Ratios That Precede Stock Pullback

by Victoria Duff

Technical analysis of the securities markets is a relative science. As John Murphy, a leading expert, advises: "Technical analysis is a skill that improves with experience and study." The put-call ratio is one of the most reliable signals of market change, but it can give false signals and the levels where signals occur are mutable. The best way to use the put-call ratio is via a chart and in comparison to other market indicators.

Technical Analysis

Technical analysis methods are based on human action and reaction in the marketplace, quantified and displayed in chart form. The longer you work with technical analysis principles, the more you realize there are no definites -- only ever-changing relationships that are indicative of just a small part of a very complex whole. The put-call ratio is the number of puts divided by the number of calls outstanding on the Chicago Board Options Exchange for a market sector. The ratio is tracked over time by charting it, just as stock prices are charted. Although it is well-regarded as an indicator of market turns, if you are concerned with absolute accuracy, check it against other indicators to verify the signal.

Puts and Calls

A put is an option, traded on the CBOE, that is an agreement giving the buyer of the put the right to sell a specific number of shares of a stated stock at a stated price. The creator, or writer, of the put seeks to make money by selling the put to a buyer. The put-writer thinks the market is so strong it presents little chance the put-buyer will exercise the option. If the market declines, the buyer will "put" the stock to the put-writer, requiring the put-writer to buy the stock at the agreed price, which is likely to be higher than the current market price. A call is an option to buy a stated stock at a stated price. People buy calls because they think the market is going to rally and the call will allow them to buy the stock at a below-market price, just as a put allows the holder to sell stock at a higher than market price if the market declines. The call-writer, like the put-writer, writes the option to make money through selling it. The call-writer believes the market will stay the same or drop and the put writer thinks the market will continue to rally. Think of the option writer as making a bet on market direction, and the option buyer as taking that bet.

Put-Call Ratio

The higher the put-call ratio, the greater the chance a market rally is just ahead. The lower the ratio, the stronger the chances of a drop in the market. The logic behind this is based on supply and demand. When supply is high, the price of the supply declines. It declines because the demand is weakening. When demand is high, the price of the supply rises because there is more demand than supply.

Complacency

A good explanation for why the put-call ratio works is the level of complacency in the market. If traders get comfortable with a market rally, they write a lot of puts, figuring that the market will continue to rise and they will never see their puts exercised. They cease to be careful about writing puts because they feel they are safe. In the same way, the cash buyers of stock continue to buy because they feel the market will continue to rally. When all the cash buyers have bought as much stock as they can, there is no more demand in the marketplace. That is when prices decline. Until the tipping point is reached and the decline starts, stock buyers and options writers are complacent about the future of the market. The tipping point destroys complacency and the market turns.

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