Prologue

For the past couple of weeks, I’ve been looking into using the Put/Call Ratio as another decision point for my entry or exit rules. This ratio seems to be well received as a “predictor” of sentiment rather than a reporter of sentiment. But using it needs to come with a few caveats.

Calls vs Puts

To help me decide how to interpret a Put/Call Ratio, I’m going to explain it using AMD as an example.

The shares of AMD that I own rose above $40 a share this week. At this price, AMD has nearly doubled its value since the start of this year (11 months ago). The end of the year is approaching, and I now have a decision to make. My choices are:

• Sell my shares in AMD now and take the profit. I may miss any further rise in value since AMD has been on a tear for the past six months. Plus, I will have to pay the short-term capital gains tax for selling AMD at its high profit.
• Or hold on to my shares and take the risk of an end of the year sell-off. I understand that since AMD is now extremely overvalued, an EOY sell-off may trigger an AMD price correction that may take away a significant portion of my profits for a long time.
• Or buy a $40 Put Option for AMD that will expire shortly after the new year starts (say, 6-weeks from now).

When I buy a $40 AMD Put Options contract, I am buying the opportunity (not the requirement) to sell my AMD stocks at $40 a share anytime before the Option’s expiration date. So, if I believe that the price of AMD could drop in an end-of-year sell-off, then I could buy a $40 Put Options contract as a form of price insurance.

Therefore, for my purchased Put contract to be successful, the price of AMD must drop – which is being bearish.

On the flip side:

Over the past thirty days, the price of AMD’s stock rose from $31.76 per share to $41.19 in what some have called an end-of-year melt-up. This $9.43 per share increase in thirty days represents a value growth of nearly 30%. AMD had a great month.

When I buy a $40 AMD Call Options contract, I am buying the opportunity (not the requirement) to buy additional AMD stocks at $40 a share anytime before the Option’s expiration date. If I believe AMD will continue to rise through the end of the year, then I could buy a $40 AMD Call Options contract.

Therefore, for my purchased Call contract to be successful, the price of AMD must rise – which is being bullish.

I’m making these Put/Call comparisons as a way to explain why the mass-Marketeers would buy a whole lot of Puts or a whole lot of calls.

Put/Call Ratio

If I were to add up all the Put Options contracts that were bought today and compare it to the total of all the Call Options contracts bought, I should be able to assume what the current marketeer’s sentiment is – right now.

For example, as of this writing, there have been 4,950 Put Options contracts for ETF:DIA (DOW Jones) bought so far today. At the same time, there have been 5,473 Call Options Contracts purchased. In a hair-splitting analysis, I see more Call contracts bought than Put contracts. Therefore, more Marketeers believe that the DIA will increase in value (because they are buying more Call Options as insurance from a rising price). And sure enough, when I look at the current value of DIA, it is up to $0.50.

Calculating the Put/Call Ratio

To make this an easy matrix to look at, I can divide then the number of Put Options contracts bought by the number of Call Options contracts. Using the above, 4,950/5,473 = 0.9 as a Put/Call Ratio.

If there were the same number of Put Options bought as Call Options (say 1,000 Puts and 1,000 Calls), then the Put/Call Ratio will equal 1.0 (1,000 Puts / 1,000 Calls). If there are twice the number of Puts bought than Calls (say 2,000 Puts and 1,000 Calls = 2,000 / 1,000), then the P/C Ratio will equal 2.0. And conversely, if there are twice the Call Options bought than Puts (say 1,000 Puts and 2,000 Calls = 1,000 / 2,000), then the P/C Ratio will equal 0.5.

Therefore, a P/C Ratio that is above 1.0 signals a falling sentiment (bearish) in the DIA (or any stock that I am examining) Likewise, a P/C Ratio below 1.0 signals a rising market sentiment (bullish).

The farther the P/C Ratio is below 1.0, the higher the optimism (bullish). The higher the ratio is above 1.0, the lower the optimism (bearish). I seem counter-intuitive to how it sounds.

Interpreting the Put/Call Ratio for Stocks

From my perspective, a snapshot of what the P/C Ratio is currently is relatively nebulous. The only way that this ratio can be meaningful is if I follow it’s trend over a period of time.

Here are some possible guidelines when considering the Put/Call Ratios when trading stocks:

• A Put/Call Ratio that has oscillated for a time below .5 could mean it is severely bullish. Maybe too bullish. It could be a good time to sell my stocks and take a profit.
• A Put/Call Ratio oscillating .5 and 1.0 could mean it is still trending bullish but, but not too much.
• A Put/Call Ratio oscillating between 1.0 and 2.0 could show the stock is trending bearish, but not to fast.
• A Put/Call Ratio oscillating above 2.0 could mean it is severely bearish. Maybe too bearish. It could be a good time to consider buying low.
• A Put/Call Ratio oscillating between .5 and 2.0 could consider moving sideways.

Interpreting the Put/Call Ratio for Options

Here are some possible guidelines when trading Options:

• A Put/Call Ratio that has oscillated for a time below .5 = sell a Vertical Bull Call Debit Spread
• A Put/Call Ratio between .5 and 1.0 = sell a Vertical Bull Put Credit Spread
• A Put/Call Ratio between 1.0 and 2.0 = Sell a Vertical Bear Call Credit Spread
• A Put/Call Ratio above 2.0 = Sell a Vertical Bear Put Debit Spread

This Week’s Market Sentiment

As of 11/18/2019

General Volatility: VIX = 12.05 and falling from last week
Put/Call Ratio (all options): $PCALL = .68 and falling from last week
Consumer Sentiment Index (CSI): 95.7 – down 2.9% from 1-year
DOW 28,004: At an all-time high
S&P 3,120.46: Also at an all-time high

Right now, the super low volatility is falling towards that 2017 sweet spot where we had a year of sustained growth (AKA the Trump Bump). The Put/Call Ratio continues to fall from last week and is now approaching its three-year low of .66. And consumer sentiment remains high.

According to the Feds, unemployment is at historic lows, and the general economy seems stable (no talks of interest rate changes soon.)

All of the above suggests a continued uptick in most of the market indexes – at least for the following week. But I need to be cognizant of a possible End-Of-Year sell-off

Profit and Loss Statement

As of 11/22/2019

Although this has been a training year, the loss to date of -$818.40 is not a death blow. When I consider that $688.50 of the -$1,009.40 went to paying Ameritrade’s trading fees, these fee payments makes a whopping 68% of my losses. But the trading fees Ameritrade charged was dramatically changed this year to my favor.

At the beginning of this year, trading fees (including those fees charged when options are assigned) were somewhat debilitating (see my post “Handicapped by Brokers Fees“). In this post, I laid out how Ameritrade was gobbling up a high percentage of every trade. 

 But in October of this year, there was a seismic shake of the trading fees charged across all brokers. Most online brokers eliminated all trading fees, plus I was able to keep my negotiated Options Leg fees at $.50. Now the cost to buy/sell options contracts is reduced to about a buck per trade instead of nearly $6.00. This fee change has dramatically eliminated the most significant cancer to my project (see “Saved By The Broker” post). 

Schedule for this Week

Goals for Week:

• Max technical dollars at risk = $1,000
• Coordinate traded expiration dates to have a blend of Call/Put Credit Spreads
  • Minimize actual dollars at risk for any given expiration date.
  • Give the Call Spreads higher risk tolerance (more risk with calls than with puts).
• Place no more than one trade per day – except Friday (catch up day).

Monday:

• Determine/update this week’s market sentiment section.
• Calculate Put/Call Ratios for all stocks on the watch list.
• Review and tweak Trend-Channels for all stocks in the watch list.
• Confirm that the target expiration date for all options trades is set as follows:
  • Bull Put Credit Spreads: Dec 27 (6-weeks).
• Stage possible trades for all watch list stocks by 10:00 AM
• NO TRADING BEFORE 10 AM. (Let the market find its direction after the weekend.)
• Watch 1 Webcast or take one online mini-course to be completed by Friday.  

Tuesday – Thursday:

• Review how yesterday’s staged trades moved. Adjust premiums to take advantage of movement as “long-shots”). 
• Submit a couple of Spreads, but keep a close watch. If one takes, cancel the others (we just want one new active trade). 
  • Be mindful of Entry Rules.
  • Balance the spread strategy (Call/Put) to minimize actual risk for that expiration date.
• Update trading log file and journal (this blog) with any accepted trades.

Friday:

• Review the total technical dollars at risk for this week. If significantly below $1,000 then submit additional spreads.
• Update and post weekly journal (this blog) with any lessons learned or strategy changes.

This Week’s Trade Activity

As of 11/22/2019:

Spread Count Summary:

Current Dollars at Risk:

New Trades for This Week

Between now and the end of this year, I do not plan to open many (or any) new trades unless there is a short-term educational value to the effort. The goal is to allow the existing trades to be closed out before Dec 31 and start the new year at zero.

QQQ: 208c/212c – 1 Contract – Open 11/21 – Expires 12/13 – Credit = $34.00
(Vertical Bear Call Credit Spread)
Open: Prob. OTM = 86.7%, ROR = 9.0%, PC/Ratio = 5.41, Max Risk = $365.00

I entered this trade to test the use of the Put/Call Ratio as a decision point.

The expectation for this trade is that QQQ will drop before expiration. Besides the usual entry rules for a bear trade (the 9-day SMA has fallen below the 50-day SMA, the probability of OTM is greater than 85%, the Return on Risk is higher than 7.5%, and the current value QQQ is near the top of the Trend Channel), the Put/Call Ratio for QQQ is now above 5.0.

But the reason for this position is to review how the Put/Call Ratio relates. The Put/Call Ratio greater than 5 suggests an extreme bearish sentiment amongst the Marketeers for QQQ. There are currently five times more put options being purchased than call options. So most traders are hedging for a lower QQQ.

I’ll follow this and see how it pans out.

Epilogue

In writing this post, it occurs to me that the Put/Call Ratio may be no better of a predictor than just following the price trend. There are many purchasing conditions when buying a Put does not necessarily mean I believe prices will drop, nor buying a Call means I think the prices will rise. I could be purchasing a Put Options as a stop-loss to selling a Put Option in a Vertical Bull Put Credit Spread.

It seems that if we can restrict the count to just naked Puts or naked Call in the calculation, then that would be a meaningful matrix.

Cheers…