Everybody in the world seemed to be buying call options last Thursday.

The CBOE Put/Call ratio (CPC) closed at just 0.74. In other words, traders were buying about 35% more calls than puts.

This is a sign of extreme optimism. And from a contrarian perspective, it’s bearish.

You see, most traders tend to lean bullish. They’re inclined to buy more call options than put options. So, the CPC will usually trade just below 1.00.

But when the CPC drops sharply below 1.00 (like Thursday’s reading of 0.74, the second red arrow on the chart below), it indicates extreme optimism. And that condition often leads to short-term weakness in the stock market.

Take a look at this chart of the Put/Call ratio …

Last week, I suggested traders should keep an eye on this chart as a decline below 0.80 could lead to some selling pressure.

The last time the Put/Call ratio dropped this low was back in mid-June (the first red arrow on the chart). The S&P 500 lost nearly 3% over the next two weeks.

In strong uptrends in the stock market, the Put/Call ratio can drop even lower. In late January, the ratio got down to 0.64 as the broad stock market stretched higher into overbought conditions.

So, a low Put/Call ratio doesn’t mean the market has to pull back right away. But it does support the argument that whatever gains the market makes from here are likely to be given back in the coming weeks.

Of course, we don’t want to put too much weight into any one indicator. But the CPC has given some fairly accurate buy and sell signals over the past few months. So, after a strong rally so far this month, I’m inclined to respect the current bearish signal from the CPC.

Traders should be cautious here.

Best regards and good trading,

Jeff Clark

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