Put Call Ratio: Using Options to Tell When Stocks Are About to Fall

By Dr. Steve Sjuggerud, Chairman, Investment U
Monday, June 20, 2005: Issue #446

“I’m recommending put options on Google” my friend Porter Stansberry told me two weeks ago “So my readers can make triple-digit profits as shares fall back to earth.

“I replied, “Okay, Porter But isn’t that like standing in front of a freight train right now?”

It may be out of gas, he tells me. “Steve, a secret signal you showed me years ago, plus the activity in its options, tells me that we’ve seen the top in that stock.“

I can’t tell you the secret indicator. But I can share with you what the options trading in the world’s most widely used search engine may be telling us about where the stock price is headed.

And I can show you how to track the options activity in the stocks you own, employing the put call ratio, to help determine when they might change directions on you.

Using Options – Trading Activity & the Put Call Ratio

I find the chart below fascinating…

The red line is our stock’s share price, while the blue line is the stock’s put call ratio for options.

Simply said, when the blue line gets extremely high, it’s time for the stock to rally. And when the blue line gets extremely low, it’s time for the stock to crash.

I’ll explain why in a minute. But first, take a look at the chart below When the blue line peaked two years ago (at the beginning of this chart), shares of its stock jumped from $100 to $200 a share in no time. Now, today, the blue line is at all-time lows. Time for it to tank?

Source: schaeffersresearch.com

The blue line on the above chart shows the trading volume in stock options. When the blue line is at a high extreme, everyone is betting our stock will crash. And of course, it’s then a great time to trade on the opposite outcome.

When the blue line is at a low extreme, everyone is betting on GOOG soaring. And chances are, the opposite will happen. The “put call ratio,” as it’s called, can be used as one gauge of investor sentiment. When the put call ratio reaches extremes in either direction, it can signal a turning point in the stock’s direction.

A Whole Lot of Speculating Going On

The put call ratio is telling us that many more people are betting on shares of GOOG to rise rather than fall. Since “the crowd” now believes that the stock will rise, we may be at an extreme that signals a turning point: it may be time to go against the crowd.

Another way to check out the extreme in optimism is to look at where these options traders have placed their bets. As I write, we’re talking in the area of $280 a share.

Talk about optimism As you can see from the chart below, there are many people betting on shares exceeding $380 a share, by mid-July! Now, that’s optimism!

Put Call Ratio Chart # 2: The Options Bets That Expire in July

Even Better Than Your Basic Put Call Ratios

Put call ratios are far from perfect.

In fact, one friend of mine, Jason Goepfert of SentimenTrader.com, is fully aware of this. So he’s made a few “tweaks” to the classic put call ratios to make them more useful. He’s devising new put call indicators to specifically target what the “dumb” money is doing now.

For example, one of Jason’s indicators is his “ROBO” put call ratio. “ROBO” stands for “retail-only, buy-only.” Jason isolates the small options trades (trades of 10 contracts or less – “retail only”), and he only looks at people making “buy” orders (instead of short-selling options – “buy only.”)

This way, he figures, he’s getting at what the “retail investor” – the “dumb” money in the options market – is doing with his money.

Jason’s ROBO stock put call ratio has accurately picked the major tops and bottoms. As Jason says in his description of the ROBO put call ratio on his web site:

“At the height of the stock market bubble, retail traders were going crazy over call options. For the week ended April 7, 2000, they bought to open 1,380,000 calls and only 237,000 puts, for a put call ratio of 0.17. They were so delirious with lust that they were willing to pay an average premium of $814 per call contract to be in the game. They paid an average of $599 at the time for their puts. So they were buying nearly six times as many calls as puts, and paying 36% more for the right to do so.”

“At an opposite extreme, the week ended October 11, 2002, they bought to open 430,000 calls with an average premium of $182. During the same week, they bought 508,000 puts for an average of $250. So they were willing to pay 35% more for protection than they were for potential upside – the opposite of what they were doing during the bubble.”

Put Call Ratios: Summing It Up

When you’re trying to gauge the end of a move (in either direction) in a stock (or the overall market), put call ratios are a useful arrow in your quiver. They shouldn’t be used by themselves, but their message shouldn’t be ignored either.

You ought to take a look at the put call ratios on your favorite stocks, to see if any of them are at an extreme like our example above, and ripe for a fall. You can do this for free at schaeffersresearch.com (click “Quotes & Tools” then scroll to the bottom for “Sentiment Tools”).

Also, though it’s not for everyone, if you’re particularly interested in technical indicators for sentiment, like put call ratios, you ought to try out sentimentrader.com. Jason is doing fantastic work at a great price.

In summary, the put call ratios we use in our example today suggest GOOG may be “over-loved” and ripe for a fall. My friend Porter’s call might not be that crazy after all. Are your stocks ready for a fall, too? Find out

Good investing,

Steve

Today’s Investment U Cribsheet

• Bernie Schaeffer kindly offers free put call ratio charts on most stocks for free on his website, schaeffersresearch.com. His book on options, The Option Advisor, is in my opinion one of the best options books ever written. Check them both out.
• Again, if you’re a professional, or you like lots of technical indicators, Jason Goepfert’s sentimentrader.com is a great site with a great price.

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Three Moneymaking Secrets of a Champion Trader

By Dr. Steve Sjuggerud, President, Investment U
Thursday, January 22, 2004: Issue #307

David Ryan can teach you a few things about being a champion trader and winning in the stock market.

With an astounding 161% return, Ryan won the stock division of the 1985 U.S. Investing Championship. To prove his results were no fluke, Ryan returned to the contest in 1986 and duplicated the feat, registering a 160% return.

The post Three Moneymaking Secrets of a Champion Trader appeared first on Investment U.

16 Must-Read Investment Books: The Foundation of Your Future Profits

By Dr. Steve Sjuggerud, President, Investment U
Friday, April 11, 2003: Issue #229

Dollar for dollar, books can offer the best investing education you can get. The right investment books (along with The Investment U e-Letter, of course) can provide a solid foundation on which you can build wealth for years.

But before you head to the bookstore to load up on knowledge you should know that it’s also possible to go seriously wrong here. The wrong book will turn you off, bore you, or worse – it can cause you to end up losing a truckload of money. So today I thought I’d take a few minutes to help you sort through the thousands of investing books that are out there to find those that are just right for your situation.

You may recall that I’ve already listed what I feel are the very best investment books of all time. (See IUEL #206, “What to Read.”) So what we’ll do today is look at that list, add some new names, fill in the holes – and most importantly – talk about books on more “exotic” investments (like options) and the best ways to increase your investment knowledge in these areas. I’ve sorted my recommendations into 16 different categories so it should be easy to find a book that can help you no matter what your portfolio looks like right now.

Again, remember, you can REALLY go wrong by buying the wrong books. I would say that about 90% of the books in the “Investing” or “Personal Finance” section of the bookstore are bad books. As a general rule, they are often just “shortcut” books, written by writers. They are not books written by people who have actually built a successful career investing.

So please, before you buy another book, make sure you’ve made your way through this list. This is where the knowledge is and this is the foundation of your future profits

16 Books For Any Interested Investor

• The best investment book of the last 12 months
  Leon Levy’s, The Mind of Wall Street: This guy had over a half-century of “in the trenches” investing experience. And this book contains his memoirs, basically, with many extraordinary lessons. No textbook can teach you what Leon Levy had lived. It won’t tell you what stock to buy or what bond to buy. But the perspective is priceless.
• The best book about investment bubbles
  Devil Take the Hindmost, by Edward Chancellor, was the best book of a few years ago.
• The best book about economics in plain English
  A tie: Economics in One Lesson, by Henry Hazlitt, Eat the Rich, by P.J. O’Rourke and The Making of Modern Economics, by Mark Skousen. If you have to pick one, buy Hazlitt if you’re over 50 P.J. O’Rourke’s if you’re under 50.
• The best book about building a stock market system
  Another tie: Martin Zweig’s Winning on Wall Street and Tim Hayes’s The Research-Driven Investor. If you’re into computers and want to build a system, read Hayes’s book. Otherwise, read Zweig’s.
• The best book about being a smart trader
  Market Wizards, by Jack Schwager and Trade Your Way to Financial Freedom, by Van Tharp. Both are essential reading.
• The best book about options for individual investors
  There isn’t one. Most options books are REALLY bad. The popular Fontanills books impart information, not knowledge. The McMillan books are massive – massively boring – and again, don’t get you to profitable trading. Actually, you can throw tomatoes at me if you wish for recommending this, but here is a readable one: Bernie Schaeffer’s The Option Advisor. Schaeffer’s book is a good start, and he at least talks about how to take profits and protect yourself and he can write. The Four Biggest Mistakes in Options Trading, by Jay Kaeppel is also useful. But there’s not much in this area that’s really good.
• The best book about bonds for individual investors
  Again, this book hasn’t been written yet. Try Bill Gross on Investing. It’s not a textbook – but isn’t that a good thing? It’s written by Bill himself – the world’s biggest money manager (not in body weight, you smart alecs – Gross is a little guy). Gross is the biggest in money under management – how about a few hundred billion dollars.
• The best book about technical analysis
  Martin Pring’s Technical Analysis Explained is excellent. ‘Nuff said.
• The best book about gold
  The Power of Gold, by Peter Bernstein. It doesn’t tell you how to invest, but it is the story of gold told by a great storyteller, with excellent insights into the gold markets.
• The best book on how to succeed in short-term trading
  Financial Freedom through Electronic Day Trading, by Van Tharp and Brian June
• The all-time investment classic
  Reminiscences of a Stock Operator, by Edwin Lefevre
• The best book about real estate stocks
  Investing in REITs, by Ralph Block
• The best book about investing for individual investors
  Well this could be a long list. Jeremy Siegel’s Stocks for the Long Run is good. A Random Walk Down Wall Street, by Burton Malkiel is also good, though more complicated than Siegel’s.
• The best book on short-selling
  The Art of Short Selling, by Kathryn Staley.
• The best historical reference book
  Anything by Paul Johnson. The History of the American People, by Paul Johnson is a “must-have” book.
• The best book on oil
  The Prize, by Daniel Yergin – if you’ve got a lot of time on your hands. Check out the PBS video series “The Prize” instead at your local library. It’s a good show. And when you return that, check out the PBS series “The Commanding Heights” on the story of freedom by Daniel Yergin as well. Great stuff. You’ll want your kids to watch it and your grandkids.

I’ll stop here. You’ve got some work to do.

Good investing,

Steve

Today’s Investment U Crib Sheet

• This list is only of books I’ve read. Of course there are others. Post your favorite investment books on the message board. Let me know what you like visit the Investment U message board.
• To make life easier for you, and to help put a few nickels in the Investment U kitty so we can keep this free service going, you can buy all these books by visiting our Further Reading page. You end up paying the same price as you would if you went directly to Amazon, but this way Amazon kicks back a few cents per book to us for recommending them

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By Dr. Steve Sjuggerud, Chairman, Investment U
Tuesday, January 14, 2003: Issue #413

Are you watching the CRB? The T-bond? The Russell?

If you’re not, then you may be missing the big pictureand what’s really going on. Learning how to follow the stock market has its benefits. Most investors follow just the Dow, the Nasdaq and maybe the S&P 500. But just following those two or three indexes could lead you to POOR investment decisions without ever realizing it.

That’s because – with just those three pieces of information – you won’t have the right information to make informed decisions about the market. Today I’ll tell you about three simple – and quick – things you can do to make sure you learn and retain the right information Every Day. And I’ll also tell you why the Dow really isn’t a good stock market barometer to follow

What’s Wrong with the Dow

The Dow Jones Industrial Average–the stock market index that everyone talks about–is actually not a very good barometer of how the stock market works. If you’re just watching the Dow, you’re missing the overall picture. It’s not bad. But it has a few problems

• The Dow only has 30 stocks. If you really wanted an accurate representation of the market, you’d want as many as 500 stocks (the S&P 500 Index) or even 5,000 stocks (the Wilshire 5,000 Index, which now actually has 5,800+ stocks). Of course, they have to be the right stocks. The Nasdaq Composite is made up of around 8,000 Nasdaq stocks. But since the Nasdaq is so small, that only represents about 19% of the total size of all stocks. So it is not necessarily a good indicator either.
• The Dow is a price-weighted index. The 30 stocks in the Dow are not treated according to size, as you might expect. The higher the price of a stock, the more weighting it gets in the index. Here’s what that means Let’s pretend that the index was 29 stocks at $1 a share and one stock at $100 a share. If each stock fell by $1, that should be a catastrophe. Any other index would crash over 90%. But the Dow would fall from $129 to $99, not really representing the crash. That’s why a “price-weighted” index can contain misleading information.

In my mind a good index has a lot of stocks, is size-weighted not price-weighted, and is widely quoted and available. By that standard, the S&P 500 is a good stock market index.

The Important “Other” Indexes To Follow

There are three vitally important indexes – the CRB, the T-bonds and the Russell – that you should follow regularly to get a gauge on what’s going on. Keeping tabs on these three indexes doesn’t take a lot of time to do yet most investors would be much better off if they did. Let’s evaluate each in greater detail

Of these, T-bonds are probably the most important, as it is the primary benchmark of the cost of money in the entire world. When people say “T-Bonds” they’re actually referring to the 10-year U.S. Government Treasury bonds. Don’t pay attention when they say “T-bonds rose 13/32s today” just listen for what happened to the interest rate: i.e. “the yield fell to 4.13%.” Though it hasn’t been the case in the last three years (as we’ve been shedding the excesses of the stock market boom). As a general rule, stocks do well when interest rates are coming down, and they struggle in the face of rising rates.

The CRB Index is an excellent gauge of what’s happening in commodity prices, as it’s an index of a basket of 17 commodities. It includes metals, oil and gas, livestock and agricultural commodities. The index often moves in the opposite direction of bonds. Interestingly, the CRB index is up about 20% in the last year, signaling higher inflation and lower bond prices (higher interest rates) ahead.

The Russell is the benchmark index of small stocks. It’s actually the Russell 2000 Index. It’s important to follow nowadays because we’re coming out of recession and the worst stock market crash since 1974. After that crash, small stocks absolutely trounced large stocks, beating them nine years in a row, as reflected in the chart below:

As a rule, you should also keep your eye on the S&P 500, and what Greenspan does when he tinkers with rates. After that, if you know what T-bonds, commodities and small stocks are doing, you’ll have a pretty complete picture of how to follow the stock marketand what’s going on out there in nearly the whole investing world.

Good investing,

Steve

Today’s IU Crib Sheet

* As we stated earlier, the Dow is a decent – though flawed – stock market index but there are better indexes to follow. It’s worth an extra few minutes each day to keep tabs on T-bonds, the CRB and the Russell 2000. All three of these can be followed on the front page of http://www.barchart.com/. If you do that, you’ll be much better informed than most investors these days

* Of course – since I follow the stock markets for a living – there are a number of other indexes I track. Here’s a brief list of just a few that I like to follow (along with its symbol or web site)

• World Stocks: The World Index, available at www.mscidata.com
• Emerging Market Stocks: The Emerging Markets Free Index also at www.mscidata.com
• Real Estate stocks: The Morgan Stanley REIT Index (^RMS)
• A “Fear” Gauge: The “Vix” Index (^VIX)
• Gold: www.kitco.com
• Residential Real Estate: http://www.census.gov/const/www/  
• Commercial Real Estate: http://www.ncreif.org/indices/  
• Historical stock indexes: www.GlobalFinancialData.com
• Oil: www.nymex.com

The post How to Follow the Stock Market… and Get the Big Picture appeared first on Investment U.

But just what is the optimal asset allocation for you? And what’s the easiest way to get there from where you are now?

For starters, when you’re young, you need growth. You can afford to take risks, because even if you completely blow it, you’ve still got years to make up that money you lose. And when you’re older, you don’t want to have to go back to work. So you’ve got to be much safer with your investments.

A Simple Asset Allocation Rule That Could Save You Money

The simplest rule of thumb I use to account for these different investment needs is this:

100 minus your age is the percentage you should have in stocks. (Particularly in a “set it and forget it” portfolio.)

So if you’re 30, you should have 70% of your investable funds in stocks. And if you’re 70, you should have 30% in stocks. This is because stocks are less safe than the alternatives, so the older you get, the less you should have in them.

This rule of thumb is very rough, I know, but it’s not just pulled out of the sky. It comes from studying nearly 80 years of stock market returns. Now let’s take it to the next level here. And using all this homework I’ve done, let’s get closer to the perfect asset allocation model for you.

What History Tells Us About Achieving Optimal Asset Allocation

Take a look at how the three particular portfolios listed below have performed over the last 76 years. While you look at them, consider which one is most appropriate for you. Consider things like, “Is it worth it to take more risks to improve my investment returns from a ‘safe’ 7% a year to a ‘risky’ 10%?” This does make a big difference over the long run. But I can’t answer that question for you.

You are the only one who knows what level of risk lets you sleep at night. All I can do is arm you with the facts, to know whether you should choose a safe or a risky portfolio. Here are the facts, as history tells us:

• SAFE PORTFOLIO — 20% stocks, 80% bonds. Throughout history, this portfolio has averaged 7.0% a year. Its WORST year was a loss of 10.1%. It lost money 17% of the years.

• BALANCED PORTFOLIO — 50% stocks, 50% bonds. Throughout history, this portfolio has averaged 8.7% a year. Its WORST year was a loss of 22.5%. It lost money 22% of the years.

• RISKY PORTFOLIO — 80% stocks, 20% bonds. Throughout history, this portfolio has averaged 10.0% a year. Its WORST year was a loss of 34.9%. It lost money 28% of the years.

So what’s appropriate for you? To find out, you’ve got to answer tough questions, like, “Can I handle a 35% loss in a year if I held the risky portfolio?” or “Do I really need to risk it all, when the difference between being safe and being risky is only 3%?”

Let’s keep digging, to get you even closer to what’s appropriate for you…

An Optimal Asset Allocation Model

In talking with C.A. Green, he outlined using a portfolio of about 60% stocks as a good moderate choice, based on history. That type of portfolio has returns nearly as nice as the “risky” portfolio, having returned 9.1% annually (on the average) throughout nearly 80 years of history. But it doesn’t have quite as much risk, because 40% of the recommended asset allocation is outside the stock market.

Along these lines, I talked with a longtime friend and financial consultant this week to get his input, and he had a great suggestion.

He reminded me that, to really get the most return for the least risk, you must diversify within each investment class. For example, he told me that a lot of his clients came to him with what they thought was a diversified portfolio of stocks and bonds.

But the reality is that those people weren’t properly diversified; they only held tech stocks, instead of stocks from all sectors.

C.A. Green talks about this regularly. His general recommendation for investment allocation is:

• 30% U.S. Stocks
• 30% Foreign Stocks
• 10% High-quality Corporate Bonds
• 10% High-yield Bonds
• 10% U.S. Treasury bonds (TIPS)
• 5% Real estate stocks
• 5% Gold and precious metals

This is really starting to get specific now! But that’s okay. You’re now armed with a lot of information, which can help you better decide what path to take to allow you to sleep at night. You’ll of course need to tweak this a little based on your age and risk tolerance.

However, I also like to use my knowledge to make adjustments to my perfect portfolio based on market conditions. For example, as you know, I think the stock market is extremely expensive right now. So I’m recommending that my readers lower their exposure to the stock market, as I think stock market returns will not be very good in the coming years.

Never Forget Asset Allocation’s Tactical Basics

The more you read about this topic of asset allocation, the more confusing it often gets. Different “scientific” studies on this topic give strikingly different results. (In fact, many studies based on only the last 10 years of data said you should be 100% in stocks but you would have been clobbered in recent years on that advice.) So while I of course recommend doing all the homework on optimal asset allocation you can, keep in mind the basic strategies I’ve laid out here:

• The “100 minus your age rule” is a great starting point for how much you should have in stocks.

• As you do more homework and see different strategic allocations, don’t forget the numbers I presented to you they’re based on 80 years of data and include the 1929 crash, so they are a true representation of what to expect.

• The 60/40 mix as recommended C.A. Green is a good mix of risk and return for many – “set it and forget it” portfolios.

• As both C.A. Green and my longtime friend recommend, for best results you’ve got to diversify among different types of stocks and bonds as well as among asset classes.

It bears repeating, the truth is that there is no one perfect asset allocation model. It’s different for everyone based on age and risk tolerance. However, if you stick with these four basic suggestions, you should be more than capable of finding the most optimal asset allocation for you.

Good investing,

Steve

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