Put-Call Ratio

The put-call ratio (PCR) is a derivative metric that investors and traders use to measure whether the market is about to turn bearish or bullish. The put and call options enable existing or potential derivative instrument holders to sell and buy underlying assets at predefined prices within a specified time frame.

A put call ratio also indicates the financial market sentiment. For example, the ratio greater than 1 indicates hedging sentiment, while anything less than 1 represents speculative sentiment. The two approaches used to calculate the ratio are open interest and trading volume.

• The put-call ratio is a financial indicator that compares the trading volume or open interest of put options to call options. It provides insights into investor sentiment and market expectations regarding the future direction of the underlying asset.
• The put-call ratio is commonly used in technical analysis as a contrarian indicator. High put-call ratios may suggest bearish sentiment, while low put-call ratios may indicate bullish sentiment.
• Changes in the put-call ratio offer valuable insights into market sentiment and direction. Monitoring shifts in the ratio over time can help identify potential shifts in investor sentiment, influencing future price movements. 

The put-call ratio gives traders and investors a better idea of when to trade based on trading volumes. It considers the predefined value of all open positions or volume of options trading for a specific duration. Generally, investors buy more calls than puts, giving a PCR ratio less than one on most occasions.

• Anything ranging from 0.7 to 1 signals a bearish market, and 0.5 to 0.7 signals a bullish market.
• Likewise, a PCR of 0.5 to 1 suggests a sideways market trend.
• The put-call ratio equaling one shows that put and call options are purchased at the same frequency.
• Ideally, the number of call options purchased affects PCR.
• Remember, the open positions for both trading activities at predetermined prices and a specified time are considered for the calculation.

As already stated, the put call ratio calculator involves two methods – open interest (OI) and trading volume (VOL). So, the put call ratio formula for the former method is:

PCR (OI) = Total Put Options Open Interest/Total Call Options Open Interest

Similarly, the put-call ratio based on the trading volume can be calculated as:

PCR (VOL) = Total Put Options Trading Volume/Total Call Options Trading Volume

The put call ratio indicator implies investors’ investment strategy. Also, investor activity defines the valuation of put and call options.

When investors expect the price of an underlying asset to fall, they prefer to buy more puts. Simultaneously, they purchase more calls as the underlying asset price is expected to rise. In simpler words, a higher ratio implies hedging, while a lower ratio indicates speculating.

#1 - PCR Interpretation In Terms of Ratio 

• PCR = 1 denotes a neutral market trend, with an equal amount of put and call options being purchased
• PCR = <1 means a bullish market trend, with most investors buying call options in the hopes of a price rise
• PCR = >1 denotes a bearish market trend, with most investors purchasing put options in the hopes of a price fall

#2 - PCR Interpretation In Terms of Investment Strategy

• Contrarian Investment

A group of traders sees the put-call ratio in the reverse perspective. It means that they expect a turnaround when the output is higher and consider it a bullish market indicator. Again, the lower ratio makes them conclude it is a bearish market indicator as they expect a pullback.

For instance, an analysis of key market metrics to understand whether a stock market crash is possible in 2021 as the dot-com crash in 2000 estimated that the put-call ratio for February 2021 (0.4) mimics March 2000 (0.39).

• Momentum Investment

It is the default investment strategy used to calculate the put-call option.

Let us look at the following S&P 500 Index to understand the concept better.

Source
In the above chart, as one can observe, the put-call ratio was above 1 before the steep decline in the index in March. The high PCR signaled a bearish sentiment, indicating that the investors were looking to purchase put options, possibly expecting a downside move. If individuals utilized a short-sell strategy around February 20, anticipating the significant downward movement, they could make significant financial gains.

If individuals wish to enhance their knowledge of this technical analysis indicator, they can consider looking at charts with the same indicator on the online platform of TradingView.

Let us look at the following examples to understand the concept better:

Example #1

Assume the Facebook stock price on NASDAQ is $250 in March 2021. Someone places a bet (buys a call option) on it growing to $280 (strike price) by April 2021. If the prediction comes true, they will earn a profit of $30.

On the flip side, someone places a bet (buys a put option) that the Facebook stock price will drop to $230 by April 2021. And if the price falls to $230 by the set expiry date, they will earn $20.

Example #2

Suppose open interest for put and call options at the S&P 500 Index with a strike price of 9,000 for March 2021 has 60,100 and 99,800 contracts, respectively. Then the PCR would be:

PCR = 60,100/99,900 = 0.60 (bullish market)

Example #3

Suppose trading volumes for put and call options at the S&P 500 Index with a strike price of 9,000 for March 2021 has 99,400 and 90,800 contracts, respectively. Then the PCR would be:

PCR = 99,400/90,800 = 1.09 (bearish market)

A put-call ratio divides put options by call options to indicate directional bets for a particular asset. Using the put call ratio indicator, investors consider buying securities when the output is low and vice-versa. It also helps traders understand the level of risk involved in securities trading. The put call ratio trading strategy in the options market can include:

#1 - Strike Price

Also known as per strike, the strike price is the best way to assess the PCR when trading illiquid assets. It is the price at which assets are sold (put option) and bought (call option). Since illiquid options tend to have lower trading volumes, retail traders use this measurement.

#2 - Trading Volume

Here, traders consider the strike price and expiry date for a given asset to get the trading volumes for put and call options. It is a helpful indicator for directional price movements in the broader perspective. Traders trade based on what most strike prices suggest (bearish or bullish).

#3 - Open Interest

Outstanding contracts or open interest give a clear picture of the market movement. When applied to PCR, it lets investors evaluate trading volume in the put and call options within a defined period. Increased open interest means that money is flowing in the market. A decline in it indicates that money is moving out of the market.

This has been a guide to Put-Call Ratio and its meaning. Here we discuss how it works, along with formulas, examples, and how to trade it. You can learn more from the following articles –

• Rho in Options
• Options Spread
• Bermuda Options