The Put-to-Call Ratio at Extreme Values
In my previous not-so-flattering post on the put-to-call ratio (PCR) I demonstrated that predicting the direction of the PCR, though very easy, had no market timing value. In this post, I want to look at how the market reacts when the PCR reaches extreme high or low values.
Unfamiliar with the put-to-call ratio? Read my earlier primer.
First off, I’ve sliced and diced this thing six ways to Sunday and everything I’ve found shows that extreme high and low PCR values have NOT been consistently predictive of stock market returns (note emphasis on “consistently”). I know that making a statement like that is sort of like saying there are no black swans because I haven’t seen one, but until I find evidence to the contrary, my opinion stands.
But this just wouldn’t be MarketSci unless I left my readers with some nugget of wisdom – so here goes…
Even though high and low put-to-call ratios haven’t been predictive of market returns, they have done a pretty good job at predicting next-day volatility. The table above shows the increase or decrease in next-day volatility (standard deviation) of the S&P 500 at different PCR levels from 1996 to the present. The PCR is broken down by how far the PCR closed above or below its 50-day moving average.
High PCR levels (top row) indicate a bearish sentiment (high level of puts relative to calls purchased) and have been followed by a significant increase in volatility (+29.7%). Low PCR levels (bottom row) indicate a bullish sentiment and have been followed by a significant decrease in volatility (-17.3%).
These results have been fairly consistent over the entire 12+ years, but the effect has clearly been losing some steam in the new millennium. See graph below of the 5-year rolling average of next-day relative volatility at different PCR levels.
So combining the two put-to-call reports we can conclude (for now): (1) predicting the direction of the PCR is easy, but useless, (2) extreme high/low levels of PCR have NOT been consistently predictive of market returns, and (3) very high levels of PCR have been followed by an increase in volatility and very low levels followed by a decrease in volatility, but this effect isn’t as strong as it once was.
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