$SPY - Head & Shoulders Pattern Forming?

As indicated in the chart below, the put-call ratio is overly bearish which sets up nicely for a rally in the S&P.  In addition, several other indicators show that we might be due for a rally.

If we get a rally over the next several weeks, I'll be watching how the S&P interacts with the 1150-1170 levels of former support and resistance, as well as the 50-day moving average (currently at 1163).  Should the S&P fail to break through these levels and start to retreat, it will form the right shoulder of a head and shoulders topping pattern, which would be immensely bearish.

If it forms, this right shoulder should complete well ahead of Terry Laundry's August 26 projected top date.

$$ More Put/Call Ratio

Expanding our view from individual stocks/ETFs discussed earlier, the CBOE tracks three broad-based put/call ratios throughout the day which are best applied to the action in the Dow and S&P:  

1.  The Equity PC ratio;

2.  The Index PC ratio, and 

3.  The Combined PC ratio.  

The Equity PC ratio is generally much lower than the Index PC ratio, as the Equity reflects a retail investor crowd with a tendency to favor longs (more calls), while the Index PC ratio reflects the institutional investor crowd with a greater interest in hedging (more puts). 

The Combined PC ratio gives the trader the best gauge of what the overall market is thinking.  Of the three, this is the ratio I watch.

In his excellent book Mastering the Trade, John Carter writes that if the Combined PC ratio falls below 0.6 intraday, he will ignore all long set ups and start looking at short set ups.  He explains that below 0.6 represents extreme bullishness with near full participation from the long side.  In other words, there's:

1.  Very few left to buy, and

2.  Lots of sell stops sitting beneath the current price, just waiting to be hit.

Conversely, if the Combined PC ratio rises above 1.0 intraday, Carter will ignore all short set ups and start looking at long set ups.  He explains that above 1.0 represents extreme bearishness with near full participation from the bear side.  There are many buy stops sitting above the current price, just waiting to be taken out.

On Stockcharts.com, the symbol for the Combined PC ratio is $CPC.  Via subscription, it can be tracked real-time intraday.  Let's take a look at a 30-minute chart over the last month, with the S&P charted below it by comparison:

As you can see, tracking the Combined PC ratio would have alerted you to the extreme greed at  the yearly market highs in late April, extreme fear after the May 6 correction, as well as the gyrations between greed and fear late last week.  

We'll see if ~1130 turns out to be a swing low, or if the market continues to slide some more before turning around.  One thing is certain, the odds are against you trying to build a short position here with a Combined PC ratio of 1.11.  You should have been looking at long set ups on Friday.

$SLV Put-Call Ratio at One Year Low

SLV will likely make a 2-year price high today.  As of yesterday, the put-call ratio made a 1-year low.  This is evidence of extreme greed:

If you are long SLV, a reading of extreme greed is usually a good indication that you need to start planning your exit strategy. Note:  I didn't say exit right away.  Nor did I say start building a short position.

Chart courtesy of Schaeffers.

$$ Various Put-Call Ratios

Schaeffer's Investment Research provides lots of free sentiment information and charts. One of my favorites is their chart showing the 21-day average of the put-call ratio.

On any given day, the put-call ratio is simply the number of put options traded that day divided by the number of call options traded that day. The ratio falls when call trading dominates put trading. The ratio rises when put trading dominates call trading. Calls are by nature bullish, and puts are bearish.

So, when the 21-day put-call ratio average spikes to a multi-month low, it's a sign of euphoria and greed. When the the 21-day put-call ratio average spikes to a multi-month high, it's a sign of fear and pessimism.

Many traders use the put-call ratio as a contrarian indicator. When price rallies up as the put-call ratio spikes down, traders often look to sell or short the security. When price corrects down as the put-call ratio spikes up, traders often look to build a long position or cover their shorts.

Let's take a look at a couple of examples. The charts are courtesy of Schaeffer's. Here is SPY:

So we can see that the 21-day put-call ratio showed greed in early January as price rose to $114, fear in early February as price fell to $106, greed in mid-March to mid-April as price was rising to $120. Currently, we are at a 6-month high in the put-call ratio showing extreme fear during this latest price correction.

Here's the GLD chart:

Again, greed prevailed in early December as price spiked to $118. Note the fear spike in the put call ratio in early February and again in late March as price corrected to $104 and $106 respectively. These were excellent entry points to get long.

Currently, we are approaching early December greed levels in the put-call ratio as price rallies to near it's early December high. While this type of analysis is not infallible, it's probably not the best time to start building a position in gold. Better to wait for a price correction that results in a up spike in the put-call ratio.