The options market is, by its nature, very speculative. Options are highly leveraged tools that allow investors to “control” a large block of shares with relatively little down. This control only applies if the stock is at a certain price within a certain time, however, and this is why the options market is risky and speculative. The buyers of call or put options are prompted into action when they are more optimistic (greedy) or pessimistic (fearful) than usual. Measuring the options market is a good gauge for overall sentiment, since this market is speculative in nature and will tend to represent extremes.
By analyzing the CBOE put/call ratio – that is the total number of puts traded per day compared to the total number of calls traded – one can get an accurate reading of the temperature of the market. Most of the time the put/call ratio is within a normal range and offers little guidance. However when the ratio reaches extremes it may indicate a temporary bottom. As a Market Technician, remember that sentiment indicators are better at determining bottoms than tops, since greed and fear are not polar opposites. Greed can exist for long periods of time, while fear often reaches a head and climaxes.
I don’t think the chart below needs much explanation. The total CBOE Equity Put/Call Ratio is graphed below the S&P 500 average. Notice anything uncanny regarding temporary bottoms? Is it any wonder why Market Technicians are taught to analyze sentiment trends? Despite the recent success of this gauge, remember that no technical indicator is ever guaranteed, and proper risk management control should always be practiced regardless of the strength of a signal.