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What is Put Call Ratio And How to Use it

08 Aug 2022 0 COMMENT

Options are derivative instruments, which means that their value is derived from some underlying asset, like stocks, bonds, or currencies to name a few. Typically, options are used for speculation or as risk-hedging tools by market participants. But options can also be put to an alternative use, like that of predicting the market movement.

The Put-Call Ratio, or the PCR, which is a metric widely deployed by investors to assess the sentiment which is driving the market and is used to predict whether the current trajectory is heading towards a bull-run or a bear-run.

Let’s first go through a quick recap around the basics of options before getting into the details of the Put-Call Ratio.

Options basics revisited

An option is a contract that offers the option-buyer a right, but not an obligation to buy or sell the underlying asset. One can either buy or sell the asset at a predetermined price known as the strike price on a predetermined date which is known as the expiry date, after which the option will no longer be valid.

There exist two basic kinds of options, a Call option, and a Put option.

A Call option buyer gets the right to buy the underlying security in the future at a strike price and at a prefixed date while a Put option buyer gets the right to sell the underlying security in the future at a strike price and at a prefixed date.

The Put-Call Ratio

As the name suggests, the Put-Call Ratio or PCR is a measurement of the volume of Puts relative to the volume of Calls within a specific time-period calculated with the objective of determining market sentiment and predicting future price action. A high Put-Call Ratio indicates a prevailing bearish outlook in the markets and a relatively lower Put-Call Ratio implies a bullish outlook.

The Put-Call Ratio can be calculated using 2 formulae:

  • PCR = Put Volume / Call Volume, where Put volume and Call volume are the number of Put and Call options traded over a specific day.
  • PCR = Total Put Open Interest / Total Call Open Interest, where the numerator and denominator are the Put Open Interest and Call Open Interest on a specific day.

As an example, if for a particular security on a particular day, the number of Puts traded is 1278 and the number of Calls traded is 1903, then the Put-Call Ratio for the security is 1278/1903, which is 0.671.

Generally speaking, a PCR value below 1 is indicative of the fact that more Call options are being purchased relative to the Put options which signals that investors are anticipating a bullish outlook for the markets ahead.

Similarly, a PCR value above 1 indicates that more Put options are being purchased relative to the Call options which signals that investors are anticipating a bearish outlook for the markets ahead.

A PCR value equal to or close to 1 implies the number of purchased Call options and Put options to be roughly the same and is indicative of there being a neutral trend in the markets.

Typically, a PCR value below 0.7 and approaching 0.5 is indicative of a strong bullish sentiment in the markets as more Calls are being bought as compared to the Puts. While on the other hand, a PCR value above 1.0 is considered to portray a strong bearish sentiment in the markets, characterised by more Put options being bought as compared to Call options. Such PCR values usually imply that investors are speculating that the markets will decline or that participants are trying to hedge their portfolios to reduce potential losses in the event of a mass sell-off.

Trends in the Put-Call Ratio and their interpretations

If one were to carry out the trend analysis of the values of the Put-Call Ratio from the perspective of option sellers, the following observations can be noted:

  • If one observes the Put-Call Ratio to be decreasing in value during a down-trending market, then it usually signifies a bearish outlook, characterised by option writers engaging in aggressive selling of the Call option strikes.
  • If one observes the Put-Call Ratio to be increasing while minor dips are being bought simultaneously in an up-trending market, then it may possibly signify a bullish outlook, characterized by Put-option writers engaging in aggressive writing during the above-mentioned minor market dips with the expectation that the uptrend will continue.
  • If one observes the Put-Call Ratio to be decreasing in value while the markets are touching resistance levels, then it may signify a bearish outlook, characterized by Call-option writers attempting to build new positions with the expectations of a relatively limited upside or a market correction.

Due to such wide-ranging interpretations which can be derived by carrying out an analysis of the Put-Call Ratios of the securities in varying market outlooks, it is considered to be a useful tool in helping traders frame decisions around the price movement of their concerned underlying security/securities and assisting them in placing directional bets on those securities.

It is important for one to give due consideration to the demands of both, the Put options and the Call options in the market, which are given by the numerator and the denominator of the formula for the Put-Call Ratio, respectively.

Since the number of Call options traded is represented by the denominator of the formula, it means that if the number of Calls traded were to reduce, then the value of the Put-Call Ratio will increase. The implication of this relationship is that buying a fewer number of Calls may possibly increase the value of the ratio without an increase in the number of Puts being bought, which means that one doesn’t necessarily need to observe Put-options being bought in large quantities for the value of the Put-Call Ratio to increase.

Put-Call Ratio as a contrarian indicator

It should also be noted that the Put-Call Ratio is interpreted differently on the basis of an investor’s investment methodology. The Put-Call Ratio is also considered to be a contrarian indicator, which is a characteristic of contrarian investing. Contrarian investing is defined as a strategy which focuses on going against the prevailing market sentiment.

It is usually beneficial to assess the Put-Call Ratio during major events like earnings calls to see how the market observes the future-outlook. When the ratio touches extreme levels, it is usually indicative of the fact that the market is currently characterised by overly bullish or overly bearish sentiment.

Trends in the Put-Call Ratio and their contrarian interpretations

One must be familiar with what Implied Volatility is to better understand how the Put-Call Ratio also functions as a contrarian indicator. Implied Volatility is a likely movement in the price of the security as forecasted by the market, and is a measure of estimating any fluctuations (volatility) in the price of the security in the future, on the basis of some predictive factors. Generally speaking, implied volatility tends to increase in bearish markets and decrease in bullish market. The important take-away here is that options with higher-levels of implied volatility are usually priced at higher premiums and vice-versa.

Following are some contrarian signals indicated by the Put-Call Ratio:

  • If one observes the value of the Put-Call Ratio to be increasing during a correction in an up-trending market along with a decrease in the Implied Volatility, then it is potentially a bullish indication characterized by Put-option writers aggressively writing during market-dips.
  • If one observes the value of the Put-Call Ratio to be increasing accompanied by a rather sharp increase in the Implied Volatility while the Nifty Spot is nearing its resistance levels, then it is an indication of a potentially bearish outlook.

To summarise the utility of the Put-Call Ratio as a contrarian indicator, an extremely high Put-Call Ratio suggests that the market is extremely bearish, which to a contrarian is a bullish signal implying that the market is in the oversold zone and up for a turnaround, which may be a good buying opportunity.

Similarly, extremely low values of the Put-Call Ratio would imply the exact opposite and indicate to the contrarian that the market is in the overbought zone and too bullish, thereby implying that the market is due for a sell-off and it may be a good selling opportunity.

Conclusion

All in all, the Put-Call ratio shouldn’t be the only metric one uses while making trading decisions, as it is highly unlikely for any single ratio to independently predict whether the market is at its top or at its bottom. Instead of using the PCR in isolation, it should be used in combination with other market indicators while making buy/sell/hold decisions.

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