Use Options to Predict Market Bounces

By TradeSmith Editorial Staff

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Everyone wants to catch those face-melting rallies that accompany market plunges.

But they call it “catching a falling knife” for a reason. Most who attempt to pick the bottom end up getting cut.

I want to show you a way to predict market bounces using options.

This method is by no means a guarantee of perfect timing, but it can help you identify higher-probability points of a market reversal.

In the past, I’ve talked about how implied volatility works in both directions for stocks.

That’s true, but it oversimplifies things a bit.

In the options world, there’s a concept known as “skew,” and it’s the foundation of this little-known strategy.

Digging Deeper into Implied Volatility

“Skew” refers to a lopsidedness in one side or at one price along all the calls and puts.

Stocks tend to have a call skew, while indexes and ETFs have a put skew.

Said differently, for most stocks, if you take a call and a put that are equidistant from the current price, the calls will tend to be more expensive.

With indexes and ETFs, puts tend to be more expensive.

Here’s an example with an options chain for Apple (AAPL).

Source: CBOE

Apple last traded at $174.62, as shown in the top-right corner.

That means the $175 call option is out of the money by $0.38, while the put is in the money by $0.38.

So we adjust the last price for the $175 put and call by $0.38 to create an equivalent comparison.

To reach the at-the-money strike, we’ll add $0.38 to the last price of the call option ($3.45), since it is out-of-the-money, to get $3.83.

Because the put is in the money, we have to subtract to get to the $175 at-the-money strike. Subtracting $0.38 from the last price of the put option ($3.90), we get $3.52, showing that the call is more expensive.

Now, let’s do the same thing for the SPDR S&P 500 ETF Trust, SPY.

Source: CBOE

SPY last traded at $466.32, as shown in the top-right corner.

That means the $466 call option is out of the money by $0.32, while the put is in the money by $0.32.

We again adjust the last price for each, getting $4.61 for the call and $5.00 for the put.

This time, the gap between the adjusted price of the put and the call is much wider.

But why? Why are calls more expensive for stocks and puts more expensive for ETFs and indexes?

It boils down to how we use them.

A stock could see a buyout or other event that sends shares soaring. We saw this in GameStop (GME).

With indexes and ETFs, you can’t get buyouts or other company-specific events.

Instead, investors who own a portfolio of stocks will use put options on ETFs as a hedge or insurance policy.

Why This Is Important

When stocks are plunging, this disparity starts to change.

And, we can measure this change!

It’s called the put/call ratio.

Now, there are several variations of the put/call ratio. The one we’re concerned with deals with options volume for all products (we’ll refer to this as the PCVA going forward).

The PCVA looks at the volume of put contracts for equities and divides it by the number of call contracts for equities.

So, when you get more put options traded (i.e., put volume), the ratio increases. If more call volume trades, then the ratio decreases.

Going back to what we discussed earlier, we know that there is more demand for calls on stocks. Adding to that, there’s generally more demand for stock options overall than there is for index options.

That’s why the PCVA tends to move between 0.5 and 0.7 as opposed to trading over 1.

Below is a daily chart of the S&P 500 Index over the last few months.

The top half graphs the put/call ratio.

The bottom half, with the red and green candlestick marks, graphs the SPY.

The blue line represents the daily closing index number for the put/call ratio, while the pink line is the average of the closing prices for the last 10 days.

Source: Tradingview

What we’re looking for are times when the volume of put options stays too high for too long, giving the put/call ratio a reading outside the range of 0.5 to 0.7.

That’s why I use the 10-day simple moving average to smooth things out.

Once that 10-day moving average goes above 0.7, I know that investors have become too bearish because they keep buying “insurance” against further market declines.

You can see that on Dec. 3, when the moving average (pink line) went above 0.7, SPY also hit its most recent low.

I also highlighted a time back at the end of September, just before the first vertical yellow line, when stocks were falling.

The difference then was that it was more of a slow, steady decline versus a violent one.

Nonetheless, the indicator did a pretty good job identifying when the low might be in for stocks.

However, it brings me to a very important point.

The upper and lower boundaries you use need to adjust over time.

For now, 0.5 to 0.7 works great.

But if you tried using them any time before 2020, you would have gotten burned.

Sometimes, a range of 0.5 to 0.8 or 0.9 might be more appropriate.

It’s all relative to the overall market conditions and the conditions of the options market.

With more retail traders than ever before jumping into options trading, we’ve seen a spike in the number of call options traded since the market bottomed in 2020.

Should those traders evaporate, we’ll need to adjust the range.

Now, this is just one indicator you can use to analyze the market.

I’m curious which indicators are your favorites and why. How do you use them to make better decisions? Which ones would you like to know more about? Send me a message. While I cannot respond individually, I do read every one.