Put-Call Ratio

What Is a Put-Call Ratio?

The put-call ratio is a measurement that is widely used by investors
to gauge the overall mood of a market.

A "put" or put option is a right to sell an asset at a predetermined price. A

"call" or call option is a right to buy an asset at a predetermined price.

If traders are buying more puts than calls, it signals a rise in bearish
sentiment. If they are buying more calls than puts, it suggests that they see a
bull market ahead.

Understanding the Put-Call Ratio

The put-call ratio is calculated by dividing the number of traded put options by
the number of traded call options.

KEY TAKEAWAYS

 A put option gets the trader the right to sell an asset at a preset price.
 A call option is a right to buy an asset at a preset price.
 If traders are buying more puts than calls, it signals a rise in bearish
sentiment.
 If they are buying more calls than puts, watch out for a bull market
ahead.
A put-call ratio of 1 indicates that the number of buyers of calls is the same as
the number of buyers for puts. However, a ratio of 1 is not an accurate
starting point to measure sentiment in the market because there are normally
more investors buying calls than buying puts. So, an average put-call ratio
of .7 for equities is considered a good basis for evaluating sentiment.

In general:

 A rising put-call ratio, or a ratio greater than .7 or exceeding 1, means

that 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.
 A falling put-call ratio, or below .7 and approaching .5, is considered a
bullish indicator. It means more calls are being bought versus puts.

The put-call ratio can be an indicator of how the market views recent events or
earnings. A ratio at either extreme suggests an overly bearish or an overly
bullish sentiment.

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The data used to calculate put-call ratios are available through various
sources, but most traders use the information found on the Chicago Board
Options Exchange (CBOE) website.

Special Considerations
The put-call ratio helps investors gauge market sentiment before the market
turns. However, it's important to look at the demand for both the numerator
(the puts) and the denominator (the calls).

The number of call options is found in the denominator of the ratio. That
means a reduction in the number of traded calls will increase the value of the
ratio. This is significant because fewer calls being bought can push the ratio
higher without an increased number of puts being purchased. In other words,
we don't need to see a large number of puts being purchased for the ratio to
rise.

As bullish traders sit on the sidelines, the result by default is that there are
more bearish traders in the market. It doesn't necessarily mean the market is
bearish, but rather that 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.

.7
The average put-call ratio for equities that is considered a good basis for
evaluating sentiment.
It's helpful to watch the put-call ratio to see how the market views recent
events or earnings. When the ratio is at extreme levels, it might indicate an
overly bearish or an overly bullish sentiment.

For this reason, some investors use the put-call ratio as a contrarian
indicator.

A Contrarian Indicator
Contrarian investors use the put-call ratio to help them determine when
market participants are getting overly bullish or too bearish.

An extremely high put-call ratio means the market is extremely bearish. To a

contrarian, that can be a bullish signal that indicates the market is unduly
bearish and is due for a turnaround. A high ratio can be a sign of a buying
opportunity to a contrarian.

An extremely low ratio means the market is extremely bullish. A contrarian

might conclude that the market is too bullish and is due for a pullback.

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No single ratio can definitively indicate that the market is at its top or its
bottom. Even the levels of the put-call ratio that are considered extreme are
not set in stone and vary over the years.

Typically, investors compare current ratio levels to the average over some
period of time to gauge if sentiment has changed recently. If the put-call ratio
has fluctuated in a tight range and suddenly bumps higher, traders might see
this as a sudden increase in bearish sentiment and make their moves
accordingly.

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Forecasting Market Direction With Put/Call
Ratios
While most options traders are familiar with the leverage and flexibility options
offer, not everyone is aware of their value as predictive tools. Yet one of the
most reliable indicators of future market direction is a contrarian-sentiment
measure known as the put/call options volume ratio.

By tracking the daily and weekly volume of puts and calls in the U.S. stock
market, we can gauge the feelings of traders. While a volume of too
many put buyers usually signals a market bottom is near, too many call buyers
typically indicates a market top is in the making. The bear market of 2002,
however, has changed the critical threshold values for this indicator. In this
article, I will explain the basic put/call ratio method and include new threshold
values for the equity-only daily put/call ratio.

KEY TAKEAWAYS

 One of the most reliable indicators of future market direction is a

contrarian-sentiment measure known as the put/call options volume
ratio.
 On balance, option buyers lose about 90% of the time.
 As often happens when the market gets too bullish or too bearish,
conditions become ripe for a reversal.
Betting Against the Crowd
It is widely known that options traders, especially option buyers, are not the
most successful traders. On balance, option buyers lose about 90% of the
time. Although there are certainly some traders who do well, would it not make
sense to trade against the positions of options traders since most of them
have such a bleak record? The contrarian sentiment put/call ratio
demonstrates it pays to go against the options-trading crowd. After all, the
options crowd is usually wrong.

In late 1999 and early into the new millennium, option buyers were in a frenzy,
buying up truckloads of call options on tech stocks and
other momentum plays. As the put/call ratio pushed below the traditional
bearish level, it seemed like these frenzied option buyers were like sheep
being led to the slaughter. And sure enough, with call-relative-to-put buying
volume at extreme highs, the market rolled over and began its ugly descent.

As often happens when the market gets too bullish or too bearish, conditions
become ripe for a reversal. Unfortunately, the crowd is too caught up in the
feeding frenzy to notice. When most of the potential buyers are in the market,

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we typically have a situation where the potential for new buyers hits a limit;
meanwhile, we have lots of potential sellers ready to step up and take profit or
simply exit the market because their views have changed. The put/call ratio is
one of the best measures we have when we are in these oversold (too
bearish) or overbought (too bullish) zones.

CBOE Put/Call Ratio Data

Looking inside the market can give us clues about its future direction. Put/call
ratios provide us with an excellent window into what investors are doing.
When speculation in calls gets too excessive, the put/call ratio will be low.
When investors are bearish and speculation inputs get excessive, the put/call
ratio will be high. Figure 1 presents the daily options volume for May 17, 2002,
from the Chicago Board Options Exchange (CBOE). The chart shows the data
for the put and call volumes for equity, index, and total options.

The equity put/call ratio on this particular day was 0.64, the index options
put/call ratio was 1.19 and the total options put/call ratio was 0.72. As you will
see below, we need to know the past values of these ratios to determine our
sentiment extremes. We will also smooth the data into moving averages for
easy interpretation.

Chicago Board Options Exchange (CBOE) Options Volume

VOLUM
P/C RATIOS
E
EQUITY OPTIONS
Puts 462,520 -
Calls 721,163 .64
INDEX OPTIONS
Puts 134,129 -
Calls 112,306 1.19
TOTAL OPTIONS
Puts 596,669 -
Calls 833,624 .72
Figure 1: Daily options volume for May 17, 2002
Source: CBOE Market Statistics 5/17/02

Total Weekly Put/Call Ratio Historical Series

There are different ways to construct a put/call ratio, but the traditional CBOE
total weekly put/call ratio is a good starting point. By total, we mean the
weekly total of the volumes of puts and calls of equity and index options. We
simply take all the puts traded for the previous week and divide by the weekly
total of calls traded. This is the weekly total put/call ratio. When the ratio of
put-to-call volume gets too high (meaning more puts traded relative to calls)

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the market is ready for a reversal to the upside and has typically been in a
bearish decline.

When the ratio gets too low (meaning more calls traded relative to puts), the
market is ready for a reversal to the downside (as was the case in early 2000).
Figure 2, where we can see the extremes over the past five years, shows this
measure on a weekly basis, including its smoothed four-week exponential
moving average.

Figure 2: Created using Metastock Professional. Data Source: Pinnacle IDX

Figure 2 shows the ratio's four-week exponential moving average (top plot)
gave excellent warning signals when market reversals were nearby. While
never exact and often a bit early, the levels should nevertheless be a signal of
a change in the market's intermediate-term trend. It is always good to get a
price confirmation before concluding a market bottom or top has been
registered.

These threshold levels have remained relatively range-bound over the past 20
years, as can be seen in Figure 2, but there is some noticeable drifting (trend)
to the series, first downward during mid-1990s bull market, then upward
beginning with the 2000 bear market.

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Figure 3: Created using Metastock Professional. Date Source: Pinnacle IDX

Despite the trend, the smoothed put/call ratio is still useful; however, it is
always best to use the previous 52-week highs and lows of the series as
critical thresholds. Put/call ratios are best used in combination with other
sentiment indicators and perhaps a price-based (i.e. momentum) indicator.
More elaborate mathematical massaging of the data (i.e. de-trending by
differencing the series) can also help.

Equity-Only Put/Call Ratio

Since it includes index options, which are used by professional money
managers to hedge portfolios of stocks, the total put/call ratio can distort the
measurement of the temperature of our purely speculative crowd. Arguably, a
better gauge is the CBOE's equity-only put/call ratio. Figure 4 contains the
CBOE raw daily put/call ratio and its 10-day exponential moving average –
both are plotted above the S&P 500 stock index. As the bear market has
shifted the average ratio to a higher range, the horizontal red lines are the new
sentiment extremes. The past range, indicated by the horizontal blue lines,
had threshold values of 0.39 to 0.49. The new threshold values are 0.55 and
0.70. Currently, the levels have just retreated from excessive bearishness and
are thus moderately bullish.

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Figure 4: Created using Metastock Professional. Source: CBOE Market
Statistics

The Bottom Line

Index options historically have a skew toward more put buying. This is
because the index put option hedging done by portfolio managers. This is also
why the total put/call ratio is not the ideal ratio (it is polluted by this hedging
volume). Remember, the idea of contrarian sentiment analysis is to measure
the pulse of the speculative option crowd, who are wrong more than they are
right. We should, therefore, be looking at the equity-only ratio for a purer
measure of the speculative trader. In addition, the critical threshold levels
should be dynamic, chosen from the previous 52-week highs and lows of the
series, adjusting for trends in the data.

As with any indicators, they work best when you get to know them and track
them yourself. While I don't like to use them for mechanical trading signals,
put/call ratios do outline zones of oversold and overbought market conditions
quite reliably. They should thus be included in any market technician's
analytical toolbox.

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Definition of 'Put-call Ratio'
Definition: Put-call ratio (PCR) is an indicator commonly used to determine the mood of the
options market. Being a contrarian indicator, the ratio looks at options buildup, helps traders
understand whether a recent fall or rise in the market is excessive and if the time has come
to take a contrarian call. The ratio is calculated either on the basis of options trading volumes
or on the basis of options contracts on a given day or period.

One way to calculate PCR is by dividing the number of open interest in a Put contract by the
number of open interest in Call option at the same strike price and expiry date on any given
day.

PCR (OI) = Put open interest on a given day/Call open interest on the same day

It can also be calculated by dividing put trading volume by call trading volume on a given
day.

PCR (Volume) = Put trading volume/call trading volume

PCR for marketwide positions can also be calculated by taking total number of OI for all
open Call options and for all open Put options in a given series.

Description: A PCR ratio below 1 suggests that traders are buying more Call options than
Put options. It signals that most market participants are betting on a likely bullish trend going
forward. For contrarians, it is a signal to go against the wind.

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On the flip side, if the ratio is higher than 1, it suggests traders are buying more Puts than
Calls. Unlike Call options, Put options are not initiated just for directional call. They are
bought also to hedge against any decline in the market.

The market sentiment is deemed excessively bearish when the PCR is at a relatively high
level. But for contrarian investors, it suggests that the market may soon bottom out. On the
other hand, when the ratio falls to a relatively low level, it is deemed excessively bullish. For
contrarians, it would suggest a market top is in the making.

The PCR can be calculated for indices, individual stocks and for the derivative segment as a
whole.

For example, suppose Nifty50 Put option at strike price 8,000 for December expiry saw a
volume of 5,609 contracts on a day. Suppose further that Call volume on that day at the
same strike price and same expiry stood at 88,220.

In this case, the PCR would be5,609/88,220 = 0.06

Now suppose the Put open interest for the same expiry and strike price stands at 4,310,600
and Call open interest stands at 6,816,250.

The PCR in this case would be

4310600/6816250 =0.63 (See table above)

If the ratio is high in a falling market, it reflects how bearish the sentiment is. But a rise in the
ratio in a rising market is considered a bullish signal.

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