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Many stock market experts cite the the ratio of the volume of put options to the volume of call options (the put-call ratio) as an important indicator of investor sentiment, with a low (high) value indicating excessive optimism (pessimism). They assert, therefore, that this ratio is a useful contrarian indicator for future stock market behavior. Is it? In this entry, we test the value of the Chicago Board Options Exchange (CBOE) daily total exchange put-call ratio (put/call) as an indicator of future stock market returns. Using put/call data and contemporaneous daily S&P 500 index closing levels from 9/27/95 (the earliest put/call data available) through 5/4/07, we conclude that:
The following chart shows the daily behavior of CBOE total put/call and the S&P 500 index over the entire sample period. Visual inspection suggests that there may be an inverse relationship between the two series. A relative low (high) for put/call corresponds to a relative high (low) for the S&P 500 index. However, over the past few years, put/call has trended up with the market, and there are no levels of put/call that are obvious short-term buy or sell signals for stocks.
To take a closer look, we examine the relationship between put/call and changes in the S&P 500 index (returns).
The following scatter plot depicts the relationship between the five-trading day (one-week) future return for the S&P 500 index and the CBOE total put/call. The Pearson correlation for the two series is a weak 0.06, and the R-squared statistic is close to zero. Put/call offers hardly any information for trading with a one-week horizon. Since 10/1/02 (where a post-bubble change in relationship may have commenced), the relationship is marginally stronger, with Pearson correlation 0.10 and R-squared 0.01, but still much too weak for trading.
Might there be specific ranges of put/call that are predictive for a one-week trade, even though the entire series is not?
The next chart is a modified version of the prior scatter plot that orders the values of put/call to facilitate analysis of specific ranges. It also eliminates S&P 500 index return series overlap by selecting just every fifth data point. Each return value is therefore independent of other return values. Sample size is 584. While the return trendline rises very slightly with put/call, there are no ranges of put/call that reliably predict returns.
Might put/call be predictive for a one-month, rather than one-week, trading horizon?
The next scatter plot depicts the relationship between the 21-trading day (one-month) future return for the S&P 500 index and the CBOE total put/call. The Pearson correlation for the two series is a weak 0.09, and the R-squared statistic again barely registers. Put/call thus offers hardly any information for trading with a one-month horizon. Since 10/1/02, the relationship is marginally stronger, with Pearson correlation 0.13 and R-squared 0.02, but still far too weak for trading.
Might there be specific ranges of put/call that are predictive for a one-month trade, even though the entire series is not?
The next chart is a modified version of the prior scatter plot that orders the values of put/call to facilitate analysis of specific ranges. It also eliminates S&P 500 index return series overlap by selecting just every 21st data point. Each return value is therefore independent of other return values. Sample size is 139. While the return trendline again rises very slightly with put/call, there are still no ranges of put/call that reliably predict returns.
Might put/call be predictive for a three-month trading horizon?
The next scatter plot depicts the relationship between the 63-trading day (three-month) future return for the S&P 500 index and the CBOE total put/call. The Pearson correlation for the two series is a weak but somewhat larger 0.15, and the R-squared statistic is again uselessly close to zero. Put/call offers hardly any information for trading with a three-month horizon. Since 10/1/02, the relationship is marginally stronger, with Pearson correlation 0.16 and R-squared 0.03, but still much too weak for trading.
Might there be specific ranges of put/call that are predictive for a three-month trade, even though the entire series is not?
The final chart is a modified version of the prior scatter plot that orders the values of put/call to facilitate analysis of specific ranges. It also eliminates S&P 500 index return series overlap by selecting just every 63rd data point. Each return value is therefore independent of other return values. Sample size is just 45. While the return trendline rises very slightly with put/call, there are still no ranges of put/call that reliably predict returns (especially given the fairly small sample size).
The correlations between CBOE total put/call and various past S&P 500 index return intervals are generally stronger (but negative) than those stated above between put/call and future returns. This result suggests that investors/traders are more reactive than predictive with their options trades. In other words, it is more likely that stock returns lead put/call than vice versa. This result also suggests that trading on the put/call ratio may be roughly equivalent to betting on reversion of past returns to the mean.
Since the mean CBOE total put/call apparently varies over the long run, we also tested put/call relative to its three-month moving average as a stock market indicator. However, correlations with future stock returns for this relative put/call are even weaker than those for raw put/call at horizons of 5, 21 and 63 trading days. Correlations with short-term past stock returns are stronger (more negative) for relative put/call than raw put/call. More succinctly, relative put/call is even more reactive and less predictive than raw put/call.
In summary, the CBOE total put-call ratio is not a useful indicator for short-term or intermediate-term trading of the overall stock market. It is more likely a lagging than a leading indicator of stock returns.
For related research, see Blog Synthesis: Sentimental Journey, encompassing a broad range of equity market sentiment measures.
