The Investment U E-Letter: Issue # 378
Thursday, October 14, 2004 A note from the desk of Dr. Steve Sjuggerud We do our best to explain how to turn a little into a lot over the long run here at Investment U. But we seem to get a good deal of questions about the short term. So we're responding… For example, Trader's U is an e-letter geared at short-term stock trading. And Karim Rahemtulla, who has been our featured options expert since the beginning of Investment U some seven and a half years ago, recently launched The Smart Options E-Report. In a recent Smart Options E-Report, Karim explained how to use the "Put-to-Call" ratio, one of the many indicators options traders watch. I've included it below. If you're interested in learning more about options or want to receive this free e-letter on options, visit http://www.smartoptionsreport.com/siup/iu.html Good investing (and trading), Steve * * * * * * * When this Number Jumps, It's Time to Trade
By Karim Rahemtulla
Options Specialist Options traders are always trying to figure out which way the market is headed next. One tool at their fingertips is the "put/call ratio." It's used to measure the current sentiment - and try to foretell when the market is about to peak or bottom. The put/call ratio measures how many put options are bought versus call options. The formula is simple: puts divided by calls. If there are 5,000 puts sold and 10,000 calls, the ratio is 0.5, a neutral number. Traders are interested in the extreme numbers: below 0.3 and above 0.8. The low reading means that not many people are interested in puts… everybody wants calls. They're feeling very bullish - and that's bearish. The higher numbers mean people are buying a lot of puts and likely feeling bearish at the moment… and that may be bullish for the future. You see, the put/call ratio is one of the so-called contrarian indicators. That is, you can read an extreme position as a warning of change to come… The idea here is that if a wide majority believes one direction is a sure thing, then they pile on. By the time that happens, the market is usually ready to turn the other way. The thundering herd is hardly ever right. So the smart money almost always bets against this ratio. But there is one problem with this theory: The put/call ratio does not give you the most important clue, time! People can stay bullish too long. How to Get the Most From Extreme Numbers The best use of the put/call ratio is to watch for extremes and be ready for a change in market direction. Don't take it as gospel. Take it as a warning. Here are a couple of problems to watch out for: - Not everyone who buys a put is really bearish. Many institutions use protective puts as insurance to hedge against losses in their large holdings. For this reason, the put/call ratio on indexes is of little use when predicting the market direction, because so many index puts on the S&P 500 or Nasdaq are merely hedges against big portfolio losses. It is the put/call ratio for individual equities that tells the most.
- The put/call ratio jumps from one extreme to the other quickly, so it's best to look at a moving average. The average over 10 days is a popular number, and many professionals use a 21-day moving average.
You can follow the put/call ratio by linking to the Chicago Board Options Exchange at: http://www.cboe.com/MktData/default.asp. About halfway down the page you'll see the columns that provide you the numbers of put and calls. But don't jump yet… There's a bit more art involved in understanding the put/call ratio. How Low Can You Go? Better Question: How Long Can You Go Low? In March 2000, the put/call ratio was at one of the lowest points in the past 30 years - many more calls were being bought versus puts… We all remember what happened the following year as the Nasdaq 100 lost more than two-thirds of its value, with the S&P and Dow suffering losses as well. Of course, nobody knew that this would prove to be the lowest historical ratio of puts to calls until after the damage was done. In fact, the put/call ratio had already been extremely low the previous October, but the market continued to rise for another five months. On the upside for the ratio, in May 2002, the put/call ratio based on a 10-day moving average recorded 0.81 and 0.83 on successive readings. Extremely high. That meant that more than eight out of 10 options traded were puts - a very glum sentiment. And the market soon followed with one of the most explosive bull market rallies in history, just as the contrarians would have expected. So the ratio does have good use… just be careful not to trust it as infallible. Using the Put/Call Numbers to Adjust Your Risk Tolerance No doubt, keep an eye on the ratio - and be ready to adjust your risk tolerance accordingly. Here are some numbers to guide you: A ratio of 0.8 is extremely bullish. If you see the ratio approaching that number again, it would be a good idea to begin going long on strong ideas. As the ratio falls below 0.5, the market is beginning to be too optimistic, and you should begin to think about paring your long positions. The market is perennially skewed toward the bulls. People are more interested in finding stocks going up - and therefore calls - than they are in looking for losers. So as soon as the calls begin to outnumber puts by less than 2-to-1 (a ratio of 0.5), something's afoot. When it reaches 0.3 or goes even lower, it's time for some serious unloading as the market may be so bullish it is about to peak. The lowest readings on record were right around 0.10 - a sign of extreme bullishness. Great trading, Karim Today's IU Cribsheet - Karim Rahemtulla's point in today's letter is that investing against the crowd using the put/call ratio can be a useful tool. For another example of contrarian investing that could help you increase your profits now, check out IU E-Letter #284 - My 2 Favorite "Left-for-Dead" Investments. To sign up for a free subscription to Karim's Smart Options E-Report, just visit click here.
- If you want a complete immersion in the art of smart investing (along with a great networking opportunity), I encourage you to check out the New Orleans Investment Conference 2004, scheduled for November 10-14, 2004 at the Sheraton Hotel in beautiful downtown New Orleans… only blocks from the French Quarter. The event's going to feature an entire day of Oxford Club, Pirate Investor, Sovereign Society and Daily Reckoning speakers… including top speakers like Alexander Green, Porter Stansberry, Eric Roseman, Karim Rahemtulla, Eric Fry, yours truly and Agora President and Founder Bill Bonner, as well as many many others. Fantastic headliners will also be on hand such as Jim Rogers, Dick Armey and James Dines. For information, contact Event Manager Steven King at 410.223.2633, or 800.992.0205 (e-mail: sking@oxfordclub.com… or sign up online at http://www.oxfordclub.com/bin/k/b/index.html). Early bird discount was just extended to October 22, so sign up now. Hope to see you there.
Good investing, Steve Back to Archive | 
