Valuable CBOE Put/Call Ratio Education ~ The Risk Averse Alert

Saturday, November 07, 2009

Valuable CBOE Put/Call Ratio Education

Some say options are a losing game. Yet are not options an instrument designed to limit loss? After all, options are meant to hedge — provide insurance — against some larger position, all at a cost of a relatively small premium.

And if mine eyes do not deceive me, as hedges appears precisely how options are used...


Seems intuitive that, in a bear market short positions increasingly would be hedged with call options. That's what the black line drawn above reveals, while the red line but adds an exclamation point ... highlighting increased call option buying during the worst of the stock market's bloodbath from Q4 '08 through Q1 '09. These call options were increasingly hedging winning short positions as the stock market was pounded into the ground.

Increased hedging of underlying short positions using call options is persisting over the course of the market's rally off March '09 bottom. We see this via the CBOE Put/Call Ratio's reaching a new absolute low late-August 2009, as well as via the trend of the Ratio's 200-day moving average.

Beyond this case making it rather plain options generally are employed as intended there's other valuable information also to be gleaned from the CBOE Put/Call Ratio...

For example, how might right psychological conditions just prior to a bout of selling take shape in the CBOE Put/Call Ratio? How about via fewer call option hedges being added, because confidence to press underlying short positions is fading while prices of the underlying continue their rise. That's what the blue lines you see drawn above suggest.

And right psychological conditions just prior to the stock market's turning higher? That's when fewer put option hedges are being added, because confidence to press underlying long positions is fading while prices of the underlying are finishing out their decline. You see this via the green lines drawn above.

Map these Put/Call Ratio divergences to the S&P 500 and you see how fair warning is given. The message is not always one suggesting an imminent reversal of fortunes. Rather, we also see (May-June, 2008) how a diverging CBOE Put/Call Ratio can warn of an imminent acceleration in the given direction the S&P 500 has already begun to travel...


Of course, these diverging CBOE Put/Call Ratio instances give no indication of the magnitude of movement in the S&P 500 one might subsequently expect. Well enough is fair warning given near tops and bottoms.

Inasmuch as March '09 bottom coincided with markedly fewer put options hedges being added to protect long positions than was the case at November '08 bottom, one might expect the end of the S&P 500's counter-trend rally off March '09 bottom to coincide with fewer call options hedges being added to protect short positions than has been the case thus far. Yet whether this is a necessary precondition for signaling the imminent resumption of the stock market's decline begun October 2007 is cast in doubt by the fact no such similar divergence occurred during the market's counter-trend rally from March 17th - May 19th, 2008.

So, there's a brief, Stock Market Analysis 301 primer using the CBOE Put/Call Ratio. Mixing my metaphors, whether you live long or short may you assuredly prosper putting the insights presented here to profitable use managing your risk investing in the stock market...

The 3 Gurus Plus
Online Seminar
November 10-12, 2009

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© The Risk Averse Alert — Advocating a patient, disciplined approach to stock market investing. Overriding objective is limiting financial risk. Minimizing investment capital loss is a priority.

Analysis centers on the stock market's path of least resistance. Long-term, this drives a simple strategy for safely investing a 401(k) for maximum profit. Intermediate-term, investing with stock index tracking-ETFs (both their long and short varieties) is advanced. Short-term, stock index options occasionally offer extraordinary profit opportunities when the stock market is moving along its projected path.

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