While most options traders are familiar with the leverage and flexibility that options offer, not everybody is aware of their value as predictive tools. Yet one of the most reliable indicators of future market direction is a contrarian-sentiment measure known as the put/call options ratio. By tracking the daily and weekly of puts and calls in the U.S. stock market, we can gauge the feelings of traders. While a of too many put buyers usually signals that a market bottom is nearby, too many call buyers typically indicates a market top is in the making. The bear market of 2002, however, has changed the critical threshold values for this indicator. In this article, I will explain the basic method and include new threshold values for the equity-only daily . (Find out how to play the middle ground in Hedging With Puts And Calls.)
Betting Against the "Crowd"
It is widely known that options traders, especially option buyers, are not the most successful traders. On balance, option buyers lose about 90% of the time. Although there are certainly some traders who do well, would it not make sense to trade against the positions of option traders since most of them have such a bleak record? The contrarian sentiment demonstrates that it does pay to go against the options-trading crowd. After all, the options crowd is usually wrong.
As often happens when the market gets too or too , conditions become ripe for a reversal. Unfortunately, the crowd is too caught up in the feeding frenzy to notice. When most of the potential buyers are "in" the market, we typically have a situation where the potential for new buyers hits a limit; meanwhile, we have lots of potential sellers ready to step up and take profit or simply exit the market because their views have changed. The is one of the best measures we have when we are in these oversold (too ) or overbought (too ) zones.