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If you are reading about derivatives, there’s a good chance that you have heard about indicators like the moving average and RSI (relative strength index). Investors use such technical indicators to assess different facets like the trend, momentum, or volatility of the security. Likewise, the put-call ratio (PCR) is also an indicator, primarily used in options trading, to assess the sentiment of the overall market. So, by referring to the put-call ratio, an options trader may attempt to predict the direction of the options market for the short term.
Table of Contents
Defining Put-Call Ratio
The put-call ratio, also called PCR, is a ratio that shows you the volume of puts traded against the volume of calls in the market, in a specific time frame. You know that buying a put gives you the right to sell the underlying asset at a predetermined price. Conversely, buying a call gives you the right to buy the asset at a predetermined price.
Calculating Put-Call Ratio
You can learn the PCR formula and use this component for your trade in the stock market.
The PCR in the stock market can be based on the open interest (OI) of that trading session. To calculate the PCR you need to divide the OI value in the contract of that day with the open call interest of the same day.
PCR (with OI)=Put Open Interest/Call Open Interest
Based on Volume of Option Trading
The put volume indicates the total put options initiated over a specific time, along with the call volume which indicates the total call options initiated over a specific time frame.
Consider this example where a trader plans to use the put-call ratio to measure the market sentiment of a XYZ securities. The PCR is as follows:
Puts: 1,200
Calls: 1,300
PCR = 1,200/1,300 = 0.92
As the output is less than 1, you can evaluate that the market is buying more call options compared to put options which will indicate a bullish trend in the stock market.
Put-Call Ratio = Put Volume/Call Volume
So, for instance, if we assume the number of puts traded is 700 and the number of calls traded is 1,000, then the put-call ratio would be:
Put-Call Ratio = 700/1000 = 0.7
It’s worth noting that some stock market traders calculate the PCR by dividing the total number of open interest in a put option by the total number of open interest in a call option with the same strike price and expiry date.
Analysing Put-Call Ratio
To further analyse the PCR you can interpret options sellers into multiple considerations some of these considerations can be displayed in the below table:
| Put-Call Ratio | Market Sentiment |
| PCR goes up with small uncertain dips in the current trend | Interpreted as put writers are aggressively writing at dips, expecting an upcoming trend. |
| PCR decreases while markets struggle at resistance levels | Interpreted as an indication of a bearish trend. |
| PCR decreasing during a bearish market | Interpreted as options writers aggressively selling the call option strikes in the stock market. |
Since the puts give traders the right to sell at a predetermined price, traders will buy puts when they believe the market is likely to fall. On the other hand, calls are bought when the traders are expecting an advance in the market. So, we can conclude that if the number of puts traded exceeds the number of calls traded, a majority of traders are exhibiting a bearish sentiment. Conversely, the opposite indicates that the sentiment of the majority is bullish.
In terms of the put-call ratio, the ratio happens to be above 1 when the put volumes exceed the call volumes and it is below 1 when the number of calls traded exceeds that of puts. So, when the PCR is less than 1, it indicates bullishness in the markets, and when it’s higher than one it indicates bearishness. However, because our trading psychology leans toward advancements, more traders tend to buy calls than puts. This is why the PCR of 1 doesn’t represent a neutral sentiment. Rather, many traders consider a PCR of 0.7 as the neutral point for stocks. So, many interpret that there is bullish sentiment prevailing in the market if the PCR is under 0.7 and bearish if it exceeds 0.7.
Contrarian Indicator
It is a common practice among traders to use the put-call ratio as a contrarian indicator when the values are at either extreme. What this means is that if the PCR is 1.3, which is indicative of a strong bearish sentiment, traders may anticipate a cooldown. In other words, they soon expect to see an upturn or some bullish signs, which is why they may consider buying calls.
On the other hand, when the PCR is extremely low, say around 0.4, which is indicative of extremely bullish sentiment, many traders start anticipating a reversal. They anticipate a sell-off or profit-booking trend, and hence, they consider buying puts. So, many call put buyers may exit their positions when they see that the PCR is extremely high and switch to calls and vice-versa.
However, it’s worth noting that there is no specific number that confirms the market may see a reversal. In other words, a PCR of 0.4 will not necessarily signal the end of the bullish trend and the beginning of the sell-off. Extreme sentiments can continue to persist longer than anticipated. At other times, you may see the sell-off way before the PCR reflects the number you consider to be extreme for bearish sentiment. The opposite is true, so keep in mind that there is no such thing as an ideal put-call ratio.
Importance of Put-Call Ratio
Some of the importance of PCR in the stock market is as follows:
- It guides traders on the best time to bet in the stock market based on the direction in which the price moves of the securities.
- A contrarian instrument allows traders to assess whether the recent drop or the rise of the market is excessive or if it is the right time to decide to take a risk. In general, traders utilise the ratio as a counter-trend indicator once the ratio has reached high levels.
- It is a useful instrument to assess the market’s direction and mood at any given time.
- It can also assist in studying the overall behaviour of traders.
Limitations of Put-Call Ratio
As discussed in the previous section, the put-call ratio is used as a contrarian indicator, but a number that you perceive as an extreme doesn’t guarantee the bottom or top. This is because the ratio doesn’t account for important external factors like interest rate hikes, strong expected earnings, or other external factors. These factors can influence market sentiment and the strength of market trends to a great extent. Hence, it is necessary that you don’t solely depend on the PCR to make your trades. You will be better off if you’re up-to-date with the news and if you also incorporate other indicators in your trading strategy.
Besides this, you can only use the PCR to assess the sentiment around those stocks that trade in the options markets. So, if you are not an options trader, you may find other indicators more beneficial than the PCR.
Lastly, you must still have technical knowledge and know how to read the put-call chart correctly. However, every technical indicator has its flaws; so despite its limitations, the PCR is a very useful tool for option traders.
Conclusion
To sum it up, the put-call ratio is an effective indicator used by options traders to assess the prevailing sentiment of the market. It can help a trader predict where the price is headed next, and accordingly, traders can make their bets. To offset its limitations, consider using it in conjunction with other technical indicators and don’t rely on the PCR exclusively. At the same time, always ensure that you have risk-management measures ready in hand. The most successful option traders are those who can effectively manage risk and minimize their downsides. Learn about what are index options for better understanding, here at Share India.