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Accumulated Put/Call Ratio

The Concept:
The Accumulated Put/Call Ratio indicator applies numerous adjustments to the conventional put/call ratio in pursuit of:
- clearer trading signals;
- adjustable sensitivity; and
- better readability.

Before getting into what the Accumulated Put/Call Ratio is, we first need to understand the original Put/Call ratio .

Put/Call Ratio
The conventional put-call ratio (P/C ratio) is calculated by dividing the number of traded put options by the number of traded call options.

A put option is the right to sell an asset, while a call option is the right to buy an asset. Generally speaking, sentiment is bearish when more put options are traded than call options. By dividing the number of puts to the number of calls, we can gauge how market participants feel about the current market condition. Since the P/C ratio uses puts as the numerator and calls as the denominator, a P/C ratio value above 1 suggests a bearish sentiment while a value below 1 suggests bullish sentiment.

However, the conventional P/C ratio also comes with some drawbacks.

Firstly, the P/C ratio is quite noisy and can create choppy trading signals.

Secondly, the P/C ratio generally moves inversely with the market, which might be counterintuitive for some people. The indicator would be much easier to read if it moved in the same direction with the market.

Thirdly, we cannot adjust the sensitivity of the P/C ratio through variable inputs (the raw P/C ratio data pulled from CBOE does not have any variable inputs).

This is where the Accumulated Put/Call Ratio comes in.

Accumulated Put/Call Ratio
The Accumulated P/C ratio attempts to address the above issues of the conventional P/C ratio by:
  • adding N bars of P/C ratio values together to get the Accumulated P/C ratio - such summation of multiple P/C ratio values greatly reduces the noisiness of the indicator;
  • calculating the difference between the current Accumulated P/C ratio and the previous high and low Accumulated P/C ratio values during a lookback period - this generates “difference from max.” and “difference from min.” signals that allow the trader to see both bullish sentiment and bearish sentiment simultaneously; and
  • adjusting the Accumulated P/C ratio such that trading signals are in the same direction as the market.

To further improve readability, the indicator calculates the mean and standard deviation values of the above differences to use as a coloring reference. A difference value closer to the mean will have more transparent colors, while a difference value closer to the 3rd standard deviation will have more solid colors (completely solid colors when > 3 standard deviations). This highlights the extreme values.

The Variables:
This indicator has three inputs: (1) N bars of accumulation, (2) Lookback Period, and (3) Standard Deviation Period.

The first variable “N bars of accumulation” sets the number of P/C ratio values for adding up. Smaller values produce fast but noisy signals, while larger values produce smooth but slow signals.

The second variable “Lookback Period” determines the lookback range for finding high and low Accumulated P/C ratio values. Again, smaller values are more sensitive but can become more choppy.

The third variable “Standard Deviation Period” is used for bar coloring only. This does not affect the indicator signal values.

The user will have to do some testing to see which settings suit their needs.

The Signals:
Trading signals for the Accumulated P/C ratio come in two forms:

1. Relative size of “difference from max.” (green bars) compared to “difference from min.” (red bars)

A P/C ratio closer to the max. is bearish (remember puts data is placed in the numerator), so when the “difference from max.” approaches 0, the indicator suggest bearish sentiment.

A P/C ratio closer to the min. is bullish , so when the “difference from min.” approaches 0, the indicator suggest bullish sentiment.

A “difference from max.” larger (in terms of absolute size) than the “difference from min.” is bullish .

A “difference from max.” smaller (in terms of absolute size) than the “difference from min.” is bearish .

2. Divergences

When the “difference from max.” is gradually decreasing during an uptrend, this forms a bearish divergence.

When the “difference from min.” is gradually increasing during a downtrend, this forms a bullish divergence .
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