Put-Call Ratio Meaning
The Put/Call Ratio is an indicator that shows put volume relative to call volume. Put options are used to hedge against market weakness or bet on a decline. Call options are used to hedge against market strength or bet in advance. The Put/Call Ratio is above 1 when put volume exceeds call volume and below 1 when call volume exceeds put volume.
Typically, this indicator is used to gauge market sentiment. The sentiment is deemed excessively bearish when the Put/Call Ratio is trading at relatively high levels, and excessively bullish when at relatively low levels. Chartists use moving averages and other tools to simplify the data and identify signals.
How to Calculate Put Call Ratio?
The put-call ratio helps measure market sentiment by comparing the number of put and call options traded. Understanding its components is essential before diving into its calculation.
- Put Options: These give traders the right to sell assets at a pre-agreed price.
- Call Options: These provide traders the right to buy assets at the current market price.
The calculation methods for the put-call ratio are as follows:
- Based on open interest
Divide the total open interest in put options by the open interest in call options for a specific day.
PCR (OI) = Put Open Interest / Call Open Interest
- Based on trading volume
Divide the total put trading volume by the total call trading volume on a particular day.
PCR (Volume) = Put Trading Volume / Call Trading Volume
Put volume reflects the total number of put options initiated, while call volume refers to the number of call options initiated within the same timeframe.
Example of Put-Call Ratio
Consider Mr. Sharma, who uses the put-call ratio to analyse market sentiment. The following trades are recorded:
- Put Options Initiated: 900
- Call Options Initiated: 1500
- PCR = Put Options / Call Options = 900 / 1500 = 0.6
Since the ratio is less than 1, it shows more call options are being purchased, indicating bullish market sentiment. This suggests traders expect the prices to rise in the future.
Analysis of Put-Call Ratio
Purpose of options
- Put options help hedge against market downturns or speculate on declining prices.
- Call options hedge against market strength or bet on rising prices.
Understanding PCR values
- PCR Above 1: Indicates higher put volume than call volume, signalling bearish sentiment in the market.
- PCR Below 1: Suggests higher call volume than put volume, pointing towards bullish market trends.
Significance of PCR levels
- A PCR value of 1 is not a reliable measure of market sentiment, as call options are generally more popular than put options.
- For equity options, a PCR average of 0.7 is considered suitable for assessing market sentiment.
Interpretation of PCR
- A PCR above 0.7 or 1 reflects increased put option purchases, indicating bearish sentiment as investors hedge against potential sell-offs or speculate on falling prices.
- A PCR below 0.7, especially closer to 0.5, signals bullish sentiment, suggesting optimism for market gains.
Significance of Put Call Ratio
- Gauge market sentiment
The Put-Call Ratio (PCR) is a useful indicator to understand the market sentiment at any given time. A high PCR suggests a bearish market, while a low PCR signals bullish tendencies. It helps investors assess whether the market is leaning towards optimism or pessimism, which can shape investment strategies.
- Predict price movements
PCR provides insights into potential price movements of underlying securities. By understanding whether more traders are buying puts or calls, investors can gauge whether the market is expecting price declines or advances, and align their trades accordingly.
- Contrarian indicator
PCR is often seen as a contrarian indicator, suggesting that when sentiment is too bearish or too bullish, there may be a market reversal. This allows traders to avoid following the crowd and instead make more informed, strategic investment decisions.
- Analyse trading behaviour
The ratio also sheds light on the collective behaviour of market participants. By tracking the trend of PCR, traders can understand shifts in market mood, risk appetite, and investor outlook, which can guide future trading strategies.
- Evaluate market extremes
Extreme values of PCR can indicate an overbought or oversold market. For instance, a very high PCR may suggest that the market is overly bearish, possibly signaling an upcoming reversal. Conversely, a very low PCR could indicate excessive optimism, possibly leading to market corrections.
Limitations of Put Call Ratio
- Does not capture all market sentiments:
PCR does not always fully reflect the nuanced market sentiment. Other factors, such as economic events or news, can influence market sentiment, which PCR may not account for.
- Limited availability for stocks without options
Many stocks do not have available options, making it impossible to compute the PCR for those stocks. This limits the usefulness of PCR for a wide range of securities.
- Needs supplementary indicators
Although PCR is considered a contrarian indicator, relying solely on it without considering other market factors can be misleading. It’s crucial to combine PCR with other technical indicators to make more informed decisions.
- Reading PCR charts accurately
Small shifts in the PCR can indicate significant market movements. Therefore, understanding how to read PCR charts correctly is essential for making accurate predictions.
- Risk and goals
Investors should also consider their risk tolerance and financial goals before basing decisions purely on PCR. It should be used as part of a broader strategy that aligns with an investor’s individual risk profile.
What Is a Good Put/Call Ratio?
The put/call ratio isn’t fixed and changes with the change in market moods. However, the market observes a ratio value of 0.7 as a compass.
Put/call ratio greater than 0.7 or exceeding one, suggests a bearish trend is building in the market. Similarly, when the put/call ratio value declines below 0.7, and falling close to 0.5, means traders are buying more calls than put, an indication of an emerging bullish trend.
The put/call ratio reflects how the market perceives the recent events of earning. While studying the put/call ratio, it is important to observe the value of both the numerator (put) and the denominator (call). Fewer exchanges of call options would push the value of the put/call ratio higher without any significant change in the volume of put options, which can give a false impression of market sentiment.
Conclusion
The Put-Call Ratio (PCR) is a valuable tool for assessing market sentiment and predicting potential price movements. By comparing the volume of put and call options, investors can gauge whether the market is leaning towards bullish or bearish trends. Ultimately, PCR serves as a key resource for informed decision-making, helping traders align their strategies with shifting market conditions.
FAQs
What if PCR is greater than 1?
A PCR greater than 1 indicates that more put options are being traded than call options, suggesting a bearish market sentiment. Investors may expect a market decline or hedge against potential losses.
What is a high PCR?
A high PCR typically refers to a ratio above 1, signifying a higher volume of put options than call options. This points to pessimism in the market, with traders expecting potential downturns.
How to read put to call ratio?
To read the PCR, divide the number of put options by call options. A ratio above 1 suggests bearish sentiment, while a ratio below 0.7 indicates bullish expectations, helping traders predict market trends.
