Every trader and investor asks, “Where is the general market (or a particular security price) headed?” Several methodologies, intensive calculations, and analytical tools are used to predict the following direction of the general market or of a particular security. Options market data can provide meaningful insights on the value movements of the underlying security. We have a look at how specific data points pertaining to options market might be used to predict future direction.

Options Indicators for Market Direction

The Put-Call Ratio (PCR)

 PCR is the usual indicator that has been used for a very long time to gauge the market direction. This easy ratio is computed by dividing the variety of traded put options by the variety of traded call options. It’s probably the most common ratios to evaluate the investor sentiment for a market or a stock.

Multiple PCR values are available from the varied option exchanges. They include total PCR, equity-only PCR, and index-only PCR values. Total PCR includes each index and equities options data. Equity-only PCR incorporates only equity-specific options data and excludes index options. Similarly, index-only PCR incorporates only index-specific options data and excludes equities options data.

Nearly all of the index options (put options) are bought by fund managers for hedging at a broader level, no matter whether or not they hold a smaller subset of the general market securities or whether or not they hold a bigger piece. For instance, a fund manager may hold only 20 large-cap stocks but may buy put options on the general index which has 50 constituent stocks.

As a consequence of this activity, the index-only PCR and the overall PCR (which include index options) values don’t necessarily reflect the precise option positions against the underlying holdings. It skews the index-only and total PCR values, as there may be a greater tendency to purchase the put options (for broad-level hedging), moderately than the decision options.

Individual traders buy equity options for trading and for hedging their specific equity positions accurately. Normally, there is no such thing as a “broad-level” hedging. Subsequently, analysts use the equity-only PCR values, as a substitute of the overall PCR or the index-only PCR.

The historical data from November 2006 to September 2015 for Cboe PCR (equity-only) values against the S&P 500 closing prices indicate that a rise in PCR values was followed by declines within the S&P 500, and vice-versa.

As indicated by the red arrows, the trend was present each over the long run and within the short term. No wonder then that PCR stays probably the most followed and popular indicators for market direction. Experienced traders also use smoothening techniques, just like the 10-day exponential moving average, to raised visualize changing trends in PCR.

To make use of PCR for movement prediction, one needs to choose about PCR value thresholds (or bands). The PCR value breaking above or below the edge values (or the band) signals a market move. Nevertheless, care ought to be taken to maintain the expected PCR bands realistic and relative to the recent past values. For instance, from 2011 to 2013, PCR values remained around 0.6. The trend gave the impression to be downwards (although with low magnitude), which was accompanied by upward S&P 500 values (indicated by arrows). The sporadic jumps within the interim provided numerous trading opportunities for traders to money in on short-term price moves.

Any volatility index (like VIX, also called the Cboe volatility index) is one other indicator, based on options data, that might be used for assessing the market direction. VIX measures the implied volatility based on a wide selection of options on the S&P 500 Index.

Options are priced using mathematical models (just like the Black Scholes Model), which keep in mind the volatility of the underlying, amongst other values. Using available market prices of options, it is feasible to reverse-engineer the valuation formula and arrive at a volatility value implied by these market prices.

This implied volatility value is different than volatility measures based on the historical variation of price or statistical measures (like standard deviation). It is taken into account higher and more accurate than historical or statistical volatility value, because it relies on current market prices of options.

The VIX Index consolidates all such implied volatility values on a various set of options on the S&P 500 Index and provides a single number representing the general market implied volatility. Here’s a comparative graph of VIX values versus S&P 500 closing prices.

As might be observed from the above graph, relatively large VIX movements are accompanied by movements of the market in the wrong way. Experienced traders are inclined to keep an in depth eye on VIX values, which suddenly shoot up in either direction and deviate significantly from recent past VIX values.

Such outliers are clear indications that market direction can change significantly with larger magnitude, at any time when the VIX value changes significantly. The visible long-term trend in VIX indicates an analogous and consistent long-term trend within the S&P 500 but in the wrong way. Options-based VIX values are used for each short- and long-term market direction predictions.

The Bottom Line

Options data points are inclined to show a really high level of volatility in a brief time period. When accurately analyzed using the fitting indicators, they’ll provide meaningful insights into the movement of the underlying security. Experienced traders and investors have been using these data points for short-term trading, in addition to for long-term investments.