Buy Signal from Equity Put/Call Ratio?

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Today's chart is a look at the equity put/call ratio and what it is telling us right now. I have followed put call ratios closely for a couple years now, and I have several different ways I look at them. In a recent post I showed a chart of the 5 day versus 63 day ratio that was showing complacency recently relative to the last quarter. That is bearish in the intermediate term, though there has been no clear breakdown in prices yet.

Today I want to show a ratio that I have never seen looked at or discussed before, though the concepts are identical to those mentioned in the 5 vesus 63 ratio. In the chart above I plotted a chart showing the ratio of the (3 day average of the equity put/call ratio) divided by the (5 day average of the equity put/call ratio). I also plotted 1.5 standard deviation bands around the data which should contain about 80% of data. First, to get the basic concept here, the long term average of this ratio should approximate 1.00, or the 3 and 5 day averages being equal. However, the 3/5 ratio will tend to oscillate around 1.00 and rarely be 1.00. Whenever the reading gets much above 1.00 that means that there is a short-term increase in fear (as evidenced by put buying) and may be a good time to initiate short-term bullish trades.

I really use this ratio to fine tune the identification of market bottoms and tops. So when the 5 vs 63 day ratio is showing excessive put buying, and then we also see the 3 vs 5 ratio jump up and show excessive put buying, you can be fairly sure that you are nearing a climax (of fear) point.

The reason I am showing this chart today is that the equity put/call ratio jumped to a high level today (1.07) and caused the 3 vs 5 ratio to jump to 1.1 which has been an excellent short-term buy signal in the past. For those interested the last times this ratio reached 1.1 were 1/9/08, 1/17/08, 2/6/08, 2/7/08, 3/17/08, 3/18/08, and 10/24/08. Incidentally, the ratio reached 1.09 on the Nov 20 2008 closing low in the S&P 500.

Now let's step back and put this reading in context. First, we are only 1 day off a 2 month high, so we aren't at a market bottom by any stretch of the imagination. Also, the longer term ratio (5 vs 63) is not showing excessive fear, in fact, it is showing excessive complacency. The last time I saw a ratio of 1.1 at a multi-day high was June 1-2 of 2006. After that signal, the market tanked for about 7-8 straight sessions before forming a major low.

So, it is tempting to see this jump in the ratio as a short-term buy signal, but I am not inclined to trust the current signal because it is not even at a multi day low. Maybe in the future I will show this chart again when we are at a multi-day low, and talk a bit more about some ideas on trading after such a reading.

Pete