The put-call ratio (PCR) is a widely used measurement tool by investors which serves the purpose of gauging the market’s overall mood. A “put” or put option means the right to sell an asset at a price that has been predetermined. A “call” or call option means the right to buy an asset at a price that has been predetermined. A rising bearish sentiment in the market usually means that traders are buying more puts than calls. The opposite scenario i.e. traders buying more calls than puts means that the market is expected to turn bullish soon. In this post, we will discuss the basics of the Put-Call Ratio (PCR) and provide you with some basic information on it. Let’s get started.
Put-Call Ratio (PCR): What is it?
Understanding the Put-Call Ratio
The put-call ratio (PCR) can be calculated by simply dividing the number of traded put options by the number of traded call options.
When you have a put-call ratio (PCR) of 1, it means that there are the same numbers of buyers for puts as there are for calls. While it does sound straightforward and simple, you must remember that a ratio of 1 is not the most accurate starting point for measuring a market’s sentiment. The reason behind that is that fact that there are usually more investors buying calls than buying puts. A good basis for evaluating market sentiment is generally a put-call ratio of .7 for equities.
Key points to remember:
- When the put-call ratio (PCR) is rising, or is greater than .7 or exceeds 1, it indicates that the equity traders are buying more puts than calls. It suggests that bearish sentiment is building in the market. Investors are either speculating that the market will move lower or are hedging their portfolios in case there is a sell-off.
- When the put-call ratio (PCR) is falling or below .7 and approaching .5, it indicates that the traders are buying more calls than puts. It indicates that the market is going to be bullish.
You can access the data used to calculate put-call ratios through various sources. However, the preferred source for most traders is the information available on the Chicago Board Options Exchange (CBOE) website.
Special Considerations About Put-Call Ratio (PCR)
The put-call ratio (PCR) is a great tool for investors to gauge the market sentiment before it turns. However, it’s important to look at the demand for both the numerator (the puts) and the denominator (the calls). Utilizing simple mathematical rules, we can deduce that a reduction in the number of call options will lead to an increase in the put-call ratio (PCR). This is extremely significant because fewer calls being bought can push the ratio higher without an increased number of puts being purchased. So, the put-call ratio’s rise isn’t necessarily dependent on just a surge in the number of puts being purchased in the market.
The result of bullish traders sitting on the sideline is an increase in the number of bearish traders in the market. That doesn’t necessarily imply a bearish market but it means that the bullish traders are in a wait-and-see mode until an upcoming event occurs like an election, a Fed meeting, or a release of economic data. They will probably make their investment decisions after those events come to pass.
Following the put-call ratio (PCR) is great to figure out how the market has responded to recent events or earnings. Extreme levels of put-call ratio (PCR) generally indicate an overly bearish or an overly bullish sentiment. Because of this, a small but significant number of investors tend to use the put-call ratio (PCR) as a contrarian indicator.
Using the put-call ratio (PCR) as a contrarian indicator
Contrarian investors use the put-call ratio (PCR) to help them figure out when the participants of the market get overly bullish or bearish.
As discussed earlier, a high put-call ratio points towards an extremely bearish market. However, a contrarian investor will see the bearish signal as a sign of an unduly bearish market due for a turnaround. A contrarian investor might choose to buy when the put-call ratio (PCR) is high.
We also discussed early on, a low put-call ratio points towards an extremely bullish market. A contrarian investor will infer that the market is extremely bullish and due for a pullback.
You must remember, there is no single ratio that definitively indicates whether the market is at its top or its bottom. Even when it comes to put-call ratio (PCR) levels that are considered extreme, nothing is permanent and it can vary considerably over time.
Usually, investors tend to compare current ratio levels with the average over some period of time. This is done in order to gauge if sentiment has changed recently. If the put-call ratio has fluctuated in a tight range and suddenly bumps higher, seasoned traders might infer that as a sudden increase in bearish sentiment and choose their next moves accordingly.
So that was our brief coverage of the put-call ratio (PCR). Hopefully, you have a basic understanding of it now and you will be one step closer to using it to make the correct investment decisions in the stock market.