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Demystifying Put Call Ratio to Help You Make Money

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.

What is the Put-Call Ratio?

Put/Call Ratio is a popular derivative indicator, specifically designed to help traders gauge the overall sentiment of the 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.

The ratio is calculated either on the basis of options trading volumes or on the basis of the open interest for a particular period. If the ratio is more than 1, it means that more puts have been traded during the day and if it is less than 1, it means more calls have been traded. The PCR can be calculated for the options segment as a whole, which includes individual stocks as well as indices.

Let’s see how PCR analysis can be interpreted taking option sellers into consideration who are the major players in the market as compared to the retail public who are usually on the buying side of the trade.

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. 

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.

How to Analyse Put Call Ratio?

Let’s see how PCR analysis can be interpreted taking option sellers into consideration who are the major players in the market as compared to the retail public who are usually on the buying side of the trade.

If put-call ratio increases as minor dips getting bought in during an up-trending market - Bullish Indication. It means the put writers are aggressively writing at dips expecting the uptrend to continue

If put-call ratio decreases while markets testing the resistance levels -Bearish Indication. It means call writers are building fresh positions, expecting a limited upside or a correction in the market.

If put-call ratio decreases during down trending market - Bearish indication. It means option writers are aggressively selling the call option strikes.

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 be 

5,609/88,220 = 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 

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.

Why Is PCR Important?

Put/Call ratio is an important tool used by traders to gauge the overall sentiment of the market. Put/call ratio help traders decide the price movement of an underlying security and guides them to place directional bets on the stocks. Being a contrarian indicator, it helps traders not to get trapped with Herd Mentality. As the ratio is calculated both in terms of open interest and volume, the entire trading behaviour of market participants can be analysed using the Put/call ratio.

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 side-lines, 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. 

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.

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.

Combining PCR with Implied volatility (IV)

A smart way of interpreting PCR is by combining it with IV. Remember, IV is the volatility that is implied in the option price and it reflects the risk perception in the market. Here are a few pointers.

  • If the PCR increases with an increase in IV, it indicates that the put activity is increasing with a heightened sense of risk. That is a bearish signal.
  • If the PCR increases with a decrease in IV, it indicates that put activity is increasing with a falling sense of risk. That means more writing of puts and is a bullish signal.
  • If the PCR decreases with decrease in IV, it is indicative of unwinding of Puts and can be interpreted as a signal that markets may be bottoming out.
  • If the PCR decreases with an increase in IV, it means that puts are just being covered and the markets will again fall once the covering is done with.

So, what does Nifty Put Call Ratio tell us?

The put-call ratio measures the value of outstanding put options relative to call options of the Nifty, Bank Nifty and stocks. A higher value of puts outstanding will reinforce the bullish momentum while a higher value of calls outstanding will mean that the markets could be driven lower by profit booking.

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