaging 0.1% (80%). The distribution of put-call ratios appears unrelated to size, book-to-market and momentum factors.
• Stocks with low put-call ratios outperform stocks with high put-call ratios by an average of more than 0.4% the next day and more than 1% over the next week. The effect dies out over several weeks with no subsequent reversal, indicating transfer of new information from option trades to underlying stock price.
• The predictive power of the put-call ratio is concentrated in contracts with far out-of-the-money strike prices.
• The effect is stronger for small-capitalization stocks and for stocks that exhibit a relatively high probability of informed trading (PIN).
• The effect is not a result of firm-specific news.
• There is no evidence of informed trading for market index options. There is some support for use of the NASDAQ 100 index put-call ratio as a contrarian indicator.
• Most or all of the predictive power of the put-call ratio comes from signals available only to those with access to detailed options trading data. Signals observable by the public predict stock returns for only one or two trading days and are subject to reversals.

In summary, put-call option ratios as defined have significant predictive power for individual stocks, with high (low) ratios indicating short-term underperformance (outperformance). However, this effect relates predominately to data that is not publicly available. Also, the effect does not work for index options.

For related research, see Blog Synthesis: Sentimental Journey. See also our blog entry of 10/9/06 on broad options trading behavior, apparently derived from the same dataset.