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A look at Option Activity (i.e. Market Sentiment)

“From the Desk of Michael Sheldon, CIO”

With the recent market pullback, many investors are looking for an indicator that can help determine what direction the market will head next. At RDM Financial, we rely primarily on fundamental indicators like sales, profits, GDP, inflation and interest rates.  However, we also like to keep one eye on market technicals which include indicators like bullish versus bearish sentiment, the percent of stocks trading above their 50 and 200 day moving averages and the ratio of puts versus calls.

One indicator that investors use is the put to call ratio, which measures  how many investors are trading put options vs. call options. If we see a high put to call ratio, more investors are buying put options, thus indicating a bearish sentiment (which can be used as a contrarian indicator). Recently the CBOE put/call ratio blew past the 1.3 level and actually ended last Wednesday at 1.41 (see chart below – source: Factset).

The interesting thing is that when the put/call ratio gets too high, it can actually be a good sign for stocks as it indicates an oversold environment. In fact, 7 of the last 8 times the put/call ratio exceeded the 1.30 threshold, the S & P 500 generated positive returns over the next 10 days. As you can see in the chart below, the 10-day return following a spike in the put to call ratio has been favorable and has averaged 3.42% over the last 2 years.

While trade issues between the U.S. and China remain unsolved and this may lead to additional market uncertainty over the next several months, the put to call ratio indicates that at least on a short-term basis, equity markets appear due for a modest rebound.  Keep in mind that global geo-political events or government policy statements (like the recent tariff announced last week regarding Mexico) may also influence short term market volatility.

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This document was created for informational purposes only; the opinions expressed are solely those of the team and do not represent those of HighTower Advisors, LLC, or any of its affiliates.