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Traders in the stock market come with different preferences. While some of them use their personal judgements, other investors largely depend on indicator-based trading.
Well, indicator-based trading can be beneficial if investors understand that these are signals of what may happen and not guaranteed outcomes. Here is one such indicator that can help traders analyse the sentiments of the options market – The put-call ratio.
Today’s article is about the put-call ratio, its calculation and its significance in the options market.
Also read: Do all technical analysis tools work equally well?
What is a put-call ratio?
A put-call ratio is a mathematical indicator that represents and compares the number of put options and call options traded on a stock exchange. It is an indicator used by a large number of options traders to assess the mood of the market.
Understanding PCR
The PCR indicates the number of puts versus the number of calls for a particular stock, index, sector, or the stock market as a whole. When puts are greater than calls, it indicates a bearish market. When the number of calls is greater than puts, the market is said to be bullish.
Important terms to know:
- Put options: It is an options contract that gives the holder the right without an obligation to sell the asset.
- Call options: The holders of call options get the right but no obligation to buy the underlying asset.
- Open interest – The number of active derivative contracts whose settlement dates are yet to arrive.
- Volumes – Includes the total number of contracts for a given period (Both open and closed contracts).
A section of traders refer to PCR as a contrarian indicator.
A contrarian indicator suggests doing the contrary of what most traders are currently doing. PCR considers the contracts under calls and puts. Generally, a high ratio must indicate a bearish market since the number of puts is high. Contrary to this, some traders suggest that the ratio is high even when the number of puts is constant, but the number of calls reduces. So, it does not necessarily indicate a bearish market.
However, looking at the PCR trend for a specific period, rather than just once, can help clarify the actual indication of the ratio.
Also read: Stock options – The beginner’s guide to the options marke
Put-call ratio calculation
- Ratio on the basis of open interest
This considers the number of active put and call contracts.
Put-call ratio formula = Number of open interests for puts / Number of open interests for calls
- Ratio on the basis of volume
It indicates the total number of contracts.
PCR formula = Total number of put contracts / Total number of call contracts
Example:
Let us calculate the put-call ratio on NSE’s benchmark index – NIFTY.
As of 20 December 2023, below are statistics of NIFTY options.
- Number of open interests on put options: 18,33,250
- Number of open interests on call options: 38,35,319
- Volume of put options: 6,69,13,534
- Volume of call options: 6,74,58,229
The put-call ratio of NIFTY based on open interest:
= 18,33,250 / 38,35,319
= 0.48
The ratio of 0.48 indicates that the number of puts is almost half of the number of calls, suggesting a bullish market.
The put-call ratio of NIFTY based on volume:
= 6,69,13,534 / 6,74,58,229
= 0.99
The ratio of 0.99 indicates that the number of calls is slightly higher than puts, hinting at a slight inclination towards a bullish market.
The significant difference between the two is due to the number of inactive contracts excluded under open interest but considered under total volume.
Pros and cons of the put-call ratio
Benefits:
- PCR is easy and simple to calculate. Individuals can arrive at the numbers by themselves as the required information is publicly available.
- PCR is useful in determining market sentiment. Hence, it helps traders who wish to trade with the trend and against the trend, too.
- Comparing ratios on different days can help in identifying changing trends and potential reversals.
- The ratio is flexible and can be calculated for different sectors, indices, securities or the whole market. It helps traders with a comprehensive outlook on individual sectors and the entire market.
Limitations:
- There is no standardisation in interpretation as contrarian indicators have a different school of thought.
- The indicator does not provide thresholds of what the ideal number is, making it difficult to interpret and conclude.
- The PCR ratio shows market sentiments but is incapable of providing suggestions on the entry and exit points.
- The ratio is a lagging indicator. It shows what has already happened. It is not very helpful in forecasting future possibilities.
Bottomline
The put-call ratio is, indeed, a functional tool for analysing the options market, however, it comes with limitations due to its restricted data set. It works best when traders use the ratio to get a basic idea of the market and use other tools in parallel to analyse the details.
FAQs
A high open interest for calls indicates more number of active call option contracts. This can be an indication of a bearish market, where the number of people looking to sell the underlier is high.
A PCR of less than 1 indicates that the number of calls is more, hinting at a bullish market. A PCR of more than 1 indicates that the number of puts is higher, suggesting a bearish market. When PCR is one, it suggests that there is no dominance by either.
A put-call ratio of 2.5 indicates that the number of puts is on the higher side. It suggests that puts are 2.5 times more than calls, hinting at a strong bearish market.
Neither. Both puts and calls are hedging strategies in the options market. The choice between the two entirely depends on how the investor sees the market. A bullish investor would choose a call option, while a bearish investor would choose a put option.
The put-call ratio is undoubtedly a simple, straightforward indicator showing the sentiment of the majority of investors in the options market. However, it is not helpful in planning entry and exit strategies. Hence, the accuracy of this ratio depends on the other tools used.