Introduction

Are you looking to dive into the world of investing? One key tool that investors use to assess the market’s mood is the put-call ratio. Understanding this financial measurement and its role is crucial for making informed investment decisions. Let’s explore the ins and outs, including the put-call ratio formula and its practical applications.

Define Put Call Ratio (PCR)

The put-call ratio is a derivative indicator used to measure the sentiment or emotions of the options market. The PCR serves as a contrarian indicator, which provides insights into bullish or bearish influence in the market. By analysing recent market movements, traders can make informed decisions and decide whether to make a contrarian call (i.e. going against the market trend) or not.

The ratio helps traders understand the overall mood of the market and is based on comparing put and call options. If traders buy more puts than calls, it signals a bearish sentiment, i.e. they are feeling negative about the market. Whereas, buying more calls than puts suggests a bullish market ahead, i.e. they are feeling positive.

Terminologies explained

Let us dive into certain terminologies used above.  

Options trading

Options trading are derivative market instruments which gives the bearer of the instrument the right, but, not the obligation to sell (put option) or buy (call option) the derivative instrument.

Call Option

Call options give the buyer the right to buy the option at a specified price within a specific period. Call buyers profit when the asset’s price goes up, and the seller can profit from the premium if the price drops below the specified price at expiration. Call options offer more flexibility than put options. They can be purchased for speculation, sold for income, or combined with other options in spread or combination strategies.

Put Option

A put option gives the buyer the right to sell a specified amount of an underlying security at a predetermined price within a set time. They differ from call options, allowing the holder to buy the underlying security at a specific price.

Put options gain value when the underlying asset’s price drops, its price volatility increases, and interest rates decrease. Conversely, put options lose value when the underlying asset’s price rises, its price volatility decreases, interest rates rise, and the expiration date approaches.

Formula/s for Put-Call Ratio (PCR)

There are two formulas for calculating the Put-Call Ratio (PCR).

PCR calculation (volume of trading)

The first formula calculates the ratio of volume of Put to Call Options traded over a particular day.

Put-Call Ratio (PCR) = Put Volume / Call Volume, where Put volume and Call volume are the number of Put and Call options traded over a specific day.

Say for instance, at a particular day the total volume of the Put options traded is 40,000, and the total volume of call options traded is 20,000. Therefore, here the Put to Call Options ratio for the day is 2:1.

When the PCR value is close to equal 1, the number of purchased Call options and Put options is about the same, showing a neutral market trend.

A PCR value below 1 indicates that more Call options are being purchased than Put options, suggesting investors are expecting a bullish market ahead.

Conversely, a PCR value above 1 means more Put options are being purchased than Call options, signalling that investors anticipate a bearish outlook for the markets.

PCR calculation (Open Interest)

This formula calculates the ratio of the total put open interest to the total open call interest on a particular day.

Put-Call Ratio (PCR)

= Total Put Open Interest in a particular day / Total Call Open Interest in a particular day

For instance, take the open interest for puts for Nifty 50 at 15,000 strike is 40,00,000 contracts and the open interest of calls for the expiry is 50,00,000 contracts. Therefore, for the same contract the Put-Call Ratio (Open Interest) is –

PCR (OI)

= 40,00,000/50,00,000

= 0.80

= 80%

The Put Call Ratio (PCR) of NIFTY 50 options with a strike price of 15,000. The PCR is much lower than 1, indicating that the number of outstanding call options exceeds the number of outstanding put options.

Based on this analysis, the trader has two options: interpret the low PCR as a bullish sentiment and take a bullish position, or interpret it as a sign of unwarranted market optimism and take a short position in the market.

A short call is a strategy used in options trading. In this strategy, a trader sells a call option, expecting the underlying asset’s price to decrease. On the other hand, the buyer of the option is anticipating an increase in the asset’s cost.

The Importance Of Put-Call Ratio (PCR)

Call options give the holder the right to buy a specific security at an agreed price within a set time period, while put options give the holder the potential to sell shares of the underlying security at a mutually pre-decided price within a specified period. Both types of options allow investors to make money from changes in the price of the financial instrument.

When the Put-Call Ratio goes up during small decreases in a market that is trending upwards, it is considered a sign that the market will likely continue to go up. This suggests that people who write put options are actively doing so during decreases, expecting the upward trend to continue.

Conversely, if the Put-Call Ratio goes down while the market tests resistance levels, it is seen as a sign that the market is likely to go down. This indicates that people who write call options are opening new positions, expecting either a small increase in the market or a correction.

Moreover, if the Put-Call Ratio decreases during a market that is trending downwards, it is also considered a sign that the market is likely to go down. This suggests that option writers are aggressively selling the call option strikes.

Put Call Ratio FAQs:

What is writing of a put option?

When an individual writes a put, they commit to purchase the underlying option at the strike price if the contract is exercised. In this instance, writing refers to selling a contract to initiate a position.

Who are Call-Writers?

The seller of a call option has the obligation, but not the requirement, to sell the shares at a predetermined price. By writing a call option, an individual sells the call option to the holder and is obligated to sell the shares at a strike price if the holder chooses to exercise it. In exchange, the seller receives a premium from the buyer.

What is the strike price?

The strike price is the mutually agreed price at which the buyer (buy in case of a call option) and the seller (sell in case of a put option) of an option enter into a contract or exercise a valid and unexpired option.

Which are the two methods used to find the Put-Call Ratio?

The first method divides the total put options volume traded in a day to total number of call options volume traded in the day. The second method takes into account the put options (open interest) to call options (open interest) traded in a day.

What are the limitations of PCR ratio?

PCR may prove to be misleading in highly volatile markets. Doing technical and fundamental analysis and taking a holistic view of the market is equally important when making a decision to purchase or sell the options.

How to interpret a high PCR?

A high PCR suggests a bearish market sentiment, indicating that more put options are traded than call options. This may signify that investors anticipate a market decline.

How to interpret a low PCR?

A low PCR indicates a bullish market sentiment, suggesting that more call options are traded than put options. This could mean that investors expect the market to rise.

Ready to invest like a pro? The Unicorn Signals app equips you with 100+ Free tools and knowledge you need to succeed. Download the Unicorn Signals app and gain access to daily stock lists, insightful market analysis and, much more!