The Put-Call Ratio is a tool to determine the market sentiment. It is used by the investors to assess if the stock market buying or selling is at an extreme level.
Put Call ratio
This ratio is calculated on the basis of the volume of the put option and the call option. The put option volume plays on a reduction of the stock prices, and the call option plays on the increase of the stock prices. The traders observe the extremes of the put/call ratio, and speculate when the re-bounce can happen. Hence, this ratio is also used as a contrarian indicator.
Options are used by the traders and hedge fund managers to make speculations and do hedging. They use the call option if they hope the equity price to increase, to hedge a short stock position. They use the put option if they think the equity price will increase, to hedge a long stock position.The individual traders are aggressive on the options of individual stocks, and hedge funds are more active on index options.
How to calculate?
The Equity PutCall ratio is calculated by dividing put volume by call volume traded on equity options. The Index PutCall ratio is calculated by dividing put volume by call volume traded on index options. If the ratio increases, there are more number of puts than the calls. If the ratio decreases, there are lesser puts than calls. Put Call Ratio can also be calculated by dividing sum of Open Interest of put options of each strike price by sum of Open Interest of call options of each strike price.
The PutCall Ratio isused as a contrarian indicator to find if the stock market is bearish or bullish. A very high PutCall Ratio means short-term bull for the stocks. A very low PutCall Ratio means short-term bear for the stocks.
Interpretation of PCR
Put Call ratio is a simple calculation that uses the traded volume of options. When volume of the put options is greater than the volume of the call options, the ratio will be higher and it will mean that the market is having a bearish sentiment, and the PCR will be greater than 1. This happens when the investors invest more in the put options as compared to the call options as they see a market downfall in future. Increased call options mean the market is bullish and PCR will be less than 1. To summarize:
• If put call ratio is more than 1.00, it means a bearish sentiment. Since the market is oversold, the contrarian traders use it to take long positions.
• If put call ratio is between 0.50 to 1.00, it signals sideways trend. You should avoid trading at this time.
• If put call ratio is less than 0.50, it signals a bullish sentiment. Since the market is overbought, the contrarian traders use it to take short positions.
• Put Call ratio is a favorite of many contrarian traders, because it signals the reversals correctly.
Check out live put call ratio values on BloombergQuint.