What is a Put-Call Ratio?

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 interestOpen InterestOpen interest refers to the total outstanding or open contracts in a derivative market at any time. The quantitative value shows the total number of contracts that have yet to be liquidated in the market. It is frequently observed in conjunction with data from the futures and options markets.read more and trading volume.

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Key Takeaways

  • The put-call ratio (PCR) is an efficient financial measure to understand the financial market trend at a given time.A put option is about selling a security at a pre-specified (strike) price, and a call option is the right to purchase an asset at a prefixed price.PCR is the proportion of the open interest or trading volume of the put option and the call option over a particular time.A PCR above one indicates traders buying more put options (bearish sentiment), below one indicates traders purchasing more call options (bullish sentiment), and at 1 indicates a neutral market.

Put-Call Ratio Explained

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

Interpreting Put-Call Ratio

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 purchasedPCR = <1 means a bullish market trend, with most investors buying call options in the hopes of a price risePCR = >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 pullbackPullbackA pullback occurs when the price of a stock or commodity pauses or goes against a prevailing trend in the stock market. It is a temporary dip in a generally upward trending asset price. Unlike ‘reversal,’ which are more permanent price drops, a pullback remains only for a short while.read more.

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.

Examples of Put-Call Ratio

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)

How To Trade Using Put-Call Ratio?

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 priceStrike PriceExercise price or strike price refers to the price at which the underlying stock is purchased or sold by the persons trading in the options of calls & puts available in the derivative trading. Thus, the exercise price is a term used in the derivative market.read more 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 –

Investors and traders use the put-call ratio (PCR) to determine whether the market is about to turn bearish or bullish. Put and call options allow existing or potential holders of derivative instruments to sell and buy underlying assets at predetermined prices within a preset time frame. The put-call ratio also reflects the mood of the financial markets. The proportion is calculated using two methods: open interest and trading volume.

The put-call ratio is the proportion of the open interest or trading volumes of the put option and the call option over a given period. A ratio of more than one shows hedging emotion, smaller than one implies speculative sentiment, and equal to one denotes a neutral market.

In general, the put call ratio shows as an investor’s investment strategy. The valuation of put and call options reflects investor activity. The two common strategies are Contrarian – where traders expect a turnaround when the ratio is higher (a bullish market indication) and a retreat when the proportion is lower (a bearish market indicator). Momentum is another default strategy to measure the put-call option.

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