It is more important to know how much total money is being spent on puts versus calls, than merely to know the volume, writes the man who wrote the definitive book on options—Larry McMillan.
Put-call ratios are useful, sentiment-based, indicators. The put-call ratio is simply the volume of all puts that traded on a given day divided by the volume of calls that traded on that day. The ratio can be calculated for an individual stock, index, or futures underlying contract, or can be aggregated—for example, we often refer to the equity-only put-call ratio, which is the sum of all equity put options divided by all equity call options on any given day. Once the ratios are calculated, a moving average is generally used to smooth them out. We prefer the 21-day moving average for that purpose, although it is certainly acceptable to use moving averages of other lengths.
The chart on the right above is a sample one—of IBM. Buy and sell points are marked on the chart. Note that buy signals occur when the ratio is “too high” (i.e., near the top of the chart) and sell signals occur when the ratio is “too low” (near the bottom of the chart). The chart on the left above is that of IBM common stock, with the put-call ratio buy and sell signals marked on it. You can see that, in general, the signals are good ones. In reality, we couple technical analysis—using support and resistance levels—with the signals generated by the put-call ratios. The combining of the two methods normally produces better-timed entry and exit points in our trades.
NEXT PAGE: Normal vs. Weighted Ratios