Over the past days we have read several articles by so called pundits explaining how the VIX has come down, but that several other indicators are pointing to very nervous investors. Authors have referred to among other indicators the put/call ratio having been elevated over past days, especially the 10 day average of the CBOE put/call index.
Unfortunately many times pieces like these are written by people that have no trading experience and the articles tend to be misinterpreted as they actually do NOT explain rightfully what is happening.
A high put/call ratio is often referred to as an indicator showing “underlying fear” among investors, often many times despite the VIX being low.
This is not really true, and above all there is no correlation between a high put/call ratio and a falling market. It is often actually the inverse relationship, ie when the put/call ratio is high (investors buy a lot of puts relatively), the market many times bounces higher or marks a low.
Another effect is the fact when VIX falls (as it has done since the Trade War panic), puts become relatively cheap in terms of premium. This makes puts relatively cheap hedges and is often used by traders/investors to hedge the portfolio. The logic being why not spend some premium on cheap(er) puts just in case something happens.
Below is a chart showing the put/call ratio (white) and SPX (orange). Note how the market actually has started big moves higher when the put/call ratio has been elevated. At the moment, the put/call ratio is not even that extreme, so it is a bit surprising the media writes about it and refers to the big “underlying fear”.
Below is the same chart but weekly and over 5 years.
But the SKEW Index is elevated, that’s showing fear? Well, this is another popular index people that haven’t traded much options often refer to. What is the SKEW Index?
CBOE SKEW Index is a global, strike independent measure of the slope of the implied volatility curve that increases as this curve tends to steepen. The index is calculated from the price of a tradable portfolio of out-of-the money S&P 500 options, similar to the VIX Index. (Bloomberg)
You can clearly see in the chart below, showing the SKEW Index (white) and SPX (orange), that when the SKEW Index is high does NOT correlate to falling markets, despite the so called pundits writing about it.
Volatility and volatility trading is a rather complex area. We won’t go into deep explanations of how complex volatility trading works here, but we would like to outline that high put/call ratio and a high SKEW Index do NOT correlate with falling markets. Many professional traders actually use it as a contrarian indicator.
Source: charts by Bloomberg