Utilizing Market Sentiment Indicators With Options

Options traders rely on data to build positions, make informed trades, and implement strategies to achieve their profit and hedging goals.

Trading ratios are popular metrics for reference and identifying current market sentiment. Many ratios are security-specific, meaning they only account for individual metrics with a specific contract or underlying company such as IV or one of the greeks.

However, in this post, we will discuss the put-call ratio (PCR), which will help us gauge larger market sentiment to identify if traders are feeling bullish or bearish.

The PCR is also a prevalent ratio for contrarian traders. These traders often go against the mainstream and look for opportunities when there seems to be a herd mentality in the markets.

Put-Call Ratio Defined

The PCR is calculated by taking the number of open market interest (OI) for puts and dividing it by the open interest in calls.

If XYZ company has 2,300 open puts and 3,443 open calls, then the PCR would be 0.668 or ~ 0.67. Since the PCR is < 1, this could be interpreted as bullish sentiment for XYZ company.

When the put-call ratio is > 1, there are more open puts than calls which would be a bearish indicator for the stock.

For instance, if the same XYZ company had 3,900 open puts and 2,281 open calls, the PCR would be ~ 1.71. This tells us that many traders anticipate a steep price drop or hedge their long positions if they expect poor quarterly performance.

Since the number of calls is the denominator for the PCR, it’s important to track how many puts are being purchased. Imagine if the ratio shot up quickly due to a decline in call interest, but the number of puts remained stable. In this case, it would look like there was a dramatic bearish turn for the underlying, without any ‘real’ increase in bearish activity.

Options Can Provide Market Insights

The PCR helps traders identify overall sentiment for the securities in question by determining if the market is pointing towards a breakout or crash. If you want to use the PCR to gauge the market’s perception, you could apply it to equity indexes such as SPY. Although one index does not necessarily guarantee that the market it represents will move one way or another, most analysts and investors rely on long and short interest to make predictions and build positions.

Implementing a Contrarian Strategy

Momentum traders generally use the PCR to source new positions they can jump in when the market starts moving aggressively up or down.

However, the put-call ratio is also a very popular contrarian indicator which may come as a surprise.

Contrarian traders build their strategies by searching for markets that are “overweight” and have too much herd mentality behind them. Famous examples of contrarian investors include Dr. Michael Burry, who predicted the housing market crash in 2008 and subsequently made a fortune on his short position.

Options contrarians will use the PCR in hopes of finding an index or a security that has an extreme bullish or bearish sentiment. Our example earlier had a PCR of 0.67, which is moderately bullish.

Contrarian traders would look for ratios closer to 0.22, which is very bullish, or 1.92, which is highly bearish.

Using Put-Call Ratios to Identify Reversals

Once the contrarian traders find a PCR with their target parameters, their next step would be to build a position that goes the opposite direction in hopes of making a profit on a large reversal.

If there is too much call interest on an underlying security, it may indicate a market top, leading to a large collapse in the contract price, yielding a huge win for the contrarian trader.

Gathering Reliable Put-Call Data (Lantern)

Whether you are a momentum trader looking for the next big move, or a contrarian trader trying to capitalize on a reversal, you should certainly consider implementing the put-call ratio into your research and analysis. Remember, there is no such thing as a perfectly accurate ratio, so always perform due diligence in your options trades.

Your ratios are only as good as the data you use to make them. Thankfully, the Lantern API and Lantern App give you direct access to the most up-to-date options data you could need.