Is Put Call Ratio Worth Your Time
According to Wikipedia, the Put Call Ratio is a technical indicator used by market participants to measure investment sentiment.
That is a decent explanation, unfortunately, it is somewhat incomplete. The presumption behind the Put-Call Ratio is that options trading volume is predictive of future returns. That is technically true, as evidenced by the popularity of the VIX Index (CBOE Volatility Index). However, that is true because the volatility index is based on the S&P 500 Index.
What that means is that statistics for a population tend to be relatively robust and easier to predict. Statistics for individual persons or financial instruments tend to be significantly more challenging.
A good analogy here will be selling life insurance to a 50-year-old man. Given that life expectancy in the most developed countries is close to 80 years, selling such insurance should be positive expectancy.
However, if you sell only one policy, you might get unlucky, and your customer could die in a car accident, so you do not necessarily make money on the policy.
Why Option Inputs Work Better for Indexes
In general, option inputs such as the Put-Call Ratio tend to work best for indexes, rather than single stocks, commodities, or any other single instrument. There are many reasons for that.
The most important one is that an index is diversified, hence subject to less specific, unpredictable volatility. The second, equally important reason, is that margin requirements for selling options on indexes are markedly lower. Therefore, the pool of potential option sellers is much larger, and the volumes they could sell short are also higher.
Finally, many risk management systems used by institutional investors treat short options positions in single stocks rather conservatively. Therefore, investors themselves may face significantly higher internal limitations on single-stock positions than they do in indexes.
VIX Indexes: A Superior Alternative to Put-Call Ratio
So, in a nutshell, if you are going to use option inputs like Put Call Ratio, those inputs should work best on options on indexes or ETFs. However, in index option trading, there is such a big choice of volatility indexes that makes the usage of the Put Call Ratio rather silly.
For the S&P 500, we have the VIX (30-day volatility index), VIX3M (3-month volatility Index), VIX6M (6-month volatility Index), VIX1Y (1-year volatility index), and finally, VIX9D (9-day volatility index). In our experience, the combination of VIX and VIX3M is the best choice for S&P500 volatility inputs. The results using those indexes outperform any informational input based on the SPY put-call ratio, so we do not use it for the S&P 500 at all.
When it comes to other indexes, we have VXN (Nasdaq 100 30-day volatility index), VXD (DJIA 30-day volatility index), RVX (Russell 2000 30-day volatility index), and so forth. There is also OVX (VIX for USO oil ETF) and GVZ (VIX for GLD ETF) for a full list; visit the CBOE website for more information.
To conclude this section, we will reiterate that option inputs work best for indexes like the S&P 500. However, the option inputs that work best are those based on option prices, such as VIX indexes, rather than put-call ratios. Since many indexes already have volatility indexes continuously calculated and disseminated, their usage is relatively easy, even easier than put-call ratios.
Moving on to Volatility Inputs on Single Stocks/Instruments
The most important criterion here is that there is enough option volume. In general, based on our experience, if a stock or instrument has listed maturities for at least 18 months out, option volumes are likely to be present and options can be used as an input into trading. Usually, that means that the stock is a constituent of the S&P 500.
Suppose a stock is not among the top 500 US stocks by capitalization, option volume ratios, or any other relevant metric. In that case, these figures cannot be relied upon to produce reliable and valuable results. We will return to those smaller stocks later on. Let’s first focus on the large stocks – constituents of the S&P 500.
First, there are single-stock VIX indexes. VXAPL (VIX for AAPL), VXAZN (VIX for AMZN), VXIBM (VIX for IBM), etc. For a complete list of single stock VIX indexes, please see the CBOE website. Again, if a VIX is calculated for any instrument, we will use that index over any other option input, such as the put-call ratio.
However, most single stocks do NOT have VIX calculated for them. In that case, we will calculate VIX ourselves. This can be easily done with a professional trading platform, such as TradeStation. Alternatively, if you don’t have one, you can use www.alphaquery.com. Again, it is best to use continuously calculated implied volatility from a professional trading platform; however, end-of-day calculations using an option calculator or data provided by a website like AlphaQuery.com are also acceptable.
Less Liquid Instruments and Alternative Approaches
Finally, we will delve into less liquid instruments, such as stocks that are not constituents of the S&P 500. In our opinion, option inputs are not particularly useful here. The money wagered on options for those stocks is too small, and the results they produce are much less reliable.
In our opinion, other fundamental data inputs, such as consensus price targets and short interest, produce much better results overall for smaller stocks.
Important Considerations: The Predictability Factor
It is essential to note that option inputs of any kind will only be effective if investors, as a group, possess a solid understanding of the business. The test here is the significant earnings gaps.
For example, AMZN is notoriously difficult to predict, and the stock tends to exhibit significant gaps, both up and down, around earnings announcements. In that sense, volatility inputs on AMZN are potentially not that important. AAPL, on the other hand, tends to be much more predictable around earnings, and thus option inputs on AAPL might be more reliable.
However, nothing beats experience in trading or investing in the sector. Option inputs are not a panacea for not thoroughly understanding the products you invest in or trade.
The Bottom Line
As a conclusion to our article, we will say that option inputs can be beneficial in trading. However, the put-call ratio is a rather crude technical indicator that we have stopped using entirely. Instead, we use VIX indexes when possible. If a VIX index is not available for the instrument being examined, we attempt to create or calculate one ourselves.