The Put/Call Paradox

#68: Put/Call Ratios are unsophisticated, incomplete, and yet compelling.

I have a confession to make. I like the Put/Call Ratio.

A Put/Call Ratio (P/C) simply compares the volume of Put and Call options traded in a given period (usually a single trading day) on a given exchange. A P/C above 1.0 means more Puts are traded than Calls and vice versa.

In my view, simple P/Cs such as those published by the Chicago Board Options Exchange (CBOE)¹, are useful for gauging market sentiment and overall equity market direction. Generally speaking, greater Call volume corresponds with higher market prices, while greater Put volume corresponds with lower prices.

This is a confession, because there are many legitimate reasons why this relationship may not hold, and plenty of smart people recoil at the notion.

The ratio is too simplistic because it ignores net dealer positioning. It’s too simplistic because it ignores the direction of Puts and Calls (i.e. bought or sold)². It’s too simplistic because it ignores the multiple variables impacting dealer hedging including moneyness (i.e. ITM vs. OTM), changes in volatility, and time to expiry. It’s too simplistic because it doesn’t capture all options exchanges and off-exchange volume.

These criticisms are totally valid.

So why do I like it? Because it works in the most intuitive and simplistic way, even when it’s not supposed to.

Hedging

Options are derivative contracts. While their values vary based on changes in the price of underlying security, they are merely bi-lateral contracts between two participants.

Theoretically, two entities with opposite views could enter into an option contract with each other, with equal and opposite payout profiles. Unless the option is ultimately exercised with physical delivery of the underlying shares, this option contract should have no impact on the market - it is a zero-sum bet between the two parties.

Yet in practice, this is a rare occurrence. Instead, the options market involves buyers and sellers who want directional exposure to an underlying security, transacting with options dealers who want to make money selling options.

To some extent, the directional exposure of options buyers and sellers offset each other on the books of dealers. But the dealer is always left with some exposure that it doesn’t want to hold. The dealer offsets this net exposure by buying or selling in the underlying market³.

In this process, dealers transfer the directional exposure of individual⁴ options buyers/sellers directly to the underlying market as soon as options contracts are traded. Accordingly, options volume can have a significant and immediate impact on underlying share prices, well before expiry.

Large volumes of Call buying gives the dealer short exposure (i.e. if the stock goes up, the Call buyer makes money and the dealer loses money). To hedge this short position, dealers buy the underlying, putting upward pressure on the price. Similarly, Put buying gives the dealer long exposure, which is hedged by shorting the underlying.

This basic premise is not controversial. We see the practical implications over and over again particularly on the single-stock level. The parabolic surges in some of the highest flying stocks, like Tesla, NVIDIA, have been punctuated and propelled by thrusts of Call buying (combined, in part, with covering of direct and derivative short positions).

But both Calls and Puts can also be sold to dealers, which has the opposite effect on dealer hedging flows. If an individual sells a Call⁵, the dealer will short the stock, and if an individual sells a put, the dealer will buy the stock. Merely looking at volumes of Calls and Puts doesn’t necessarily tell you the directional view that investors are expressing and that dealers must hedge.

For example, if an individual buys a Put, the initial hedging action may send a stock lower. But if that same person sells their Puts to lock in a profit, the share price might reverse higher as the dealer unwinds its hedges. Both trades show up as Put volume in P/Cs, but with opposite directional implications.

Besides the problem of ambiguous direction, there are other reasons why simple P/Cs may be misleading. The price of an option is highly dependent on how far away the strike is from the current trading levels. Cheap out-of-the-money (OTM) options may skew volumes without having nearly as much of an impact on hedging requirements as near-the-money options.

Further, cross correlation between volatility, options pricing, time to expiry, and hedging requirements means that dealer hedging is not as simple as the long vs. short dichotomy I’ve presented here. Finally, options are traded across multiple venues, and so measures of a single venue like the CBOE may not be representative of the broader market.

These criticisms, while valid, tend to miss the forest for the trees.