There are two things that a model should do, at a minimum. First, it must have sound theory behind it (book smart). Second, it has to make money (street smart).It is with those two basic requirements in mind that I turn my sights to the put/call ratio.
A contrarian indicator?
On Friday, the CBOE equity-only put/call ratio closed at a recent low. Consider the following chart of that ratio. Would you interpret the low reading as bullish or bearish?
Viewed in isolation, most technical analysts tend to view the Friday reading bearishly. Casey Murphy at Investopedia writes:
The put-call ratio is primarily used by traders as a contrarian indicator when the values reach relatively extreme levels. This means that many traders will consider a large ratio a sign of a buying opportunity because they believe that the market holds an unjustly bearish outlook and that it will soon adjust, when those with short positions start looking for places to cover. There is no magic number that indicates that the market has created a bottom or a top, but generally traders will anticipate this by looking for spikes in the ratio or for when the ratio reaches levels that are outside of the normal trading range.
Sell signal from the 21 dma
At the same time, I have been seeing comments like this all week. The 21 day moving average of the equity-only put/call ratio has been reached a low and starting to rise - it`s a sell signal, (I am not singling out Mr. Prybal, but his commentary is one example out of several that I`ve encountered.)
Did the 21 dma signal work?
On that basis, this use of the put/call ratio does not pass the first test of my criteria. It does not have a sound theory behind it. As well, the 21 dma equity-only put/call ratio has shown limited value as a timing signal. Consider this chart of the ratio with the SPX for the last three years.
I have defined the "sell signals" as occasions when the ratio has fallen to a local low and started to rise again. Each signal is marked with a vertical line. I have further color coded the lines, where green=the market continued to rise, red=market fell and black=market was flat. A glance at the chart shows slightly more red lines than green lines, but barely. Even if we were to regard this ratio as a black-box indicator, without regard to understanding the theory behind how the signal was generated, its record can only be described as weak.
Last week, the equity-only put/call ratio has reached a low and began to rise again. How should the latest signal be interpreted? How much trust should you put in an indicator that has little theoretical backing and has shown a spotty track record?
A put/call cycle?
From a technical viewpoint, the ebb and flow of the put/call ratio might better be described using cycle analysis. The chart below shows some quick and dirty cycle analysis by overlaying a 61-day cycle on the put/call ratio. The blue vertical lines correspond to highs in the ratio while the red vertical lines correspond to the lows of the ratio. An examination of the chart shows that if we were to regard the blue lines as buy signals and the red lines as sell signals, the record looks reasonable. On the other hand, using the red line as a short signal and the blue line as a cover signal seems to be effective.
In conclusion, I would not suggest using the 21 dma of the equity-only put/call ratio as a timing tool, largely because it runs counter to the contarian underpinnings of the use of put/call ratio. However, technical analysts may use this exercise to conduct further research in whether the rise and fall of the 21 dma of this ratio is subject to a cycle that might prove to be profitable.