Traders and analysts use various ratios and indicators to understand the market volatility and the price trend. This helps them in ascertaining and understanding the direction of the price trend and possible reversals for the same. The Put-Call ratio is one such common indicator often used for this purpose. Given here is the meaning of this ratio and other related details of the same.
What is the meaning of Put-Call Ratio?
The Put-Call Ratio also known as PCR is a financial ratio used to assess the market sentiment for a specific stock or security or index. PCR is the ratio of outstanding put options to outstanding call options. A put option provides the holder with the right to sell a stock at a predetermined price, while a call option gives the holder the right to buy a stock at a predetermined price.
A high PCR indicates that investors are more bearish or negative on the market outlook, as they are purchasing more put options to protect themselves from potential losses. On the other hand, a low PCR suggests that investors are more bullish or positive on the market outlook, as they are purchasing more call options to benefit from potential gains.
How is a Put-Call ratio calculated?
As mentioned above, PCR is calculated by dividing the total number of outstanding put options by the total number of outstanding call options for a particular stock or index. It can be calculated for any time period i.e., daily, weekly, or monthly and for diverse security options or indexes.
The formula for Put-Call Ratio is as follows:
PCR = Total number of outstanding put options exercised during the specified period / Total number of outstanding call options exercised during the specified period
For example, suppose the total number of outstanding put options for a stock is 500 and the total number of outstanding call options is 1000. The Put-Call Ratio for this stock would be:
PCR = 500 / 1000 = 0.5
This means that the Put-Call Ratio for the stock is 0.5, which indicates that the market sentiment towards the stock is bullish or positive. In other words, there are twice as many outstanding call options as put options, suggesting that investors are more optimistic about the stock’s future price movements.
How to interpret Put-Call Ratio?
The Put Call Ratio formula shows results in the absolute number that can be equal to 1 or above or below the same. The interpretation of this ratio for traders is highlighted hereunder.
- When the PCR is above 1
It suggests that there are more outstanding put options than call options, which indicates that investors are more bearish on the stock or index. A high PCR suggests that the market sentiment is bearish or negative towards a particular stock or index. This means that investors are buying more put options to protect themselves from potential losses.
- When the PCR is below 1
It suggests that there are more outstanding call options than put options, which indicates that investors are more bullish on the stock or index. A low PCR suggests that the market sentiment is bullish or positive towards a particular stock or index. This means that investors are buying more call options to benefit from potential gains.
- When the PCR is equal to 1
It suggests that the market sentiment towards a particular stock or index is neutral. This means that the number of outstanding put options is equal to the number of outstanding call options which indicates that investors have an equal level of bullish and bearish sentiment towards the stock or index. It also shows indecision among the traders regarding the future market sentiment or the particular security in consideration.
What are the pros and cons of using the Put-Call Ratio?
Some of the advantages of using the Put-Call Ratio are mentioned below.
- Easy to calculate
The Put-Call Ratio is a simple calculation that can be easily done by dividing the total number of outstanding put options by the total number of outstanding call options for a particular stock or index. This makes it a quick and easy way for traders to determine the direction of the market movement or the market trend.
- Provides insight into market sentiment
The PCR can provide traders with a quick snapshot of the market sentiment towards a particular stock or index. A high PCR suggests bearish sentiment, while a low PCR suggests bullish sentiment. This information can help traders make informed trading decisions.
- Can help identify potential reversals
A significant shift in the PCR can indicate a potential reversal in the market sentiment towards a particular stock or index. For example, if the PCR has been high and starts to decline, it may indicate that traders are becoming more bullish on the stock or index. This can provide traders with an opportunity to enter or exit trades.
- Can be used in combination with other indicators
Traders can use the PCR in conjunction with other technical indicators, (like moving averages or support and resistance levels) to confirm or validate trading signals. This can provide them gain greater confidence in their trading decisions and help in identifying potential trading opportunities.
Some of the key limitations of using the Put-Call Ratio are highlighted hereunder.
- Not applicable to all stocks or indices
The PCR may not be applicable or useful for all stocks or indices. This is due to the fact that not all stocks are traded in the derivative market i.e., have options available for their stocks. The PCR can vary depending on market conditions and individual stock factors. Traders should evaluate the usefulness of the PCR on a case-by-case basis and should not rely solely on it to make trading decisions.
- Can be influenced by other factors
The PCR can be influenced by other market factors, such as news events, economic indicators, and company earnings reports. These factors can affect the accuracy of the PCR and can lead to false signals. Traders should consider these factors when interpreting the PCR and should not rely solely on it for trading decisions.
- Does not provide complete information
The PCR only considers outstanding put and call options and does not provide information on the size or duration of these positions. Traders should consider other market indicators, such as volume and open interest, to gain a more complete understanding of market sentiment. The PCR should, therefore, not be used as the sole basis for trading decisions. Traders should consider other technical indicators and market factors, such as news events and economic indicators, to gain a comprehensive view of market sentiment.
The PCR is among the many technical analysis indicators that can be used by traders to effectively analyse market sentiment. This will help them take suitable trading positions and evaluate the trading options available. However, as mentioned above, this indicator should not be used in isolation in order to have an accurate idea of the market sentiment.
PCR can be used as a contrarian indicator by many traders which implies that a high PCR could indicate an oversold market due for correction and vice versa.
PCR is a simple analysis of the ratio of the number of outstanding put options to the outstanding call options in the market. Therefore, there is no ideal PCR as the result of the ratio can be used to interpret the buying or selling sentiment of the market.
When the PCR is equal to 1 it means there are an equal number of outstanding call and put options. This implies a neutral market sentiment or indecisiveness of the traders in the market to show a clear market direction.
The basic difference between the out option and the call option is that the former provides an option to sell the underlying asset to the option holder while the latter is the option to buy the underlying asset.