The Put Call Ratio (PCR) is a tool in the stock market to understand how investors feel about a stock or the market's future. It compares the number of put options to call options traded. More puts traded mean investors expect prices to fall (bearish). More calls traded mean investors expect prices to rise (bullish).
Put option vs call option
Let us explore the key differences between put and call options:
Put option:
- A put option gives the holder the right, but not the obligation, to sell a specified amount of an underlying asset at a predetermined price (strike price) within a specified timeframe (until expiration).
- Put options are used by traders who anticipate the price of the underlying asset will decrease. If the asset's price falls below the strike price, the put option becomes profitable because the holder can sell the asset at a higher price than the market value.
- Investors buy put options to hedge against potential losses in their stock holdings or to profit from a downward movement in the market.
Call option:
- A call option gives the holder the right, but not the obligation, to buy a specified amount of an underlying asset at a predetermined price (strike price) within a specified timeframe (until expiration).
- Call options are purchased by traders who expect the price of the underlying asset to rise. If the asset's price exceeds the strike price, the call option becomes valuable because the holder can buy the asset at a lower price than the market value.
- Investors buy call options to benefit from price increases, to hedge short positions, or as part of more complex trading strategies.
Key differences:
- Put options profit from a decline in the underlying asset's price, while call options profit from an increase.
- Put options offer limited risk (premium paid), with potentially unlimited reward if the asset's price drops significantly. Call options also have limited risk (premium paid), with potentially unlimited reward if the asset's price rises substantially.
- Put options are used in bearish or defensive strategies, while call options are used in bullish strategies.
Understanding the differences between put and call options is crucial for options traders to effectively manage risk and capitalise on market movements.
Additional read: What is the difference between Nifty and Sensex
How to calculate the put call ratio?
The put call ratio is calculated by dividing the total open interest of outstanding put options by the total open interest of outstanding call options for a specific security or market. The open interest represents the total number of options contracts that have not been exercised or expired.
Based on open interests of a specific day
- The PCR is calculated by dividing the total open interest of outstanding put options by the total open interest of outstanding call options for a specific security or market.
Formula:PCR = Total open interest of put options / Total open interest of call options
Example:
Suppose we want to calculate the put call ratio for "XYZ Ltd," listed on the Bombay Stock Exchange (BSE).
- The total open interest for put options on XYZ Ltd is 5,000 contracts.
- The total open interest for call options on XYZ Ltd is 10,000 contracts.
Using the formula:
PCR = 5,000 (Put options) / 10,000 (Call options) = 0.5
In this scenario, the put call ratio for XYZ Ltd is 0.5.
Based on the trading volume of a specific day
- Alternatively, the PCR can be calculated using the trading volume of put and call options on a specific day. This method provides insights into the current market sentiment based on the day's trading activity.
Formula:PCR = Total trading volume of put options / Total trading volume of call options
Example
Let us consider the trading volume on a specific day for "ABC Ltd" on the National Stock Exchange (NSE).
- The total trading volume of put options on ABC Ltd is 3,000 contracts.
- The total trading volume of call options on ABC Ltd is 6,000 contracts.
Using the formula:
PCR = 3,000 (Put options) / 6,000 (Call options) = 0.5
In this scenario, the put call ratio for ABC Ltd on that specific day is 0.5.
Interpretation of PCR
The put call ratio can be interpreted in the following ways:
- PCR < 1:When the PCR is less than 1, it indicates that there are more open call contracts than put contracts, which can be seen as a bullish sentiment in the market. Traders and investors expect the underlying asset's price to rise.
- PCR > 1:When the PCR is greater than 1, it suggests that there are more open put contracts than call contracts, indicating a bearish sentiment. Traders and investors anticipate the underlying asset's price to fall.
- PCR = 1:When the PCR is close to 1, it implies a balanced sentiment in the market. Investors and traders do not show a strong bias either towards bullish or bearish views.
Time frame
PCR should be analysed over different time frames, such as daily, weekly, or monthly, to gain insights into short-term, and long-term market sentiment. Different time frames may reveal varying degrees of market sentiment and trends.
Historical data
Comparing the current PCR to historical values is crucial for determining significant shifts in market sentiment. An abrupt change in the PCR can indicate a potential reversal in the market.
Significance of put call ratio
The put call ratio holds significant importance for traders and investors:
1. Market sentiment:
It provides a snapshot of market sentiment, helping traders and investors understand whether the market is leaning towards bullish or bearish sentiments.
2. Contrarian indicator:
It can act as a contrarian indicator. When the PCR reaches extreme levels (either very high or very low), it may indicate that the market sentiment is overly optimistic or pessimistic, suggesting a potential reversal.
3. Risk management:
By tracking the PCR, traders can assess the risk and make more informed decisions. A bearish PCR may lead to protective actions, while a bullish PCR can encourage risk-taking.
4. Volatility indicator:
An increase in PCR can often be associated with higher market volatility, as more traders and investors are buying put options to hedge against potential downside risks.
5. Leading indicator:
In some cases, the PCR can act as a leading indicator of market movements, especially when extreme levels are reached.
Additional read: What is the fear and greed index
Limitations of put call ratio
While the put call ratio is a valuable tool, it has its limitations:
1. Lack of precision:
The PCR does not provide specific price targets or timings for market movements. It offers a sentiment overview but does not predict precise market movements.
2. Options expiry:
The PCR can be influenced by options nearing expiration. As options expire, they may skew the ratio, causing temporary distortions in market sentiment.
3. Overreliance:
Relying solely on the PCR for tradingdecisions can be risky. It is crucial to consider other factors, such as technical and fundamental analysis.
4. Varying interpretations:
Interpretations of the PCR can vary among analysts, as it is just one indicator among many used in the market.
PCR - The contrarian indicator
The put call ratio's contrarian nature makes it a unique and valuable tool for traders. When the PCR reaches extreme levels, it often signals a potential reversal in the market. Here is how it works as a contrarian indicator:
1. High PCR (Bearish sentiment)
When the PCR is significantly above 1 (indicating bearish sentiment), it may suggest that the market is excessively pessimistic. This could be a contrarian buy signal, as market participants may have already priced in the negative news, and a rebound may be imminent.
2. Low PCR (Bullish sentiment)
Conversely, when the PCR is significantly below 1 (indicating bullish sentiment), it may indicate an overly optimistic market. This could be a contrarian sell signal, as excessive optimism may lead to a market correction.
Example
Suppose the PCR for a particular stock is 2.0, which is a relatively high value. This suggests bearish sentiment. A contrarian trader might interpret this as an opportunity to buy the stock because the market may have become excessively pessimistic, and a rebound could be on the horizon.
Conversely, if the PCR is 0.5, indicating a bullish sentiment, a contrarian trader might consider selling the stock, anticipating a potential correction as market optimism may have reached unsustainable levels.
How to trade using a put-call ratio?
Trading using the put-call ratio (PCR) involves analysing the relationship between the number of put options and call options in the market. In the context of the Indian securities market, the following steps can be considered for a put-call ratio trading strategy:
1.Understanding put-callratio (PCR)
- The put-call ratio is calculated by dividing the total open interest of put options by the total open interest of call options. It helps traders gauge market sentiment and potential future price movements.
2.Interpreting PCR values
- A high put-call ratio (above 1) indicates a bearish sentiment, suggesting that investors are more inclined towards buying put options, possibly anticipating a market decline.
- A low put-call ratio (below 1) implies a bullish sentiment, indicating a higher preference for call options, possibly anticipating a market rise.
3.Using strike price
- Assess the PCR based on the strike prices of options. Illiquid assets may have lower trading volumes, making the strike price a crucial factor. Analysing the strike prices can provide insights into market expectations.
4.Considering trading volume
- Evaluate the trading volumesof both put and call options.Look at the strike price and expiry date for a particular asset to determine the overall directional movement. Higher trading volumes can indicate stronger market consensus.
5.Examining open interest
- Open interest refers to the total number of outstanding contracts for a particular option. Apply open interest to the PCR to assess trading volume in bothput and call options over a defined period.
- Increased open interest can suggest growing market participation and potential price movements. A decrease may indicate reduced market interest and potential reversal.
Conclusion
The put call ratio is a versatile tool that can offer valuable insights into market sentiment, serve as a contrarian indicator, and aid in risk management. However, it is essential to consider the PCR with other technical and fundamental analysis tools for a more comprehensive view of market conditions. Monitoring the PCR over various time frames and comparing it to historical data can help traders make informed decisions in the dynamic world of options trading.
