Put Call Ratio

Investors use several financial measures to gauge the market temperament before parking their money into the same. Put call ratio is one such financial tool which proves useful for investors in more than one way.

To understand the application and role of this financial measurement one needs to be well-versed in its basics. Here, we have elucidated the nitty-gritty of the same, including the put call ratio formula and other facts. 

Put Call Ratio Meaning

Typically, a put-call ratio is a derivative indicator. It is designed to enable traders to determine the sentiment of the options market effectively. This ratio is computed either by factoring in the open interest for a given period or based on the volume of options trading. 

Also known as PCR, this particular ratio serves as a contrarian indicator and is mostly concerned with options build-up. Such an indicator helps determine the extent of bullish or bearish influence in the market.

In other words, it helps traders to understand whether a recent increase or decrease in the market is excessive or not. 

Based on this information, traders decide if they should opt for a contrarian call in the prevailing market.

Such an investment strategy is based on the practice of purchasing or selling investment units against the prevailing market conditions, to combat mispricing in the securities market.

How is Put Call Ratio Calculated?

Before learning about the put call ratio formula, it is crucial to understand the components of this ratio individually.

For instance, the put option provides traders with the right to purchase assets at prefixed prices, whereas, the call option offers the right to purchase assets at the current market prices. 

Put call ratio calculation can be done in the following ways -

• Based on Open Interests of a Specific Day

PCR is computed by dividing open interest in a put contract on a particular day by open call interest on the very same day.

• Based on the Volume of Options Trading

Here PCR is computed by dividing the put trading volume by the call trading volume on a specific day.

Here, Put volume indicates the total put options initiated over a specific time-frame. Conversely, Call volume indicates the total call options initiated over a specific time-frame. 

Notably, the interpretation of this said ratio differs as per the type of investor. 

Example of Put Call Ratio

Take a look at this put call ratio example to understand the put-call ratio calculation better.

Mr. Kumar, an investor, plans on using the put-call ratio to measure the market sentiment of a particular security. The puts and calls initiated are as follows -

PCR = Total put open interest/ Total call open interest

= 1300/1700

= 0.7647

Since the outcome is less than 1, it indicates that investors are buying more call options when compared to put options. It further symbolizes that investors are forecasting a bullish trend in the future.

Analysis of Put-Call Ratio

It must be noted that the put options prove useful for hedging market weaknesses or helping traders to take chances on the market decline.

On the other hand, call options are used extensively to hedge against the strong suit of the market or simply to bet on its advances. 

As per put-call ratio analysis -

• A PCR above 1 indicates that the put volume has exceeded the call volume. It indicates an increase in the bearish sentiment.
  
  
• A PCR below 1 indicates that the call volume exceeds the put volume. It signifies a bullish market ahead. 

Nonetheless, it must be noted that a PCR of 1 is not a reliable point to measure market sentiment. It is because more traders tend to buy call options than put options. Resultantly, an average PCR of 0.7 for equity options is deemed to be suitable for assessing the market sentiment.

That being said, a PCR over 0.7 or 1 signifies that more traders are purchasing put options when compared to call options. With the build-up of bearish sentiment, more investors either hedge their portfolios in case of sell-offs or speculate a falling market. Conversely, a falling put-call ratio below 0.7 and approximately 0.5 signifies bullish tendencies. 

Significance of Put Call Ratio

These pointers below highlight the importance of PCR in brief -

• It serves as an efficient tool that helps to determine the market sentiment prevailing at a given time.
  
  
• PCR aids traders in understanding the direction of the price movement of underlying securities. In turn, it enables them to organize directional bets on orders.
  
  
• It is essentially a contrarian indicator; as a result, it helps traders to escape the herd mentality when it comes to investing in a given market.
  
  
• This said ratio proves useful in analyzing the overall trading behavior of the market participants.  

Regardless, this derivative indicator has its share of drawbacks as well. Investors must find out about them in detail if they wish to combat the misgivings of market sentiments effectively. 

Limitations of Put Call Ratio

Probably, one of the biggest flaws of PCR is that it does not always represent the crucial nuances of market sentiments.

Other limitations of this ratio include-

• Many company stocks do not make options available. This makes it impossible to compute the PCR for most stocks.
  
  
• Even though it is a contrarian indicator, investors must weigh in other prominent factors before betting on the prevailing market sentiments.
  
  
• To arrive at effective outcomes, one must use PCR in addition to other potent indicators. 
  
  
• Investors must know how to read the put-call ratio chart correctly; as even a small shift serves as an essential indicator of the plausible market movement.

Nonetheless, to make the most of this derivative indicator, investors should be aware of where to find the PCR ratio of a particular stock and use it to make an informed decision.

Other than these, investors must factor in their risk-taking capability and financial goal before they decide to tread market sentiments against security.

PCR - The Contrarian Indicator

Traders generally use the Put Call Ratio (PCR) as a contrarian indicator when the values touch extremely high levels.

What this implies is, traders might consider a high Put Call ratio of say 1.4 as a great opportunity for buying because they believe that the market sentiment is extremely bearish and will soon adjust, when those having short positions switch places to cover and the market will eventually face a downturn.

However, there is no specific number that indicates that the market has created a bottom or a top, but traders generally anticipate this by looking for jumps in the ratio or for when the ratio reaches outside of the normal trading range levels.

Generally, NIFTY Put call ratio follows a trend in which it seems to oscillate between 0.8 and 1.3 with 0.8 being the lower band and 1.3 being the upper band.