The put to call ratio (PCR) is a very important measure for options traders. It helps traders determine the overall mood of a market. So, if you are interested in learning all about the put to call ratio, then you are on the right platform.
Because we are going to define the put to call ratio and discuss how to use it in today’s post. So, stay tuned and keep reading.
Put to call ratio definition
The put to call ratio is a contrarian indicator that options traders use to gauge the mood of the options market. This measure determines options buildup and helps traders determine whether the current rise or fall in the market is excessive. Thus, it enables traders to understand whether it is time to take a contrarian call or not. Moreover, the put to call ratio calculation is based either on options trading volume or options contracts during a given period of time.
How to calculate the put to call ratio?
There are two methods to calculate the put to call ratio.
- You can calculate the ratio by dividend put trading volume by call trading volume on a particular day or time period. The formula is;
PCR (volume) = Put trading volume ÷ Call trading volume
- You can also calculate this ratio by dividing the number of open interests in a put option by the number of open interests in the call option. The strike price and expiry date of both options contracts must be the same.
PCR (OI) = Open interest on a put option ÷ Open interest on a call option
How to interpret the put to call ratio?
The interpretation of the PCR is quite easy. You can interpret it in the following ways.
- PCR above 1 indicates that options buyers are more interested in buying put options contracts as compared to calls. That suggests a bearish sentiment in the options market. Moreover, if the value is well above 1, it means the market is oversold. Therefore, you can expect an upcoming reversal and the market could go up.
- PCR below 1 indicates that options buyers are more interested in buying call options contracts as compared to puts. That suggests a bullish sentiment in the options market. Moreover, if the value is well below 1, it means the market is overbought. Therefore, you can expect an upcoming reversal and the market could go down.
- Whereas, if you get a value between 0.9 and 1.1, it suggests that the market is neutral. In other words, such a value indicates that neither bullish nor bearish sentiment is in control of the market.
Usage of the PCR
Options traders generally use the put to call ratio as a contrarian indicator when values reach the highest levels. That said, traders consider high values such as 1.4 as a buying opportunity. Why so? Because high values indicate extremely bearish sentiment and a reversal is imminent. Conversely, traders consider low values such as 0.5 as a selling opportunity. That is because low values indicate extremely bullish sentiment and it may soon adjust.
However, it must be remembered that the PCR isn’t a magic indicator that pinpoints a top or bottom. It is just an indication and you need to initiate trades after further confirmation. What do experienced traders do with the PCR? They generally look for spikes in the ratio or when the ratio gives extremely high or extremely low values. When the ration gives them this information, they anticipate the market’s top or bottom.
The PCR interpretation isn’t only confined to looking at the value it gives. Instead, it is also important to look at the demand for both puts and calls. As call is the denominator in the formula, the reduction in demand for call options will give a higher PCR value. This is important to note here because only a reduction in call options demand is pushing the ratio higher without an increase in demand for put options. So, you can conclude that bulls are in watch and wait for mode. Additionally, it also indicates that although there is a bearish sentiment, the market isn’t completely bearish.
On the flip side, the reduction in demand for put options will give a lower PCR value because a put is a denominator. Again, it is important to note here that only a reduction in put options demand is pushing the ratio lower without an increase in demand for call options. So, you can infer that bears are sitting on the sidelines. Additionally, it also indicates that although there is a bullish sentiment, the market isn’t completely bullish.
The put to call ratio is an important measure for options traders. They use it to gauge the overall sentiment in the options market. Moreover, it is pretty simple to calculate as well as interpret the PCR. A PCR value above 1 suggests a bearish sentiment in the market that may adjust soon. Conversely, a PCR value below 1 indicates a bullish sentiment in the market and the market may reverse very soon. Furthermore, traders use the put to call ratio as a contrarian indicator because extremely high or low PCR values indicate extremely bearish or extremely bullish sentiment in the market.