Friday, May 25, 2007

PCVXO: Combining Put to Call Ratios and Volatility Data

I talk a lot about put to call ratios and the VIX in this space, but I almost always talk about them as separate indicators and haven’t spent much time dedicated to discussing when to give one precedence over the other, what to do when the two indicators disagree, etc.

As luck would have it, Jay Kaeppel, who is the author of several books on options and a frequent contributor to Optionetics.com, has already written about one such model, which he calls the PCVXO. The name refers to the fact that the PCVXO combines a put to call ratio and the VXO. Essentially, the PCVXO boils down to an average of the ratios of the 10 day simple moving average to the 65 day simple moving average for both the put to call and VXO. The full details of the PCVXO calculations and buy/sell rules are available in Kaeppel's “Can We Bounce Yet: Part II.” You can also try a full search on “PCVXO” at Optionetics.com to get more information.

Like its components, the PCVXO is a contrary sentiment indicator, so it generates buy recommendations when a combination of relatively high put activity and increases in volatility signal excessive bearishness and fear. Likewise, when relative put activity and volatility are in a downtrend and suggest that greed and complacency are figuring prominently into the markets, the PCVXO is most likely to generate sell signals.

Kaeppel says that he uses the total put to call ratio and the VXO because there is a much larger quantity of historical data for these measures than for some of the alternatives. Of course, there are many possible permutations and combinations for indicators that are similar to the PCVXO. I generally prefer the ISEE and the equity put to call ratio to the total put to call ratio (or the index put to call ratio.) I also favor the VIX over the VXO, but believe that the VXN, RVX and VXD are all worth evaluating in the context of a combined sentiment indicator. Finally, there are an almost infinite number of simple and exponential moving averages to consider, but four of my favorite for sentiment data are the 5, 10, 20 and 50 day SMAs. With 4 put to call ratios, 5 volatility measures and 6 moving averages (that’s four factorial for those scoring at home), that means 120 ‘off the shelf’ combined put to call and volatility indicators.

I have been crunching numbers on quite a few of these PCVXO analogs and will have some more to say about this indicator next week.

1 comments:

Bill Luby said...

pleadership, if you are still lurking out there, thanks for encouraging me to do some research into the PCVXO. So far I like what I see and think it will have some application to my trading.

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