Predicting Market Extremes Using the Put/Call Ratio
Updated: March 22, 2013 at 2:43 PM
Options have long been popular with forex traders for hedging, for directional bets, maximizing profit or for more complex strategies that are out of the scope of this article, but over the years, the record of options trading for buyers has not been stellar exactly. Predicting market direction in a specific time frame is always a difficult endeavor, and when the options trader must make those predictions in strict adherence to the terms of the options contract, the chances of success plummet. About 90 percent of option buyers eventually lose money, in sad testimonial to the difficulty of market timing.
Option writers have been increasing the types of available contracts to satisfy the hunger of the crowd for these instruments, and if not for the recent economic crisis, the volume and diversification in this market would certainly have continued to accelerate. In spite of all that, the basic puts and calls remain the most popular tools for the trader who desires to try his luck in this field, and there’s always a great deal of demand for the ever increasing supply coming from option brokers.
The attractiveness of various types of options to the trader mostly arises from the limited nature of the risk. For instance, a stock trader who shorts the firm X will face unlimited losses if the firm’s price moves in the other direction, but if he simply buys a sell-option on the firm’s stock, the maximum amount he could lose will be limited by the value of the contract (in the same case, the option writer’s risk is unlimited, in theory). But that aside, there’s no reason to think that on a basic level options trading is any different from spot trading, and the similar nature of the spot forex market to the options market will be the basis of our market predictions.
Definition of put and call options
Before examining the nature of the put/call ratio, and its significance for forex, let us remember that a put option is a contract that allows the buyer to sell an underlying asset at a specified price, and a call option is the kind which allows the buyer to buy the underlying asset. Thus, a buyer of the call option is expressing a view that the price will be higher at a specific point in the future, while the buyer of the put option believes that the price of the underlying asset will fall.
What happens when a bubble is created?
Now, what happens when euphoria (or panic) overtakes a market, and a bubble is created, as spot traders of any asset flock to grab a share of some security or futures contract on which options are available? How will the options trader’s reaction to the bubble be? Of course, the option trader is no different from the spot trader, and the bubble in the spot market has its mirror image in the options market as well. In other words, it is possible to identify extreme values in the spot market by looking at how ebullient option traders are, and the put/call ratio is utilized in a contrarian fashion to identify and exploit these extreme values for profit.
The put/call ratio
As most of us know, a contrarian strategy focuses on finding undervalued or overvalued assets in a market, and betting against the market in those assets to exploit the correction that will inevitably occur. It is always possible to define oversold or overbought values on the raw price data, and to make counter-trend wagers on that basis, but the highly volatile nature of the forex market makes this a relatively risky effort. That is why the trader always attempts to confirm his positioning with reference to more than one type of data, and with the volume data gained through the usage of the COT report, and the put/call ratio options market extremes can help traders identify opportunities in the spot market. We calculate the put/call ratio by dividing the total amount of puts by the amount of calls and on that basis get a value that reflects the bias of the market. For example, if there are 24,000 put options on EUR/USD, and 60,000 call options, the put/call ratio would be 0.4 implying a bullish market. The put/call ratio will rise as sellers drive the trend, and it will fall as the buyers are more numerous. As positioning reaches extreme values, so will the put/call ratio, until a point is reached where the drivers of the bubble are exhausted, which is usually followed by a violent collapse. We can identify the values registered during past collapses, and by comparing the value of the put/call ratio with past data, we can gain an idea on the market direction in the near future.
Trading the put/call ratio depends on identifying the put/call values registered during past price extremes, and comparing that with today’s values, as we mentioned before. If a breakout or spike is not confirmed by an equivalent change in positioning in the options market, we will be reluctant to act in the direction of the trend. Such a situation would signify that options traders are not convinced by the action in the spot, and do not believe that it will lead to a sustainable price action. Since many speculative deals in the spot market are hedged in the options market, lack of a confirming movement could suggest that the price action is driven by less-informed, smaller players. For contrarian trades, we will take note of extreme values in options positioning, and will enter counter-trend orders in anticipation of the collapse. This method is really straightforward, allowing the trader ease of mind and clarity of analysis.
Two difficulties with this method
Let us also remember two of the difficulties which this method poses for the trader.
1. Needless to say, the definition of extreme value is arbitrary, and there’s no way of knowing which of the previous peaks will hold, or if a new peak in the put/call ratio will be registered as a result of market action. This means that the trader should be cautious about using options market data for the exact timing of market reversals. There’s no magical quality to the put/call ratio, since quite often option traders also trade the spot market in forex, for the reasons mentioned at the top of this article.
2. Options traders are just traders, and there’s no reason to expect to be any smarter than spot dealers. Indeed, studies show that, if anything, they are more likely to suffer losses as a result of directional bets.
We conclude this section by noting that the data on put/call ratios, and trader positioning can be obtained from the CBOT website.
Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.