I was asked an interesting question on Thursday that I figure others may wonder about as well so I am going to discuss the put/call ratio.
We all know a low put/call ratio essentially tells us too many calls are being bought relative to puts. That means folks are leaning bullish; in some cases too bullish. This is why we consider a low put/call ratio to be bearish.
We also know that a high put/call ratio tells us there are more puts being bought than calls. That means folks are leaning bearish; in some cases too bearish. This is why we consider a high put/call ratio to be bullish.
So why is it that when I use a 10- or 21- or 30-day moving average of the put/call ratio that heading lower is considered bullish and heading higher is considered bearish?
It has to do with extremes. Has the ratio gotten too extreme to the point where it's too high (as it was earlier this week)? That means far too many are betting on a lower market. You want it to turn down if you are bullish because in order for the market to rally well, sentiment needs to see some shift.
Think of it like the Investors Intelligence Bulls. In late September/early October the bulls numbered 61% which was too high. The whole ride down from 61% to the current 38% this week saw many readings in the 50s and 40s. Those readings were part of the process that converted the sentiment. We don't go from 61 to 38 in a week, there has to be some middle ground. Folks rarely jump from the Bull to the Bear camp, but rather they spend some time on the fence, deciding which way to go.
It's no different with the put/call ratio's moving average. There is a middle ground, where folks are converting from one side to the other. So when the moving average is heading down, they are converting from bearish to bullish. But they haven't quite gotten to "too bullish" yet.
If we look at the current 10-day moving average of the equity put/call ratio we see that it peaked and turned down from a high level. That's what makes it bullish. You can see the chart is pretty clear that when the moving average gets too low it's bearish for stocks and when it gets too high it's bullish for stocks. The only way to get it to the high or low extreme is to have commensurate readings in between.
The 10-day moving average of the total put/call ratio did not get that extreme late last week. It did get extreme in late October. It is now pushing toward the lower end of the range. I wish I had an answer as to why the two are so different when typically they are not, but I don't.
Either way, we'll keep an eye on both for signs they are getting extreme but for now they are simply heading lower as the conversion from too bearish to bullish takes place.