The Put/Call Ratio Charts

In the Dumb Money Trader Facebook Group today, I posted this pic with the comment “I look at put/call ratios from time to time. In specific, $PCSP and $PCALL. Noticed that both bottomed today. Bottomed where they’ve been hitting bottom for quite some time. These charts sometimes coincide with what the market does – the same seesaw effect. Meaning, if PC hit bottom, the market may pullback soon.

Somebody replied to it basically asking what I meant, and what is the PC ratio telling me. And his question was my inspiration for this blog post. So here we go!

First, the only 2 PC charts I use are 1) $PCSP (put/call ratio for the S&P 500) and 2) $PCALL (put/call ratio for the entire market). There are others, but I will not get in to them right now.

The P/C ratio chart (I call them PC’s) is the ratio between puts and calls. Remember from options 101 that puts are bearish, and calls are bullish. To know what the ratio is you simply divide all the puts by all the calls.

Let’s say there are 1000 puts and 500 calls. The put/call ratio would be 2 (1000 puts divided by 500 calls). Now let’s say there are 500 puts and 1000 calls. The put/call ratio would now be .5 (500 puts divided by 1000 calls). Lastly, let’s say there are 1000 puts, and 1000 calls. The put/call ratio would be 1 (1000 puts divided by 1000 calls).

So now that you know the basic math involved, let’s discuss the basic theory behind this ratio.

According to Investopedia, a ratio above .7 is considered bearish, and below .7 is considered bullish. That is, above .7 means there are more people buying puts than buying calls. Which can be a bearish sign. Why .7? Simple. Since people typically buy more calls than puts, using a ratio of 1 would not be “accurate” to determine market direction because that would imply a 1 to 1 split between puts and calls. So, the investing gods decided .7 was a good “middle” point. Honestly, past what I just told you, I don’t know any other reason for .7 being “neutral.”

Now, what can this ratio tell us? I use these charts from time to time, to help me determine which direction I think the market is going. If I open this chart and see a rising PC, I may go easy on my bullish bets. But if I open this chart and see a falling PC, I may increase my bullish bets. I have noticed that this ratio sometimes coincides well with market moves. Meaning, I have noticed that some very bearish days in the market was preceded by a rise in the PC ratio.

If people are getting bearish, they’re not going to buy calls, and vice versa if people are getting bullish. So, if the PC is rising, that can be a sign that people may be getting more bearish because they are buying more puts. If the PC is falling, that can be a sign that people are getting more bullish because they are buying more calls. As always, does this mean it’s guaranteed bearish or bullish sign? Absolutely NOT! But the more tools you utilize to make investing decisions, the better off you might be. No one particular “indicator” is going to be 100 % accurate.

Investing is like a puzzle – You have to put all the pieces together to see the bigger picture.

PERCENT GAIN? OR DOLLAR AMOUNT?

What’s more important: Percent gain or loss, or dollar amount? If you ask me… 100%… percent!

First, let’s discuss why, no matter what your account value is, the percent gains or losses are the same.

If I have an account with $100,000 and you have an account with $1,000, what I make (or lose) will be much more than what you make (or lose), but the percent gain (or loss) will be the EXACT same.

So… Stock ABC (hypothetical company) is trading for $10 per share. We both want to buy shares because ABC is an awesome company and we think it’s going up from here. Our risk tolerance is 2% of our account value. That means my risk is $2,000 (2% of $100,000) and your risk is $20 (2% of $1,000).

For the sake of this example, I will leave any trade fees out of it.

With your $20, you purchase 2 shares ($10/share). With my $2,000, I purchase 200 shares. And wouldn’t you know it! The very next day ABC jumps up $2 per share. WOO HOO! Our analysis was correct, and we decide to exit the position with a profit.

You bought 2 shares, so you made $4 ($2 gain per share multiplied by number of shares). I bought 200 shares, so I made $400 on the trade. Fantastic! I made much more than you did… neeeener neeeener, pumpkin eater!! But guess what? Our percentage of profit was identical.

We each gained 20% on the trade, and .4% on total account value. Here are the numbers:

My account – $400 gain on a $2,000 position is 20%. $400 gain in a $100,000 account is .04%.

Your account – $4 gain on a $20 position is 20%. $4 gain in a $1,000 account is .04%.

Well well well! Would ya look at that. We both made a GREAT decision to buy. I’ll take a 20% gain for every trade I make EVERY DAY OF THE WEEK!!

What is my point with all this? That’s easy… ignore the bragger types and the ones who say stuff like “well, try doing that with a large account,” or “ya, but your account is so small.” Blah blah blah!! In investing/trading, what matters the most is that you make good investments/trades. The only way to know if your investment or trade was a good idea, is the end result. And the end result ends in a gain or loss, period! The fact someone is a millionaire, and I’m not, means nothing! Just because they’re a millionaire, does not mean they’re a good investor or trader.