I’ve discovered an interesting relationship between the S&P 500 and the OEX (S&P 100) put/call ratio that, to the best of my knowledge (though I can’t be certain), has never been shared in public. I will be tracking this strategy as part of the State of the Market report.
Unfamiliar with the put/call ratio (PCR)? Read my August primer. Note that the primer talks about the CBOE total PCR while this report is using just the OEX PCR.
(logarithmically-scaled)
The graph above shows the strategy (red) versus the S&P 500 (blue), and for comparison’s sake, the inverse of the strategy (green) from 1985. This test is frictionless and assumes NO return on cash.
Strategy rules: create a ratio by dividing the S&P 500 by the OEX PCR. Go long at the close when the 21-day (1-month) exponential moving average (EMA) of the ratio crosses below the 42-day (2-month) EMA. Move to cash when it crosses above.
And for the number lovers…
Despite being exposed to the market only about half the time, the strategy was able to match market returns while significantly reducing downside volatility. Strategy performance has been extremely consistent over the last 24 years (prior to that, no OEX PCR data was available).
What This Strategy is Measuring
I want to do a bit more testing to really understand what makes this relationship tick, but in a nutshell, it’s contrarian. It is buying when the S&P 500 has fallen and there is a high volume of puts relative to calls (a bearish measure of sentiment).
The strategy is especially interesting because when just looking at the S&P 500 or just the PCR in isolation, a 21/42-day crossunder is actually bearish. But when a ratio of the two is made, the data clearly show a crossunder is a bullish event. More to follow on this as I flesh out my thoughts.
Note this strategy does not work (even a little) using the CBOE total put/call ratio and I suspect that’s because the total PCR includes a lot of extraneous option data.
Going Short
Because I know I will be asked, I also tested going short when the 21-day EMA was above the 42-day EMA rather than moving to cash. Results are below (long-only in blue and long/short in red). Basically, downside volatility increased significantly with no benefit to returns.
(logarithmically-scaled)
State of the Market Report
Because this strategy has been so consistent over time, but more importantly, because it is a long-term indicator that is taking such a different approach than the existing indicators on the State of the Market report, this one has made the cut.
Expect to see the S&P 500 vs OEX Put/Call strategy beginning with the next daily update.
Happy Trading,
ms
P.S. this strategy was inspired by some of the work David Kneupper has done over at the dk Report. While David’s indicators were taking a much different approach, he got my brain thinking about put/call ratios again. Thanks David!
Geek Note: There are two generally accepted ways to calculate an EMA that produce slightly different results. Here I have used the ((1/Period)*2) method. If your software uses the (2 / (Period + 1)) method, simply reduce my period by one. For example, if I’ve used a 21-day EMA, the alternate EMA would be a 20-day EMA.
