All You Need To Know About Put-Call Ratio

by Vinaya HS on January 15, 2018

in Finance

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The put-call ratio is a famous and much-talked-about tool. It helps the individual investors to determine the market sentiment.

What is put-call ratio?

As the name says, this ratio is calculated by dividing the number of traded put options by the number of traded call options. Generally, the Put-Call Ratio is calculated on the basis of the trading volume, but sometimes it is also calculated using the OI or open interest volume or total dollar value. One can calculate weekly or monthly values and moving averages to smoothen the short term daily figures.

Interpreting the put call ratio

You can never get the average value for the put-call ratio as 1 because the equity options traders and investors mostly purchase more calls as compared to the puts option. Most of the time, the average put call ratio is less than 1. It is usually around 0.7 for stock options.

When you see that the ratio is nearing 1 or is greater than 1, it indicates a bearish sentiment of the market. When the put-call ratio rises, it indicates that the investors are preferring to put their money in the put options and not in the call options. This also means that the investors believe that the market is moving lower or they are beginning to hedge their portfolios in the sell-off case.

So, a higher than average number means more puts are bought by the investors as compared to the calls. This way, the traders are betting against the underlying. When the ratio is near 0.5 or lesser than 0.5, it means a bullish sentiment.

The fund managers also use a popular strategy in which they purchase the index put options to protect their portfolios. As a consequence, the put call ratio for index options is higher than that for equity options. Hence, equity put call ratio is more used as a better signal of the market sentiment and the sentiment of the speculative crowd.

A higher ratio means that the investors are going towards the instruments that gain when the prices decline. The call is the denominator in the put call ratio, a decrease in the number of calls will lead to the increase in the value of the ratio. This again means that the stock market is signally towards the start to reduce its bullish sentiment.

To the contrarian investor, the put call ratio helps to decide when the investors are going either too bullish or too bearish. As we have discussed above, a high put call ratio means a bullish signal as it indicates over-bearish crowd and vice versa. The traders use this put-call ratio as a contrarian indicator when the values go to the extreme levels. Many traders will find a large ratio as an indicator of buying opportunity because the market is bearish and soon it will re-bounce. The traders foresee this by witnessing extremes of the ratio.

Check out live put call ratio values on BloombergQuint.

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