What is Put-Call Ratio and why it is important
The put-call ratio (PCR) is a tool often used by traders to understand and analyze the current mood or sentiment of the markets. Some traders also use this ratio as a leading indicator to predict the upcoming movements in the markets and take positions accordingly. Hence, this ratio acts both as a reflection of the current market sentiment, as well as a precursor to upcoming market directions. In the past, the movements in this ratio and analysis of its moving averages have allowed traders to spot major market reversals and movements.
How does the put-call ratio work?
As the name suggests, the ratio is a mathematical fraction which can be calculated and interpreted in two different ways. First, it can be computed by dividing the number of put options traded by the number of call options traded in a given period. This shows the trader the number of put options being traded for each call option over a period of time. Alternatively, the ratio can also be calculated based on the open interest (OI). The OI calculation involves dividing the OI in the put contracts by the OI in call contracts of the options expiring on the same day and having the same strike price. This shows the trader the number of outstanding put options for each outstanding call option in the market. Hence, depending on whether the volume or OI is being used to compute the put-call ratio, the interpretation of the ratio changes slightly.
The put-call ratio is taken to be a signal of future market movements. The ratio can be understood by recollecting that a trader buys put options when he thinks that the underlying asset’s value is going to decline. On the other hand, a trader buys call options if he thinks that the value of the underlying asset is about to rise. Taking the volume or OI of the call and put options individually might not be as insightful. This limitation is overcome by the put-call ratio.
In particular, if the ratio is above 1, it means that traders in the market have taken more bearish positions by either buying more put options or simply having more OI on put contracts compared to call options. As a result, traders can interpret this as a sign of upcoming weakness in the markets. Traders with this thought process might then proceed to take up bearish positions on their own in order to benefit from this knowledge. However, there are some contrarian traders as well who look at the low ratio and interpret this as a sign of unwarranted bearishness and consider this as a sign of the markets bottoming out. Similarly, a very low value of the ratio suggests that there are lower volumes of OI in put contracts compared to call contracts. Because the number of call contracts traded or outstanding in the market is higher, traders interpret this as a sign of more strength in the markets going forward. Based on this understanding, some traders can take up bullish positions of their own to benefit from the possible rally. Similar to the case of the low put-call ratio, contrarian traders might see the low value as a sign of unwarranted optimism and interpret this as a market top in the short term.
The ratio has also been used with Implied Volatility (IV) in order to predict market reversals. In general, a sudden uptick in the put-call ratio, along with a rise in the IV, indicates that the index is coming closer to a resistance level, and hence, traders can expect a fall in the market. On the contrary, if the market is in a correction phase during an uptrend and the ratio increases, traders can take this as a leading bullish signal.
Put call ratio formula with examples
The two alternate formulas are as follows:
PCR (volumes) = (Traded volume of put options)/(Traded volume of call options)
PCR (OI) = (Open Interest of put options)/(Open Interest of call options)
To better understand this ratio, let us look at an example. Assume that Trader A is using the put-call ratio to determine the future direction of the NIFTY 50 index. Based on his experience, Trader A considers the OI variant to be more appropriate for the index and hence, decides to compute this ratio for the options expiring on 18th Aug 2022 with a strike price of 17,700. In order to get the inputs for this ratio, the trader can access the OI on the option chain here.
Assume that for the call option expiring on 18th Aug 2022 with a strike price of 17,700:
Call option open interest (OI) is 1.24 lakhs
Put option OI is 35,000
Volume of call options traded during the day is 63,000
Volume of put option traded during the day is 20,000
In this case, the ratio can be computed as:
PCR (OI) = 35,000/1,24,000 =0.28
Since this ratio is much lower than 1, it shows that the number of outstanding put options of NIFTY 50 for the expiry of 18th Aug 2022 and a strike price of 17,700 is much lower relative to the number of outstanding call options. Based on this analysis, Trader A has 2 options:
He can either take the low of the PCR indicator to indicate that because more call options are outstanding in the market compared to the number of put options, other trading members have a bullish sentiment until the next expiry. With this understanding, Trader A might take a bullish position in the index.
the contrary, Trader A can also interpret the low value to be a sign of unwarranted optimism in the markets. As a result of this, he might be inclined to take up a short position in the market.
In the above example, if Trader A was interested in computing the ratio for the volume, it could have been done using the following PCR formula:
PCR (Volume) = 20,000/63,000 =0.32
Why is PCR ratio important?
The ratio is an important indicator for several reasons:
- It is easy to compute and simple enough to be interpreted by new traders.
- It is often considered to be an important leading indicator of the market and has proved to be effective in predicting some major market movements in the past. For example, the ratio dropped to extremely low levels right before the historic market decline in March 2000 and increased again right before the market bottomed in September 2001.
Being a quantitative indicator, it is an objective measure, unlike other indicators.
What is the put-call ratio?
PCR is the ratio of the volume/open interest of put options and the volume/open interest of the call option with the same expiry and strike price.
How can PCR be interpreted?
A small value of the PCR indicates that a smaller number of put options are being traded/are outstanding in the markets compared to call options for the same strike and expiry. This can be interpreted as:
- Signal of upcoming bullishness in the market.
- Signal of unwarranted optimism, and hence, possible short-term bearishness.
Traders usually use the PCR as a tool to validate their hunch about the general direction of the market in the coming period.
Similarly, a high PCR can be interpreted as a sign of bearishness ahead or as a signal of too much pessimism in the market, which could signal a short-term decline.
Is PCR (OI) better than PCR (Volume)?
No, both these ratios are accurate for use, depending on the trader’s preference and context.
What are some other tools which can be used with PCR?
PCR can be used with Implied Volatility (IV) to predict market reversals better. By itself, the moving averages of the PCR can also be used as important leading indicators of the market.
Does PCR work better as a contrarian indicator?
While the indicator is open to be interpreted by traders depending on what their analysis of other indicators suggests, it has been shown that moving averages of PCR can act as contrarian indicators.