Market participants use several financial measures to understand market sentiment before taking a position. Put Call Ratio is one such financial tool. This metric helps investors gauge whether the market is leaning toward a bullish (rising) or bearish (falling) sentiment.
Let’s break it down in simple terms so you can grasp how it works and how you can use it in your own trading.
What are Put and Call Options?
Before we dive into the Put Call Ratio, it’s important to understand what put and call options are. These are financial tools used by traders to bet on or hedge against changes in asset prices.
- Put Options: A put option gives the buyer the right (but not the obligation) to sell an underlying asset (like a stock) at a set price within a certain time frame or at expiry. Traders buy puts when they believe the price of an asset will fall.
- Call Options: A call option gives the buyer the right (but not the obligation) to buy an underlying asset at a set price within a specific time frame or at expiry. Traders buy calls when they expect the price of the asset to rise.
What is the Put Call Ratio (PCR)?
The Put Call Ratio (PCR) is a number that compares the volume or open interest of put options to call options.
In simple terms, it shows whether more traders are betting on the market going up (with call options) or down (with put options).
- Put Volume PCR: This is calculated by dividing the total number of put options traded by the total number of call options traded. It shows how many puts are being traded compared to calls.
- Open Interest PCR: This version looks at the number of put options that are still open (not yet settled) compared to the number of call options that are still open. It helps indicate long-term sentiment rather than just daily trading activity.
Why to calculate Put Call Ratio (PCR)?
Put Call ratio indicates the mood of the market.
PCR helps us to identify bullishness and bearishness of the market.
For example if you calculate Nifty put call ratio for today, then it will tell you the mood of the nifty option contract for today.
Similarly, you can calculate put call ratio for Bank nifty, Fin nifty, Sensex, Bankex and others.
Example Calculation
Let’s say we have the following data:
- Total Put Volume: 20,684,932
- Total Call Volume: 22,357,500
- Total Put Open Interest: 1,450,797
- Total Call Open Interest: 2,112,999
To calculate the PCR:
- Volume PCR = 20,684,932 / 22,357,500 = 0.93
- OI PCR = 1,450,797 / 2,112,999 = 0.69
Both ratios are below 1, which suggests that there’s more optimism in the market (bullish sentiment).
How to Interpret the PCR
The Put Call Ratio tells us a lot about market sentiment. Here’s how to interpret the number:
- PCR > 1: A ratio greater than one means that more people are buying put options than call options. This usually signals a bearish sentiment, meaning traders expect the market to go down.
- PCR < 1: A ratio less than one means more people are buying call options than put options. This indicates bullish sentiment, where traders expect the market to rise.
When PCR is 1, it indicates that the same number of calls and puts are being written.
PCR greater than 1 indicates more Puts are sold than calls. If the PCR value is less than 1, then more calls are sold than puts.
When PCR is more than 1, it means market participants are selling more put options than call options, which indicate bullish sentiment in the market. An extremely higher number above 1 indicates that the market is overbought and it may reverse.
If put call ratio (PCR) is below 1, then it indicates bearish sentiment, which means market participants are selling more calls than puts. Extremely low numbers below 1 indicates that the market might be oversold.
If the PCR value is around 1 i.e 0.8 or 0.9, then the market might be neutral.
Standard vs. Contrarian Interpretation of PCR
While most traders follow the standard interpretation of the Put Call Ratio, some prefer a contrarian approach, which looks for extreme values to signal potential market reversals. Let’s explore both:
Standard Approach
- Bullish Signal: When the PCR is less than 1, it suggests bullish market sentiment, as more traders are buying calls, expecting prices to rise.
- Bearish Signal: When the PCR is greater than 1, it indicates bearish sentiment, where more traders are buying puts, expecting the market to fall.
Contrarian Approach
Some traders believe that extreme PCR values could signal that the market is either overbought or oversold. Here’s what this means:
- Buy Signal: If the PCR rises to an extreme level (e.g., 1.5), it could mean that the market has become too pessimistic (over-sold), and a reversal or price increase might be coming.
- Sell Signal: If the PCR falls to an extreme level (e.g., 0.50), it could signal that the market is too optimistic (over-bought), suggesting a possible price decline.
Calculating put call ratio (PCR) by using volume
PCR can also be calculated by using volume. Total traded volume of puts divided by total traded volume of calls will give put call ratio (PCR) based on volume.
Volume PCR = Total put volume / total call volume
If volume PCR is greater than 1, then it indicates bearish sentiment as more put options are bought than calls.
When Put Call Ratio (PCR) is less than 1, then it indicates bullish sentiment as more call options are bought than put.
If volume PCR is around 1, then the market most probably is neutral.
Many use open interest PCR instead of volume PCR as it gives more accurate predictions on the assumption that sellers or writers are well informed about the market conditions and accordingly they establish their position in the market.
Open interest (OI), Put traded volume and Call traded volume can be obtained from the option chain maintained by stock exchanges such as NSE and BSE.
Other Perspectives on PCR
Another way some traders interpret the Put Call Ratio is through the lens of option selling rather than buying. Large institutions, like hedge funds, often write (sell) options instead of buying them. Here’s how option writing can influence the PCR:
- Increasing PCR: When the PCR increases, it could indicate that institutions are writing more put options. This might suggest a bullish outlook, as institutions are hedging against long positions in the market.
- Decreasing PCR: A decreasing PCR could indicate more call options are being written, suggesting a bearish sentiment as traders hedge against market declines.
Why the Put Call Ratio Matters
The Put Call Ratio is an important tool because it can give traders a quick snapshot of market sentiment. However, it’s not a perfect indicator on its own and should be used alongside other tools, like price charts or moving averages.
When used properly, the PCR can help you make better-informed decisions, whether you’re trading stocks, options, or other financial instruments. It can also help you spot potential reversals in the market, giving you a competitive edge.
Here are two major limitations of PCR;
- All stocks listed in exchange do not have option contracts. Therefore it can only be used where related futures and option products are available for trading.
- Put Call Ratio (PCR) does not predict market sentiment accurately. It’s just an indicator. Market participants consider other indicators in addition to PCR before taking a decision.
Key Takeaways
- The Put Call Ratio compares the number of put options to call options traded or held open in the market.
- A PCR greater than 1 suggests a bearish market, while a PCR less than 1 indicates a bullish market.
- Extreme PCR values can signal market reversals, with high PCR suggesting oversold conditions (potential buy signal) and low PCR indicating overbought conditions (potential sell signal).
- Always use the PCR in combination with other indicators for a more complete view of market sentiment.
By understanding how to use the Put Call Ratio, you can enhance your trading strategies and make more informed decisions in fluctuating markets.
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