Today, I’d like to introduce you to a “new” market timing indicator – the CBOE Put/Call ratio (CPC)

Okay, I’ll admit the CPC isn’t exactly new. It’s been used by technical analysts as a contrary indicator well before I started trading options back in 1982. But several years ago, it just stopped working.

That happens often with technical indicators. They’re reliable for a few years. Then, when just about everyone starts following them, the indicators stop working. So, folks swear them off as unreliable. And they stop following them.

That’s usually about the time they start working again.

I can’t tell you the last time I heard anyone talk about the Put/Call ratio. But it used to be a reliable contrary indicator.

Most traders are bullish. Most traders are buyers of call options. So, under normal conditions, the CPC will trade below 1.00. That means traders are buying more call options than put options.

When the CPC spikes sharply above 1.00, it means folks are buying more puts than calls. From a contrarian view, that’s potentially bullish.

When the CPC drops sharply below 1.00, it indicates traders are buying more calls than puts – which is bearish from a contrarian standpoint.

In my nearly four decades of trading, I’ve learned to respect this contrarian indicator when it reaches “extreme” levels. For example, when the CPC popped above 1.10, it often signaled that folks were overly bearish. In that situation, we had the potential for a short-term rally. And when the CPC dropped below 0.80, it often signaled that the bulls were too optimistic. That was usually a good time to consider shorting stocks.

A few years ago, though, this indicator just stopped working. It became too popular. Too many folks were following it. Its popularity diluted its effectiveness.

So, the CPC fell out of favor. The trading signals weren’t reliable anymore. So, folks stopped following it.

But it looks to me like the CPC is starting to work again.

Take a look at the following chart…

There’s been multiple times this year when the CPC popped above 1.10 – which signaled that traders were much more bearish than bullish. And we’ve seen several times this year when the CPC dipped towards 0.80 – indicating traders were much more bullish than bearish.

In almost every occurrence, it made sense to trade against the popular opinion.

For example, consider the large spikes higher in the CPC in February, March and April. Traders were paying huge premiums to buy put options to protect against a downside move in the stock market.

And in every example, the traders were wrong. The sharp increase in put option purchases occurred within one or two days of a big rally in the stock market.

Here’s a look at the S&P 500…

The blue arrows show the times when the CPC rallied above 1.10 – which indicated too much pessimism in the market. The red arrows show when the CPC dropped to about 0.80 – indicating too much optimism.

Yesterday, the CPC closed at 0.77. That’s the lowest level since late January – just before the broad stock market entered a correction phase.

This is a short-term indicator. So, it’s not going to get me to change my intermediate-term bullish stance on the stock market. I still think we’re going to see a strong summertime rally – perhaps to new all-time highs.

But for the short term – meaning the next few days – I suspect stocks are more likely to fall than rise.

Traders seem to be a bit too optimistic. So, I’m looking for a pullback over the next few days. And I’ll be using that weakness as a chance to put some money to work on the long side.

Best regards and good trading,

Jeff Clark

Reader Mailbag

Today, a theory on what’s holding up high-yield bonds…

Jeff, really like your insights. Now, HYG – it’s possible that older investors, who bought for income, might be taking part of that income monthly and reinvesting the rest. This would tend to keep the price up because of the lack of fear.

– Roger

Thank you, as always, for your thoughtful insights. Keep them coming right here.