Wall Streeters will try anything short of a Ouija board to divine the next move of the market. The put-to-call ratio is popular and of some usefulness.

Experienced investors know that a call option increases in value as the price of the underlying stock or index rises. Hence, someone wanting to place a bet that the market is going to rally will buy calls. At the same time, a fund manager is likely to grab some call options as "insurance” in case his/her big "short” position goes bad in a booming market. The increase in the calls should absorb some or all of the loss in the shorts. This is a classic "hedging” strategy.

Conversely, someone who thinks the market or a particular stock is going to decline will load up on put options. Puts gain in value as the underlying asset falls. Hedge fund managers with a large "long” position will limit their exposure to a sell-off via a large purchase of puts.

The put-to-call, or put/call ratio is a mathematical equation that shows where investor money is heading—toward puts or toward calls.

The put/call ratio is often considered a "contrarian” indicator. When the market is leaning heavily to calls, the wise men say, there is an increasing chance of a sell-off. On the other hand, if all the money is going into puts, a rally can be expected. Sometimes the indicator is right, sometimes it is wrong.

Enter market dynamics. Wall Street hates when everyone is a bull or bear, and it likes fear. Well, if you thought the market was going to fall, you may buy puts, right? But the market will look at that two ways. First they look at it like, "OK, enough people are scared, it's safe to buy some stock here." They might also think, "Well, if everyone thinks the market is heading down, who am I to argue with it?”

More times than not, we need to look at the length of time versus who is buying what. For the short term, a day or two, a big increase in call options in a particular stock often means that stock is going higher. Maybe there was a news leak, an anticipation of news, or a sector heating up. Likew

ise, if you see a ton of puts piling up on a stock, you can generally bet there is something brewing.

What about the longer term? Can the ratio of puts to calls on a particular stock tell you something about where the market is heading? Not as much as people may think. It's another matter, though, with the actual indexes (DOW, S&P 500, etc.).

With a stock, there can be a ton of factors that influence whether people think it's going up or down in a few weeks. Earnings, news, SEC investigations, you name it. But when the puts start appearing in force on an index, we have to look at the overall market, which could be setting up for a fall.

For instance, if we see a gazillion puts opening on the S&P, people are probably betting that the index as a whole is heading south. In some ways it is self-fulfilling because that amount of puts will frighten more people into thinking the market will slide, and often it does. But there will come a point when so many people are leaning to a downturn that the "buy when there is blood in the streets" adage will come into play, and the market will stage a comeback.

Is there a particular number on the put/call ratio that signals a buying opportunity? Well, after looking at it for years, the answer is yes and no, with no winning more than yes. The best way to use this tool is to watch the ratio, and if it is telling you that more people are getting bearish, plan to get cautious. Likewise, if it's showing that more people are getting bullish, plan on getting long for a while.

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