Put/Call Ratio Analysis Helps to Identify Stock Price Tops and Bottoms

Click on Chart to Enlarge

The chart above is a slightly different version of one I have shown many times over the past several years.  This chart is a 7 day average of the total put/call ratio with some standard deviation bands around it.

The interpretation of the chart is pretty standard for technical analysis.  I like following this data because it is not looking at price.  It looks at a measure of underlying "sentiment" as evidenced by large scale options transactions.  So price is an effect of other underlying causes in the crowd.

I have made a mental construct over the years which likens the movement of market prices to physical movement.  Once a direction is set, there is an inertia, and other than UFOs, we typically see a process of slowing or momentum changing prior to a shift in direction of the object.

That "slowing" before a change of direction is evidenced by divergences.  So we have a situation where the direction of the market in this case is still "up", but the put call ratio is showing a marked divergence indicating that the underlying sentiment or driver of prices higher is actually slowing down.

As noted on the chart with red and green lines, the general idea here is to look for an extreme data reading, outside the bollinger bands indicating that the trend may not be sustained at that rate.  These extreme points are typically NOT final highs or lows.  The actual end of a move, will most often occur after a divergence develops, with new price extremes, but often markedly non-confirming put/call ratio readings.  And the reading at the end of the move are usually well within the deviation bands, and so do not appear significant on their own.

My point here is to give a little perspective but to make note of the classic divergence pattern here in the sentiment which has put me on alert that we are near the end of this rally since November.  And we are likely to see at least a minor correction occur of the uptrend.  It has been ~2 months since the extreme reading in the put/call ratio occurred.  And my observation of this types of divergences is that a trend often persists for several weeks after the extreme before a final price high or low.  If I had to make a guestimate of the average, it would be about 6 weeks.  So here we are at about 8 weeks since the extreme, and I believe that markets are likely to peak any day now.


Pete