Let’s say you’re an investor, and you want to place a bullish bet on the stock market. One way to do this would be to buy a call option. The value of a call option goes up when the price of a stock (or stock index) goes up—and it does so at a faster rate than simply buying the stock due to the embedded leverage of the option.
On the other hand, let’s say you’re bearish on the stock market, and you want to place an aggressive bet that the market will crash. In that case, you might want to buy a put option—the opposite of a call option. If stocks go down, the value of your put option should theoretically go up.
But here’s the thing, the speculative traders buying up these options have a long history of being wrong whenever they take it to the extreme. In other words, when these traders are buying a large amount of calls relative to puts, or a large amount of puts relative to calls, it tends to happen in an environment when sentiment is lopsided and a turning point in the market is about to occur.
We look at the ratio of puts to calls to determine when these extreme levels are being reached. Shown on the bottom clip of our featured indicator above, the orange line measures the total 5-day put/call ratio. When traders buy up puts at a faster rate than calls, the line goes up, and vice versa. Historically, when this put/call ratio has gotten too high (above the upper bracket), it has coincided with an environment of extreme pessimism and better returns for the S&P 500 stock index (green line, top clip). By contrast, when the ratio falls into the extreme optimism zone (below the lower bracket), it results in above-average returns for the stock market.
Last year, when the stock market was rallying, all investors wanted to do was buy calls and chase the rally higher. But this year, things are different. Investors are gobbling up puts at a furious rate, betting that the market is headed lower. According to the Wall Street Journal, around 40 million options contracts have changed hands on an average day in 2022, on pace to smash the record from last year.
But, as I’ve highlighted on the chart, the level of puts being bought relative to calls has reached an extremely high level. In fact, it’s currently just shy of the peak reached near the bottom of the 2020 sell-off. Based on historical data, this could be a positive sign for the stock market in the near term, as it means we are perhaps reaching peak pessimism in the market.
To be sure, sentiment can always get more pessimistic, so we’re not saying that stocks are going to rip to new highs overnight. But this is one piece of evidence supporting the idea that sentiment has reached extreme levels. So if the price action can turn a corner, it could set the market up for a potential short-term rally.
This is intended for informational purposes only and should not be used as the primary basis for an investment decision. Consult an advisor for your personal situation.
Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.
Past performance does not guarantee future results.