Randy Frederick

   

It's possible that the equity ratio could be very high, while the index ratio is very low. If you combined the two, they might cancel each other out and appear to indicate a balanced sentiment. If you're going to look at the ratios intraday, you may need to decide which one has more validity.

Open Interest Put/Call Ratios

Because there are far more option strategies that involve holding a contract over a period of time instead of trading intraday, the open interest put/call ratio may be more helpful. The open interest is not calculated during the day or by an exchange.

Rather, it's calculated each night by the Options Clearing Corp. (OCC) once the day's trades from all exchanges are matched. Because the open interest indicates the number of contracts outstanding, it can be a helpful measure of sentiment over a given period of time. The OCC posts the open interest put/call ratios each day, but the OCC only calculates the ratio based on the combined equity and index values.

Because the open interest on equity options tends to be about 15 times what it is for index options, the combined ratio almost always reflects the level of the equity ratio. Through my research, I've found that when I separate equity and index values, the open interest put/call ratio on index options appears to be a much more accurate contrarian indicator of market sentiment than the equity ratio.

While the chart below only shows open interest put/call ratios, I've marked major market tops with green vertical lines and major market bottoms with red lines. What I find interesting is that, in many cases, the ratio for index options (black graph) peaked near market highs and troughed near market lows.

At the same time, it was difficult to recognize a trend in both the ratio for equities (pink graph) and the combined ratio (green graph), regardless of which way the market was headed. As you can see by the yellow trend lines, the index ratio shows much clearer trends, both up and down.

I've been tracking this data for about seven years, and although I find it helpful, it may be easier to focus on the trends that have occurred in the past year or so. Below is another chart depicting only the SPX (black line) and the open interest put/call ratio on index options (red line).

Because open interest tends to drop sharply on each monthly option expiration, I've also added a 21-day moving average (teal line) to smooth out the data. As in the longer-term chart, the ratio seems to rise and fall with the market (supporting its contra-indicator tendencies), but at times seems to change directions before the market.

Although I've found this data to be more reliable than the VIX, as with any statistical or technical indicator, be careful about relying on it too heavily. My main goal is to make sure that you understand the different types of put/call ratios that are used–and to caution you not to read things into them that may not be there.

Randy Frederick is Director of Derivatives at the Schwab Center for Financial Research. To learn more about him, read his bio.

This article originally appeared on The Options Insider Web site.

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