We spend a lot of time showing you how to use options to generate income and hedge your portfolio. These days, more and more investors are opening up to the idea of actively using options for market-beating returns and consistent income.

And while many have shed their reservations about using options for trading, there is another use for derivatives that we haven’t discussed much…

One of our favorite uses for options has nothing to do with buying or selling them directly. But instead, as a gauge of market sentiment.

Now, remember that no indicator is perfect. But this is one of the most widely followed by professional traders. It can actually help you time the market. In fact, you could have used this to avoid much of the market crash in 2008, for example.

The Put-Call Ratio

The put-call ratio is an extremely easy-to-use indicator and is marvelous in its simplicity. The ratio is the number of put options traded divided by the number of call options traded over a given period, usually one month or more.

For example, if 2.9 million put options were traded on the exchange and 3.2 million call options traded, the put-call ratio would be 0.91 for the period. Remember, calls represent an option to buy. And puts represent an option to sell. So, this measure would indicate bullish sentiment.

The ratio is most often used as a contrarian indicator — a way of betting against the investment herd. When the ratio is extremely high, i.e., many put options relative to calls, contrarian investors reason that traders are overly pessimistic. When the ratio reaches extreme highs or lows, it may mean that the bullish or bearish outlook has gone too far. So, the potential exists for a market reversal.

For example, let’s say everyone is buying calls and is overly bullish. Then, the potential for new buyers may soon hit a limit. Soon enough, the market will fall when the bulls start taking profits. Conversely, if everyone sells, the market may turn higher when buyers start scooping up lower prices.

The Chicago Board Options Exchange (CBOE) website provides historical data for the put-call ratio on equities, indices, and the overall total. The equity put-call ratio measures options traded on individual stocks. The index put-call ratio focuses on options traded on the major indices. The total put-call ratio is an aggregate measure of the two.

Since professional traders often use index options to hedge their portfolios, the index put-call ratio is usually above 1. Traders and investors are generally much more optimistic about individual stocks, so there are typically fewer puts relative to calls in the equity put-call ratio, meaning a measure of less than 1.

Using the Put-Call Ratio for Market Timing

We like to use the CBOE Total Put-Call Ratio (CPC) because it combines equity and index options for a more inclusive view of market sentiment. Since the daily ratio makes for a messy chart, the best way to use it is through a simple moving average to smooth the data. Some traders use the 10-day moving average for short-term market direction. We like using the 120-day moving average for longer-term market movements.

The graph below shows you the total put-call ratio from January 2020 through today. The 120-day moving average is noted in red, with bullish and bearish parameters at 1 and 0.85, respectively. (Note: this is a loose parameter, not a hard-and-fast rule.) When the ratio is around 0.85, there are much fewer puts than calls traded, and the market may be overly bullish. Conversely, a ratio of 1 is well above the long-term average and may indicate an overly pessimistic sentiment.

Action To Take

After the put-call ratio moves beyond one of the boundaries, you may want to wait for confirmation of a turn in sentiment by waiting for the ratio to significantly correct from the boundary line. This may mean you miss some initial change in sentiment, but it also helps avoid some of the false shifts the ratio indicates.

Looking at the chart, we can see the incredibly high levels in March of 2020. Understandably, many traders made bearish bets against the market as it fell during the Covid-19 selloff. However, as a contrarian indicator, this would have been an excellent time for bullish investors to buy. Of course, we benefit from hindsight because we know the market went on an incredible run afterward.

More recently, the critical 0.85 level was breached several months ago, coinciding with a market rally. Today, the ratio is 0.95, roughly in line with the moving average. This indicates bullish sentiment in the market right now. Keep in mind, however, that the market has a long-term bullish bias. So, this may not necessarily mean it’s time to sell. This isn’t the extreme sentiment we saw back in March of 2020. So, it may be best to simply interpret this as a neutral sign right now.

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