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Guide to Option Greeks

The Put Call Ratio Explained


Michael West

Experience traders and investors have an arsenal of indicators and measures to help decide the optimal time for entry and exit. The perfect opportunity to purchase or sell also depends on the market trend or sentiment. After all, the ideal exit price is might only available if the market is willing to buy and bullish. Therefore, it is important indicator to have is one that can highlight market sentiment. The put call ratio (PCR) is one such indicator and is a very useful once understood.


The put call ratio is very easy to calculate and is simply the number of puts divided by the number of calls. The ratio is larger than 1 when there are more puts than calls traded, and smaller than 1 when there are more calls traded than puts.

Interpretations as an indicator


Put options are purchased to hedge against price declines and also to profit from downwards price action. The opposite is true for call options: they are purchased to hedge against price increases (when shorting) but also to profit from upwards price action. Whether calls or puts are purchased reflects the sentiment of traders and can be an insight into the wider market. A large put call ratio occurs when more puts are purchased than calls and can indicate a bearish market, while a small put call ratio occurs when more calls are purchased than puts and can indicate a bullish market.

Multiple spikes in call put ratio can confirm market sentiment towards a stock
Figure 1. Multiple large put call ratio spikes confirm bearish market sentiment for FMG and is reflected in the decline of the stock price

Further, the put call ratio can be used by contrarian traders to signal the end of a bearish or bullish market. Spikes in the put call ratio occur when there is significantly larger put volume compared to call volume and can indicate the end of a trend and mark a potential entry point for contrarian traders. However, it is always better to have multiple spikes to confirm market sentiment rather than relying on a single, isolated spike in put call ratio.

Limitations


When interpreting spikes in the put call ratio, an important factor to consider is the option volume behind the spike. A large put call ratio spike of 8 can be produced from 16000 puts and 2000 calls being traded in one day or 16 puts and 2 calls. Large total option volume (including both calls and puts) with a spike in the put call ratio can confirm market sentiment; however, low total option volume with a spike may be an anomaly.

Isolated spike in Put Call Ratio does not indicate change of market sentiment
Figure 2. A single spike with relatively low option volume does not indicate a change in market sentiment or an end of a trend

Another shortfall may be determining the threshold at which a spike must pass to be considered an event. A highly volatile stock can have multiple spikes in the put call ratio, but may not indicate a shift in market sentiment. Again, it is best to observe the stock over a period of time to distinguish normal trading activity from changes in sentiment.

Conclusion


Every successful trader or investor requires a set of tools to determine best time to buy and sell. Together with other indicators and common sense, the put call ratio provides a simple but powerful tool that can provide useful insights into market sentiment to maximise profit.

Further Reading:

http://www.financialgoalie.com/explaining-the-putcall-ratio/