Day Trading: Dollar-Weighted Put/Call Ratio

By: Thomas Demark & Thomas DeMark, Jr.

The following is an excerpt from Demark on Day Trading Options

Is it possible that apples and apples and oranges and oranges may not be the same? What do we mean by this experience? First of all, whereas the call volume for a particular day will report how many call option contracts have traded and the put volume for a particular day will report how many put option contracts have traded, the volume statistics may not be comparable. For instance, a total of a 1000 puts and 100 calls would represent a ratio of puts to calls of 10:1 based upon the conventional method of sentiment measurement. However, what if the 1000 puts were valued at $1 a piece and the 100 calls were valued at $10 a piece? Then the dollar- weighted value of the puts would be exactly equal to the dollar weighted value of the calls, and the revised dollar weighted put to call ratio would be 1.00 instead of  10:1. This minor dollar-weighted adjustment should be made to account for varying costs of the options and to make the comparisons consistent with one another. In other words, by accounting for the dollar value of the options, by multiplying the put volume by the put price and the call volume by the call price, a valid comparison of dollars invested can be calculated: and then by dividing the put activity by the call activity, a measure of market sentiment can be derived.

Not only do we refer to the end-of-the day dollar-weighted put/call ratio but we also calculate the intraday dollar-weighted put/call ratio to fine-tune our entries in fact, we prefer the intraday measure over the end of day calculation. We identify the nearby expiration month and strike price, for both puts and calls, and make relevant comparison. When the dollar-weighted put volume is at least two times larger than the dollar-weighted call volume on an intraday basis, meaning the dollar-weighted put/call ratio is 2.00 or greater, the call option becomes more attractive, and a low risk call buying opportunity presents itself. Conversely, when the dollar-weighted call volume is at least two times larger than the dollar-weighted put volume on an intraday basis, meaning the dollar-weighted put/call ratio is 0.50 or less, the put becomes more attractive, and low-risk put-buying opportunity presents itself. These ratios identify where market sentiments reside, either oversold or overbought.

Therefore, if the dollar-weighted put/call ratio is greater than 2.00 on an intraday basis, then the market is defined as being oversold and traders should use an additional indicator to time their call-purchasing entry points; if the dollar-weighted put/call ratio is less than 0.50 on an intraday basis, then the market is defined as being overbought and traders should use an additional indicator to time their put-purchasing entry points; any value in between is defined as being a neutral reading. These ratios can be reduced to 1.25 for put options and 0.75 for call options when comparing the two on a daily closing basis.

Dollar-Weighted Put/Call Option Entry Point

Typically, when the call volume exceeds the put volume, the market is expected to decline and conversely, when the put volume exceeds the call volume, the market is expected to advance, resourceful traders can quickly meld the two and confirm their option trading decisions. Specifically, by dollar-weighted put and call volume intraday and reviewing the statistical information prior to placing a day trade, and then using this information with other market-timing indicators, one’s timing should improve. For example, at a suspected trend reversal price level for the underlying security, if the option trading volume is tilted in the direction of a disqualified breakout, it further indicates that the majority of traders are expecting a breakout, and that it should fail. Therefore, more money can be invested in the trade than if the option activity failed to support the other indicator.

As the composition of market participants change over time, the dollar-weighted put/call ratios representing whether a market is oversold, overbought, or neutral, occasionally need to be altered to better reflect trading sentiment. The important consideration is not so much the specific values, but rather the concept. We invite you to test alternate readings which may give an even more accurate indication of overbought and oversold conditions, and therefore a more accurate measure of the overall market environment.