Put Call Ratio

Most people are familiar to some extent about stock options, but few realize they can be used to determine if the market is at a bottom or at a top. By combing the options you can generate a put call ratio.

The formula for the ratio looks like this.

Total Volume of Puts/ Total Volume of Calls

The ratio is used to generate the sediment feelings of the overall population. If there are more puts being traded then calls the overall population feels the market is bearish. If there are much more calls being traded then puts that means the majority of the population is bullish on the market.

When this ratio, goes below .45 it said to be the market top.

The idea here is that when everyone is buying call options it is a signal that the market has been trending up for a long time and it is due to pull back. When everyone is buying put options it is a signal that the markets have been falling for a long time and will start going up. This is similar to the way in which the market top normally occurs when everyone is bullish. When the ratio gets above .70 it is said to make a market bottom. Just like the market bottom occurs when everyone believes the markets will fall forever.

Those numbers normally give off a very reasonable estimate of what will happen in the near future. However, index options historically have a higher put to call ratio then other stocks because of large institutions hedging their positions.

Another interesting thing which you can do with options is called the put to call parity. It lets you get the same return on an option that you would have gotten if you had just bought the stock. Once more you can do this for a lot cheaper than buying the stock.