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The CBOE Put-Call Ratio: A Useful Greed & Fear Contrarian Indicator? – A Statistical Analysis

Author: Robert C. Koch

Summary

  • On average, option traders lose about 80% of the time (Nithin Kamath, CEO Zerodha, July 4th, 2021). Thus, the put to call ratio is often used as contrarian indicator when reaching extreme levels.
  • In this article, we will analyze the effectiveness of the put-call ratio as contrarian indicator to exploit extreme levels of greed and fear within the option market.
  • To reduce the subjectivity of interpretation in the term “extreme greed and fear levels of the put-call ratio”, we apply descriptive statistics to derive precise thresholds to identify appropriate entry- and exit points.
  • Afterwards, we analyze these entry- and exit points based on their average forward-looking returns on the S&P 500 and test them for statistical significance.
  • Finally, we introduce a new way on how to improve the trading results by applying the z-score statistics to the put-call ratios.
  • The put-call ratio as well as its z-score normalization, show statistical significances in identifying attractive entry- and exit points.

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Risk Parity – Why Correlations & Classifications Can Be A Huge Stumbling Block!

Abstract

  • Despite the fact that the risk parity approach has some disadvantages over other risk based asset allocation strategies, if offers investors an attractive risk/return profile and has, therefore, clearly a competitive edge over traditional balanced portfolios.
  • Nevertheless, it can be quite dangerous to think that this strategy is a free lunch, since most risk parity funds/ETFs have not experienced a significant drawdown so far.
  • In our article, we review a hypothetical risk parity portfolio that consists of three risk balanced asset clusters (equity, commodity and fixed income), whereas within each bucket all single securities are also being weighted according to the risk parity approach.

Content

After a decade of extremely high macroeconomic uncertainties and increased volatility within the stock markets, investors have started to re-think their traditional asset allocation models that have often fallen short of expected returns/losses. For that reason, new risk-based portfolio construction techniques like “Risk Parity” have become extremely popular among researchers and investors. For example, the Invesco Balanced-Risk Allocation Fund (ABRIX) just recently passed USD 1.5 billion in size while the AQR Risk Parity (AQRIX) has swollen nearly to USD 1 billion. After such a success, even Global X has filed paperwork with the SEC for a “Global X Risk Parity ETF”.

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