Put-Call Ratio (PCR)

The put-call ratio (also known as the put/call ratio or PCR) is a technical metric used by investors to assess the market’s outlook. To calculate market sentiment, the ratio uses the volume of puts and calls on a market index over a specified time span. Any individual stock, as well as any index, can have its PCR measured, or it can be aggregated. A “put,” also known as a “put option,” is a right to sell an asset at a fixed price. A “call,” also known as a “call option,” is a right to purchase an asset at a fixed price. An increase in bearish sentiment is signaled by traders buying more puts than calls. If they are buying more calls than puts, it means that they think the market will continue to grow.

The sentiment is considered exorbitantly bearish when the Put/Call Ratio is exchanging at moderately significant levels and unnecessarily bullish when at generally low levels. Chartists can apply moving midpoints and different pointers to smooth the information and determine signals. The PCR is calculated by dividing put volume over a set period by call volume over the same period. In general, a lower reading (0.6) of the ratio indicates that investors are optimistic, as they buy more calls in anticipation of an uptrend. Alternately, a higher reading (~1.02) of the proportion shows a bearish estimation on the lookout. Notwithstanding, the proportion is viewed as an antagonist marker, with the goal that a limit perusing above 1.0 is really a bullish sign and the other way around.

A put-call ratio of one means that the number of call buyers is equal to the number of put buyers. However, since there are usually more investors buying calls than buying puts, a ratio of one is not an appropriate starting point for measuring market sentiment. Likewise, with most feeling pointers, the Put/Call Ratio is utilized as an antagonist marker to check bullish and bearish limits. As a result, a put-call ratio of.7 for equities is considered a reasonable starting point for assessing sentiment.

The formula for the put-call ratio is as follows:

Put Call Ratio = Put Volume / Call Volume

Where:

The number of put options initiated over a specified time period is known as Put Volume; and the number of call options initiated over the same time period is known as Call Volume.

Sentiment arrives at limits when the Put/Call Ratio moves to generally high or low levels. These limits are not fixed and can change over the long haul. Since call volume is substantially higher than put volume, a Put/Call Ratio at its lower extremities would indicate excessive bullishness. Excessive bullishness, on the other hand, would argue for caution and the risk of a stock market downturn.

In general:

  • A rising put-call proportion, or a proportion more noteworthy than .7 or surpassing 1, implies that value brokers are purchasing a larger number of puts than calls. It recommends that bearish supposition is working on the lookout. Investors are hedging their portfolios in case of a sell-off or speculating that the index will shift lower.
  • A bullish indicator is a dropping put-call ratio, which is below.7 and approaching.5. It means that more calls are being purchased than puts.

It’s important to remember that the PCR’s measurement isn’t limited to put and call volume. It is common for investors to use a variation, as shown below:

Put Call Ratio = Total Put Open Interest / Total Call Open Interest

Where:

Total Put Open Interest is the total number of outstanding puts; and

Total Call Open Interest is the total number of outstanding calls.

A Put-Call Ratio at its furthest points would show over the top bearishness on the grounds that put volume would be altogether higher than call volume. Unnecessary bearishness would contend for confidence and the chance of a bullish inversion. The data used to measure put-call ratios can be found in a number of ways, but most traders rely on data from the Chicago Board Options Exchange (CBOE). Chartists must select between equity, index, or total option volume while using CBOE-based metrics.

The put-call ratio assists financial backers with checking market conclusions before the market turns. Be that as it may, it’s critical to take a gander at the interest for both the numerator (the puts) and the denominator (the calls). In general, professional traders are associated with index options, while non-professional traders are associated with stock options. Despite the fact that professionals prefer index options for hedging or directional bets, puts account for a large portion of total volume for hedging.

Interpret the Put-Call Ratio (PCR) –

Interpreting the Number: A PCR below one (<1) indicates that investors are buying more call options than put options, implying that they are betting on a bullish trend in the future.

A PCR greater than one (>1) indicates that investors are buying more put options than call options, implying that they are betting on a bearish trend in the future.

A PCR of one (=1) indicates that investors are buying the same amount of put and call options, indicating a neutral pattern in the future.

While no PCR is perfect, a PCR of less than 0.7 indicates a strong bullish sentiment, while a PCR of more than 1 indicates a strong bearish sentiment.

Investment Style: It’s important to remember that depending on the investor’s investment style, the PCR is interpreted differently. For example, consider two investment styles:

  • A high PCR may be viewed as a bullish signal by a contrarian investor, whereas a low PCR may be viewed as a bearish signal.
  • A high PCR may be viewed as a bearish signal by a momentum investor, whereas a low PCR may be viewed as a bullish signal.

Accordingly, the PCR relies upon the financial backer’s venture style, and, in that capacity, there is nobody right approach to decipher the proportion. The quantity of call choices is found in the denominator of the proportion. That implies a decrease in the quantity of exchanged calls will expand the estimation of the proportion. This is important since fewer calls purchased without an increase in the amount of puts purchased will drive the ratio higher. As a contrarian sentiment indicator, signals from Put/Call Ratio will regularly be at chances with the predominant pattern. Call volume increments as a convention grabs hold, while put volume increments during an all-encompassing decay.

When the Put/Call Ratio approaches an extreme, it indicates that option traders are overly bullish or bearish. These contrarian signs can often accurately forecast tops and bottoms, but they can also be too early or incorrect. Since bullish traders are sitting on the sidelines, there are more bearish traders in the sector. It doesn’t really mean the market is bearish, yet rather that bullish brokers are in a cautious mode until a forthcoming occasion happens like a political race, a Fed meeting, or an arrival of financial information. Since indicators aren’t ideal, it’s crucial to recognize the extremes and wait for them to occur.

The Put/Call Ratio will usually fluctuate between these extremes. To validate signals, the Put/Call Ratio should be used in combination with other measures such as momentum oscillators or chart patterns. Normally, financial backers contrast current proportion levels with the normal throughout some timeframe to check if assessment has changed as of late. If the put-call ratio has been fluctuating in a narrow range and suddenly rises, traders can interpret this as a change in bearish sentiment and respond accordingly.

Information Sources:

  1. school.stockcharts.com
  2. corporatefinanceinstitute.com
  3. investopedia.com
  4. wikipedia