12 Keys to Trading Earnings for Profits

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#8 Put/Call Ratios

We've found that using option data is an excellent way to measure sentiment.  We have found that option volume and open interest (the number of open contracts on an option at the end of each day) data in the form of a put/call ratio is one of the better ways to quantify investor sentiment.  This straightforward indicator tells whether a stock is poised for a rally based upon large amounts of potential buying strength (as a result of the crowd leaning too far to the bearish side of the market), or poised to stall out due to a lack of cash available to push it higher (a result of leaning too far to the bullish side). 

• High put/call ratios often indicate excessive pessimism that translates into large amounts of money on the "sidelines." 
• Low put/call ratios indicate a point at which there is so much optimism that very little money is left to push the market higher (i.e., a crowded trade).

By comparing the current put/call ratio to previous readings for that stock, we can accurately gauge relative levels of investor optimism and pessimism.  This is extremely important because we have found that the absolute ratio readings can vary substantially from stock to stock. 

Thus, comparing an equity's ratio to previous ratios sets up an "apples to apples" comparison that provides a truer picture of relative sentiment for that particular stock  Higher relative ratios indicate more pessimism (which can have bullish implications), while lower ratios suggest optimism (potential bearish implications).