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the stock will be headed lower soon. But there is a flip side here too. Remember that for every put buyer who is betting that the underlying stock will fall, there is someone who sold (wrote) the put who is betting that the stock will rise (or at least remain stable). But which version is more plausible? Therein lies the mystery of using options as indicators.

Most people may view a high put-to-call ratio as a negative trading pattern, indicating an impending drop for the stock or for a sector or for the market, depending on the underlying security. But many options traders actually view this as a signal of the securities bottoming out or rising, especially where index options are concerned. There are two reasons for this:

• Many institutional investors use put options to hedge against losses against long positions. A high volume of put options indicates that many of these investors are actually engaged in buying stocks, as they believe that their long positions will become profitable. As more investors buy into this mentality, stock prices rise in response.
• Many also believe that by the time put options reach a high volume, many investors buying them have already sold their stocks in order to avoid a loss on their holdings. With most of the selling pressure gone, the market would then be poised to move up. This scenario is particularly applicable to index options, as their broad base of underlying securities are a good yardstick for the overall market.

Therefore, as the put-to-call ratio begins to pass a certain point (around 0.5, meaning 50 puts for every 100 calls), some investors would take that as a signal that the market is about to rise and they jump into long positions. …