Investors use several financial measures to gauge the market temperament before parking their money into the same. Put-call ratio is one of such financial tools which prove useful for investors in more than one way. To understand the application and role of this financial measurement one needs to be well-versed with its basics.
In this article
What is a Put-Call Ratio?
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.
It is calculated in these two 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.
PCR (OI) = Put open interest/ Call open interest
- Based on volume of options trading
Here PCR is computed by dividing the put trading volume by the call trading volume on a specific day.
PCR (Volume) = Put trading volume/Call trading volume
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 example below 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 –
|Type of option||Number initiated|
PCR = Total put open interest/ Total call open interest
Since the outcome is less than 1, it indicates that investors are buying more call options when compared to put options. It further symbolises that investors are forecasting a bullish trend in 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 put volume has exceeded the call volume. It indicates an increase in the bearish sentiment.
- A PCR below 1 indicates that 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 the market sentiment. It is because more traders tend to buy call options than put options. Resultantly, an average PCR of .7 for equity options is deemed to be suitable for assessing the market sentiment.
That being said, a PCR over .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 .7 and approximately .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 to understand the direction of the price movement of underlying securities. In turn, it enables them to organise 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 analysing the overall trading behaviour 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 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.