McClellan Chart In Focus: Equity Put/Call Volume Ratio’s 21-Day MA – By Tom McClellan

 

Chart In Focus

The stock market selloff since the last new all-time high on July 26 has brought the bears out, and they have been trading a lot of put options.  Some trade those as an outright bearish bet, and some as a hedge on portfolio risk.  Whatever the motivation for those trades, it is a sign of a bottoming condition for prices when we see persistently higher trading of put options versus call options.

This week’s chart looks at a 21-day moving average of the daily CBOE Equity Put/Call Volume Ratio.  21 trading days is roughly one month, and so it can make for a useful lookback period for this purpose.  It smooths out the daily spikes, and allows us to see what the Put/Call numbers have been doing more broadly.  When it gets to an extended level, either high or low, it says that prices should be at a meaningful turning point. 

Other lookback periods can also be useful.  I like to use a 5-day MA for this purpose also.

One problem is identifying where “high” and “low” reading thresholds are.  The horizontal dashed lines are arbitrarily placed on the chart, using the LAR method (Looks About Right).  And there can be some drift over time, as some periods see generally higher or lower numbers than other periods.

To grapple with that, years ago I did some tinkering and came up with this next indicator.  It involves a lot more computations, but it is based on the same raw data.  Its formula is as follows:

    21MA(calls) – 21MA(puts)
———————————–
  [21MA(calls) + 21MA(puts)]

Then I calculate a 50-day MA of that ratio.  Finally I measure how far that ratio is away from its 50MA to get the indicator you see here:

Equity Call/Put oscillator

By first averaging the numbers of calls and puts separately, it allows for greater volume days to not get washed out into just the daily ratios.  By placing calls ahead of puts in the formula, instead of the normal Put/Call Ratio, I am flipping the orientation of the plot to better correlate with how prices behave.  And by measuring the deviation from the 50MA, I am correcting for any drift over time in the normal levels of puts and calls, making for a nice clean oscillator with more well-defined boundaries of “normal” range behavior.

Interpretationally, the net result is the same in terms of showing us an extended condition right now.  Once again, I have set the dashed horizontal lines using the LAR method, and that seems okay for this purpose.  Someone else who might replicate this indicator could come up with a more scientific method of designating “high” and “low”, and I would not quibble with that. 

The immediate message of this indicator now is that equity options traders have been a whole lot more interested in trading puts lately versus calls.  That is a sign of trader pessimism, and when pessimism (or optimism) goes too far, it gives us a useful message.

Tom McClellan
Editor, The McClellan Market Report

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About the author

Sherman and Marian's son Tom McClellan has done extensive analytical spreadsheet development for the stock and commodities markets, including the synthesizing of the four-year Presidential Cycle Pattern. He has fine tuned the rules for interrelationships between financial markets to provide leading indications for important market and economic data. Tom is a graduate of the U.S. Military Academy at West Point where he studied aerospace engineering, and he served as an Army helicopter pilot for 11 years. He began his own study of market technical analysis while still in the Army, and discovered ways to expand the use of his parents' indicators to forecast future market turning points. Tom views the movements of prices in the financial market through the eyes of an engineer, which allows him to focus on what the data really say rather than interpreting events according to the same "conventional wisdom" used by other analysts. In 1993, he left the Army to join his father in pursuing a new career doing this type of analysis. Tom and Sherman spent the next 2 years refining their analysis techniques and laying groundwork. In April 1995 they launched their newsletter, The McClellan Market Report, an 8 page report covering the stock, bond, and gold markets, which is published twice a month. They utilize the unique indicators they have developed to present their view of the market's structure as well as their forecasts for future trend direction and the timing of turning points. A Daily Edition was added in February 1998 to give subscribers daily updates on their indicators and also provide market position indications for stocks, bonds and gold. Their subscribers range from individual investors to professional fund managers. Tom serves as editor of both publications, and runs the newsletter business from its location in Lakewood, WA.