Tasty Analytics: Put/Call Rank
Sep 14, 2018
By: Sage Anderson
When possible, I always like to add a second (or even third) level of analysis when evaluating potential trade ideas for my portfolio.
Traders sharing that mindset will find a recent episode of Market Measures extremely compelling. The focus of the show is an introduction to the Put/Call Rank, and newly released research on this metric.
As you probably already know, all else being equal, puts generally trade at "richer" prices than calls in the options market. This phenomenon is usually referenced by the term "skew," which was covered on a recent episode of From Theory to Practice.
Because we can measure the relative richness of puts to calls over time (Put/Call Rank), the Market Measures team decided to conduct a backtest to evaluate whether extreme levels in the Put/Call rank contributed to improved performance when used as a trading signal in a short premium strategy.
For example, imagine the 16 delta put and call in SPY for a given expiration. Because we know that skew exists, we can be certain without even looking at the options market that the price of the put will be higher than the call. What we can’t discern by looking at a single snapshot is how that level compares to the historical range in the Put/Call Price Ratio.
Because of this, the Market Measures team decided to look back at historical levels in the Put/Call Price Ratio and identify the range in which it typically trades - and also to see what constitutes a “price extreme” in the Put/Call Price Ratio.
The graphic below illustrates the current price of a 16 delta Put and Call in SPY, as well as the high, the low, and the average observed in the Put/Call Price Ratio in recent years:
Taking the current prices for the 16 delta put and call in SPY (from the slide above), we can calculate the current Put/Call Price Ratio as: $1.17/$0.70 = 1.67.
Comparing that data point to the other information on the slide, we can see that the historical average in the Put/Call Price Ratio is roughly 1.8, which means that current levels are almost equal to the historical average. That implies that the current price of puts in SPY is toward the “middling” range of cheap vs. expensive.
We can also see in the graphic above that the lowest reading in the Put/Call Price Ratio (0.40) occurred shortly before the onset of the 2008-2009 Financial Crisis, and that the highest reading in recent years (9.0) was observed back in October of 2016.
But how can we use this data to produce new insights on trading analytics? That was the precise question asked by the Market Measures team - and they responded by designing a study that provided some very compelling insights.
In the study, a backtest was conducted which used historical data in both IVR and the Put/Call Price Ratio to evaluate how a short premium strategy performed using each metric on its own (versus a combination of the two metrics) as a trading signal.
In the study, the Put/Call Price Ratio data was used to create a Put/Call Rank - similar to how implied volatility data over the last 52 weeks is used to compute Implied Volatility Rank (IVR). That means when the Put/Call Rank is above 50%, the relative richness of puts to calls is at the higher end of its recent range - just like when IVR is above 50%, that means that implied volatility in a given symbol is above the average level observed over the course of the last 52 weeks.
The study therefore incorporated three different backtests, each of which deployed short strangles in SPY whenever the below trading signals were activated:
Selling strangles when IVR was above 50%
Selling strangles when the Put/Call Rank was above 50%
Selling strangles when both IVR and the Put/Call Rank were above 50%
The findings from the study are summarized in the graphic below:
As you can see in the data above, each of the three backtests produced an attractive win rate as well as a positive average P/L.
However, what sticks out is how the combined approach (using both IVR and the Put/Call Rank) produced overall the most attractive results in terms of win rate and average P/L. This approach also produced the lowest standard deviation - meaning that volatility in returns was also reduced as compared to the other two approaches (i.e. less variability in P/L).
Due to the importance and complexity of this material, we hope you’ll take the time to review the complete episode of Market Measures when your schedule allows. More information on this topic can also be found in this additional episode of Market Measures.
Should you have any questions about the Put/Call Price Ratio, or Put/Call Rank, we hope you’ll leave a message in the space below or send us an email at email@example.com.
We look forward to hearing from you!
Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options before deciding to invest in options.
tastytrade content is provided solely by tastytrade, Inc. (“tastytrade”) and is for informational and educational purposes only. It is not, nor is it intended to be, trading or investment advice or a recommendation that any security, futures contract, transaction or investment strategy is suitable for any person. Trading securities can involve high risk and the loss of any funds invested. tastytrade, through its content, financial programming or otherwise, does not provide investment or financial advice or make investment recommendations. Investment information provided may not be appropriate for all investors, and is provided without respect to individual investor financial sophistication, financial situation, investing time horizon or risk tolerance. tastytrade is not in the business of transacting securities trades, nor does it direct client commodity accounts or give commodity trading advice tailored to any particular client’s situation or investment objectives. Supporting documentation for any claims (including claims made on behalf of options programs), comparison, statistics, or other technical data, if applicable, will be supplied upon request. tastytrade is not a licensed financial advisor, registered investment advisor, or a registered broker-dealer. Options, futures and futures options are not suitable for all investors. Prior to trading securities products, please read the Characteristics and Risks of Standardized Options and the Risk Disclosure for Futures and Options found on tastyworks.com.
tastyworks, Inc. ("tastyworks") is a registered broker-dealer and member of FINRA, NFA and SIPC. tastyworks offers self-directed brokerage accounts to its customers. tastyworks does not give financial or trading advice nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of tastyworks’ systems, services or products. tastyworks is a wholly owned subsidiary of tastytrade, Inc (“tastytrade”). tastytrade is a trademark/servicemark owned by tastytrade.
Quiet Foundation, Inc. (“Quiet Foundation”) is a wholly-owned subsidiary of tastytrade The information on quietfoundation.com is intended for U.S. residents only. All investing involves the risk of loss. Past performance is not a guarantee of future results. Quiet Foundation does not make suitability determinations, nor does it make investment recommendations. You alone are responsible for making your investment and trading decisions and for evaluating the merits and risks associated with the use of Quiet Foundation’s systems, services or products.
Small Exchange, Inc. is a Designated Contract Market registered with the U.S. Commodity Futures Trading Commission. The information on this site should be considered general information and not in any case as a recommendation or advice concerning investment decisions. The reader itself is responsible for the risks associated with an investment decision based on the information stated in this material in light of his or her specific circumstances. The information on this website is for informational purposes only, and does not contend to address the financial objectives, situation, or specific needs of any individual investor. Trading in derivatives and other financial instruments involves risk, please read the Risk Disclosure Statement for Futures and Options. tastytrade is an investor in Small Exchange, Inc.