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Posts Tagged ‘market sentiment’

Using Put-Call Ratios in Covered Call Trades

The Put-call ratio is a market sentiment statistic that has been around for quite some time and are followed by option traders.  This stat is based on open interest for each option strike price.  A put-call ratio is the number of put contracts divided by the number of call contracts open.  An increasing ratio is a clear indication that investors are starting to move toward instruments that gain when prices decline rather than when they rise. Since the number of call options is found in the denominator of the ratio, a reduction in the number of traded calls will result in an increase in the value of the ratio. This is significant because the market is indicating that it is starting to dampen its bullish outlook.

You can use these ratios when considering the strike price of the option that you are considering selling.  If there are more open calls than puts, you sell the strike price higher than current stock price as the indicator is showing a bullish sign.  If there are more puts, you should sell the stock price lower than the current stock price as this indicates a potential bearish move.  The ratios are influenced by option speculators who are gamblers, not stupid, very wise and putting up real dollars to back their options.

The put-call ratio is a true indicator of option market sentiment.  You can rely on the put-call ratio continuously because it is very reliable.  Recall that the idea of contrarian sentiment analysis is to measure the pulse of the speculative option crowd, who are wrong more than they are right. We should therefore be looking at the equity-only ratio for a purer measure of the speculative trader. In addition, the critical threshold levels should be dynamic, chosen from the previous 52-week highs and lows of the series, adjusting for trends in the data.

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