What is Put Call Ratio and How to Calculate It?
The Put Call Ratio or PCR assists stock traders in gauging the market sentiment and using it as a hedge to make trades with a better risk-to-reward ratio. The put call ratio is one of the most popular indicators used by traders and investors. It is highly instrumental in assessing the market mood and identifying trend reversal points before they become apparent to traders.
This article explores the meaning of put call ratio, and discusses how to calculate and use it in trading.
What is a Put Call Ratio?
Put call ratio or PCR ratio is an indicator commonly used to analyse the overall mood of the market. This indicator helps traders and investors determine if the current market trends are bearish or bullish. This also helps in determining the right time to place a contrarian call and hedge against the trend. While put options help traders hedge against market weakness, call options could help them hedge against market advances.
Investors can forecast current market sentiments by knowing the put call ratio. A high put call ratio indicates a bearish attitude, whereas a low PCR indicates a bullish sentiment. Call options are typically purchased when there is a bullish market trend. Whereas in pessimistic market sentiment, put options are purchased.
There are two ways of calculating the put call ratio. Read on to know how.
How to Calculate Put Call Ratio (PCR)?
You can calculate the put-call ratio using the simple formula mentioned below.:
Put Call Ratio = Traded Put Volume / Traded Call Volume
Where:
- Put Volume is the number of put options exercised during a specified period; and
- Call volume is the number of call options launched during the same period.
Another put call ratio formula is as illustrated below:
Put Call Ratio = Put Open Interest / Call Open Interest
Where:
- Total Put Open Interest represents the total number of outstanding puts.
- Total Call Open Interest represents the total number of outstanding calls.
Also Read: What is Sharpe Ratio and What is Its Significance?
Example of Calculating Put Call Ratio
Calculating PCR volume is quite simple and can be understood by the following example:
Assume that the Nifty 50 strike put volume is 85,000 contracts and, the call volume in the same contract for the same expiry is 1,28,000 contracts. So put call ratio according to the formula:
Put Call Ratio = Traded Put Volume / Traded Call Volume
PCR (Volume) = 85,000 / 128,000 = 0.66
By applying the simple formula, you can also calculate PCR or open interest:
Put Call Ratio = Open Interest of Puts / Open Interest of Calls
Assume that the open interest in puts at the Nifty50 strike is 38,00,000 contracts, and the open interest in calls at the same strike and expiry is 49,00,000 contracts.
So, PCR (OI) = 38,00,000 / 49,00,000 = 0.78
What is Put Call Ratio in Options Trading?
Options are a derivative investment instrument where traders can buy or sell an underlying asset at a specified price within a specified time.
Calls and puts are the two forms of options available for traders. Options grant the holder the right, but not the responsibility, to purchase the underlying security at the strike price on or before the option’s expiration date. If more put contracts are being bought compared to call options, there may be a bearish sentiment in the market. On the contrary, if more call options are being bought compared to put options, it may indicate a bullish sentiment in the market.
A Put Call Ratio at its highest would indicate excessive bearishness because the put volume would be much greater than the call volume. This would mean that traders are bearish on the market and there may be a market slump coming soon. However, excessive bearishness comes with the probability of a positive reversal and serves as a great buying opportunity for traders and investors.
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How to Trade Using Put Call Ratio?
One of the most crucial points to remember is that the PCR ratio is commonly used as a contrarian indicator to determine bullish or bearish market sentiments. That is, the conclusions are contradictory. When there are too many bearish traders, contrarians become bullish and vice versa. Here is what you can do with PCR data in analysing the mood of the market and trade using the put-call ratio:
- If the put call ratio is more than 1, it indicates that more puts are being purchased in the market than calls. This usually indicates that the market may have a bearish mood. An exceptionally high PCR ratio above 1 usually signals that the market is overvalued. At that moment, there may be speculation about sell-offs in the market, which can lead to a dip in the stock market.
- An average PCR ratio of 0.7 is taken into account for gauging the market sentiment. If the call and put ratio is less than 1, it indicates that the market is buying more calls than puts. This indicates a bullish sentiment in the market. A very low PCR under 0.7 usually signals that the market is underbought and may witness an upsurge.
Advantages of Put Call Ratio
The PCR ratio can be beneficial for traders and investors in many ways. A few of the benefits are mentioned below:
- PCR ratio is an efficient indicator that can help to analyse market sentiment prevailing at a certain time.
- It can help in analysing the direction of the price movement of the securities aiding directional bets.
- It is a contrarian indicator that could help the trader escape herd mentality.
- It is useful in analysing the overall trading behaviour of the market participants.
- The put call ratio is of immense importance to technical analysts since it helps identify probable trend reversal points before they become obvious in market prices.
- The put call ratio is an excellent method that can apply to technical and fundamental analysis.
Disadvantages of Put-call Ratio
For traders who mainly rely on technical analysis of the market sentiments, the call and put ratio may have certain limitations too:
- While the indicator provides an objective perspective of the prevalent trade volumes in options markets, its trading signals are for the current period and are short term.
- They may overlook specific investment trends that would utilise other investing analysis types.
- All companies do not have their options contracts being traded in the market. Thus, PCR cannot be analysed or compared for such stocks.
For these reasons, it is generally a good idea to include additional indicators to analyse the market in your research to provide a more comprehensive picture of the market sentiment before investing.
Points to Know About Put Call Ratio
The PCR ratio is a contrarian indicator and has immense importance for traders and investors. Here are a few points to know about put call ratio:
- A put option gives a trader the right to sell an asset at a determined price.
- A call option is the right to purchase an asset at a predetermined price.
- A bearish market is indicated by traders buying more puts than calls.
- If more call options are being bought than put, it indicates a bullish market.
- When the put-call ratio nears 1 or crosses 1, it may mean that the market is overvalued and a correction might be in sight. A low put and call ratio would indicate bullishness which can mean the market is in the underbought zone and may see an increase in its levels.
Also Read: What is Alpha and Beta in Mutual Funds?
Final Word
Put call ratio is a contrarian indicator that helps traders analyse current market patterns and the potential market sentiment. This allows traders to hedge against the market sentiment and trade in underlying assets that can yield significant returns.
FAQs
Ans. When you purchase an options contract, you are given the right to buy or sell an underlying asset at a specified price on or before a specified date – however, you are not obligated to make the trade. A call option entitles the holder to purchase a stock, whereas a put option entitles the holder to sell a stock.
Ans. PCR offers advantages, but it also has its limits. PCR can be beneficial in detecting broad patterns. Combining the put call ratio with the implied volatility yields the best interpretation and also the most effective strategy.
Ans. The put call ratio is a derivative indicator that examines option build-up to help traders determine whether a recent increase or fall in the markets is excessive and if the time is right to make a contrarian call.
Ans. A put call ratio of less than 1 indicates that traders prefer to trade call options over put options. This signifies that the market is bullish.
Ans. A put call ratio greater than 1 indicates that the market has traded more puts. This could imply a pessimistic market sentiment. Because traders anticipate a market decline, they are trading put options more than call options.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
