What is Put-Call Ratio?
Put-call ratio (PCR) is defined as a ratio of the trading volume of put options to call options. It is one of the most reliable measures of sentiment and financial tool which has been used by many investors and traders for forecasting future market direction. It attempts to measure the level of bullishness and bearishness in the market. This ratio tells how many out options are being traded relative to call options. The put-call ratio often uses by the traders who trade in the options market. These are the traders who do options trading to participate in the market without holding a large quantity of stock and to pay a small premium amount to protect their portfolios.
How to Calculate Put-Call Ratio (PCR)?
To calculate the put-call ratio, one can divide the total no. of open interest (OI) in a put contract by total no. of open interest in call contract at the same strike price and expiry date on any given day. Another way to calculate the put-call ratio is to divide put trading volume by call trading volume.
The put-call ratio can be calculated for indices, individual stocks, and for the derivatives segment. For instance, let’s assume the Nifty50 Put option is at a strike price of 6,000 for December expiry and saw a volume of 5,600 contracts on a day. Now further that day the Call volume on that day at the same strike price and same expiry stood at 81,480.
In such case, the PCR would be:
5,600/81,480 = 0.068
Now the open interest (OI) of the Put option for the same expiry and strike price stands at 3,219,000 and Call open interest stands at 6,124,654,
In this case, the PCR would be:
3,219,000/6,124,654 = 0.52
What does the Put-Call Ratio (PCR) Indicate?
On calculation, if the put-call ratio indicates 1, it means that the no. of buyers of calls is equal to the no. of buyers for puts. However, it is not entirely correct since most options buyers buy calls rather than puts.
Besides, it is widely known that most option buyers are not very successful, traders and about 90 percent of option buyers lose most of the time. So, it is not good to rely on the normal sentiment of the options market since most of the traders have a bad record. Thus the put-call ratio demonstrates it pays to go against the crowd. After all, most options traders are usually wrong. When most options traders think that the market is going in a certain direction, it usually moves in the opposite direction. This is why the put-call ratio is also known as a contrarian sentiment indicator.
What does High Put-Call Ratio Indicate?
As we mentioned, if the put-call ratio indicates 1, then it means that equity traders of call options and put options are equal. But, the rising pull-call ratio indicates that the equity traders are buying more puts than calls which indicates the bearish sentiment. But, contrarian investors who don’t follow the crowd considered it as a bullish signal since the ratio is indicating too bearish. It is because high put-call ratio indicates that the market is too bearish and it would adjust itself by bouncing back.
What does Low Put-Call Ratio Indicate?
If the put-call ratio is falling below 1 then it means that no. of buyers of calls are more than the buyers of puts. In such a situation, it should be a bullish sentiment because the traders are buying call options however according to contrarian indicator, it is the signal of bearish sentiment since the ratio is indicating too bullish. Thus, when the PCR is very low then traders become cautious and get worried that the market is too bullish and recent bullish moves are overdone. As a result, they would position themselves for a market pullback by buying either put or placing stop-loss orders.
Final Thoughts: –
It is a contrarian indicator which can be used to assess the bullishness and bearishness in stocks, indices, and both. It may not be proficient in telling the accurate direction of the market but it measures sentiment when reaches a bullish or bearish extreme level, it can provide timely reverse signals.
Note: All information & data provided in this article is for the educational purpose as well as to give general information on the finance & economy, not to provide any professional advice or service. Views & opinions are not biased against the company and do not affect any official policy or any other agency, an organization within the content.