Puts and calls

We thought it might be of interest rather than comment on the latest piece of economic news, to provide a little insight on one of the many indicators that market professionals look at to gauge current sentiment. We could have picked one of many, the one we focussed on is the put/call ratio.

A brief explanation in its simplest form: puts are considered insurance policies for investors; they can offer, for a price, protection against a market fall. Calls on the other hand are a method in which investors can leverage to the up-side. The put/call ratio is the number of puts investors are buying against the number of calls. A high ratio indicates more buyers of puts and a low ratio points to more buyers of calls.

From the chart below one can see recently there has been a sharp fall in the ratio, indicating more buyers of calls than puts. Some consider this as a sign investors getting overly bullish as they look to leverage up at the top. For this reason, some see this as a possible lead indicator for a correction in the market as they believe bullish sentiment is rising. We have highlighted times where the equity market falls, which typically coincide with dips in the put/call ratio.

There could be an alternative explanation, calls are a leveraged way of playing the upside in an asset class, but they do have the added advantage of having a finite loss value. An investor can only lose the premium he pays for the option over the stock price, should the stock go down or fail to meet his target price. Call options, when one looks at it this way, can also be a protector of profits.

If somebody invests in a company and the share price is £1 and the investor feels it is worth £1.5, then if and when it reaches that point they may decide to sell while also wishing to continue to have some exposure to the asset. The stock for example could be rumoured to be a takeover candidate. He could sell the stock and buy a call option with a strike price of £1.5 that matures in three months time for a price of 10p. If the stock falls he can only lose 10p, if the stock continues to rise he will continue to make a profit. 

As we noted at the beginning, it is considered by many that the increase in call buyers shows an increase in bullish sentiment. Market timing is notoriously difficult, the increase in call option activity may suggest on the contrary that investors are becoming more cautious as they look to replace stock positions with options. As one can see from the chart below call option buying has increased significantly recently, we shall see if it is a lead indicator for a market correction.

Posted on July 4, 2014 .