What Does Put Call Ratio(PCR) Mean?

Stock market investors often use various financial tools to analyze the market's attitude before investing their money in securities. One such advantageous tool is a put-call ratio. Investors have used the put-call ratio (PCR), a statistical indicator, to evaluate market sentiment. Investor Martin Zweig created the put-call ratio. He used this tool to forecast the 1987 stock market crash. This key technical indicator aims to depict the mood of the stock market. The proportion of put and call options issued on a specific market index is expressed by the ratio. Depending on how analysts interpret this data, the near-term market forecast will be either bullish (positive) or bearish (negative). The basic premise stipulates that the ratio of predictions made against the market to those made in its favor should indicate the prevailing perception among investors. PCR determination as its successful implementation can build your wealth to a higher degree. Sometimes not only amateur but professionals may originate few doubts regarding put-call ratio. The clarity of  terms is necessary if you want to generate profit through this investment tool. Let's explore the term "PCR," the role of "PCR," how it is determined, and how traders utilize it to predict the true direction of the stock market.

What is a Put-Call Ratio?

The entire number of available put options divided by the total number of existing call options during the same period generates a derivative ratio called the put-call ratio. When the market is in a bullish mindset, traders buy call options; meanwhile, when the market is in a bearish mood, traders buy put options. The writer is another name for the person who sells an option. When an option holder decides to exercise their contract, the writer of the option is compensated with a premium fee in exchange for the risk of having to buy or sell shares. Investors who are interested in trading call and put options and other options strategies should do thorough research before following various option trading guides. Many traders estimate the PCR using the open interest for a specific period. And by using volumes, many derive the put-call ratio. Volumes represent market flow, whereas open interest (OI) represents the stock. An arbitrage opportunity emerges if the put and call option prices diverge to the point where this relationship is no longer valid. This implies that experienced traders could benefit without taking any risks. In liquid markets, these opportunities are unusual and transient.

How to Explain a Put-Call Ratio?

The put-call ratio (PCR) is a prominent method for evaluating the options market situation. Its evaluation and application can make you profit.The ratio, a counter-intuitive indicator incorporating options building, enables traders to analyze whether a current market decline or rise is extreme and whether it is suitable to make a contrarian call. Either the volume of options trading or the number of options contracts on a certain day or period is used to determine the ratio. The explanation of the put-call ratio can be carried out by interpreting the put-call ratio in the manner specified below.

• A PCR below one (1) indicates that investors are betting on an imminent positive trend. It shows that they are buying more call options than put options.

• A PCR above one (>1) indicates that investors are speculating on a bearish trend going forward. This implies that they are buying more put options than call options.

• A PCR of one (=1) denotes a neutral trend moving ahead and implies that investors are buying the same number of put options as call options.

• A PCR below 0.7 is often seen as a strong bullish attitude, while a PCR above 1 is typically seen as a strong negative sentiment. However, no PCR is considered perfect.

Such PCR values generally help the participants fence their portfolios to limit potential losses in the case of a large sell-off or if investors are speculating that the markets will drop. The put-call ratio, effectively a contrarian sentiment indicator, is profitable when determining market sentiment. There is a possibility for arbitrage when one side of the put-call parity equation is larger than the other. To generate an essentially risk-free profit, you can sell the more costly half of the equation and buy the less expensive side.

What are a put and a call?

The put-call ratio helps traders and investors decide when to trade. It is determined mainly based on trading volumes. It considers the predetermined value of all open positions. Investors purchase more calls than puts, resulting in a PCR ratio that is typically smaller than one. In those terms, volatility aids in allowing the investor to make a profit or a loss. Let us expressly understand the significance of these terms.

Call option 

Call options offer the buyer the buying option. Though, They are not obliged to buy the underlying asset at a given strike price before the call option's expiration date. You pay the option seller a premium. Some of the variables that affect the per-contract cost are the price of the underlying asset, the strike price, and the remaining time before the option expires.

For instance, since the standard for stock options is 100 shares per contract, three contracts would offer you the opportunity to purchase 300 shares at a specific price by a particular date. Besides the contract price, the broker may also charge a fee for trading options.

Put option

When you purchase a put option, you have the choice to sell. Though, you are not obliged to dispose off the underlying asset at the specified strike price before the option expires. Policies are options, just as insurance is. Even if the underlying asset is worth less than the strike price, the buyer of a put option may sell the underlying asset at a higher price on a specific date to gain profit.

The contract premium and any broker costs are the same as those previously mentioned for call options. Put options' value rises when the value of the underlying asset falls. The value of the underlying asset rises since they allow the buyer (also known as the holder) the right to sell.

The Calculation of the Put-Call Ratio

The put-call ratio is estimated by dividing the number of traded put options by the number of traded call options. The calculation is relatively easy. We have thoroughly derived the below put-call ratio. The PCR can be calculated for indexes, stocks, and the entire derivative market in addition to just individual equities.

Two formulas are available for calculating the put-call ratio:

According to the volume of options trading, the PCR formula is:

Put Call Ratio Formula: Volume of Puts Traded/Volume of Calls Traded

Or,

Based on the open interests of a specific day, the PCR formula is:

Put-Call Ratio Formula: Open Interest of Puts/Open Interest of Calls

For instance:

Mr. Mandeep, an investor, intends to utilize the put/call ratio to determine the market's mood.

PCR = Total Put Open Interest/Total Call Open Interest

1300/1700 = 0.7778

Significance: Because the PCR is smaller than 1, market participants are optimistic about more call options than put options, which denotes a bullish outlook for the future.

Put-Call Ratio helps traders comprehend the direction of the underlying security's price movement. They can then organize directional bets on orders as a result. It is essentially a contrarian signal, which aids traders in avoiding the herd mentality when investing in a certain market.

Put-Call Ratio Examples

The put-call ratio works well as a tool for figuring out the current state of market sentiment. We derived its calculation from signifying the importance of the put-call ratio. Now, let us look at more examples to understand the concept better:

Example #1

Mr. Shubham, an investor, plans on using the put-call ratio to measure the market direction of a specified stock. The PUT and ANS call started as follows:

Total put open interest/ Total call open interest = PCR

= 1300/1700

= 0.7647

 Significance: The fact that the result is less than 1 shows investors are purchasing more call options than put options. It also represents the fact that investors believe there will be a bullish trend.

Example #2

Assume that in March 2022, the price of Apple stock on the NASDAQ is $250. By purchasing a call option, someone bets that it will increase to $280 (the strike price) by April 2022. If the prognosis is accurate, they will make a $30 profit.On the other hand, someone bets (purchases a put option) that the price of Apple stock will fall to $230 by April 2022. And they will receive $20 if the price drops to $230 before the specified expiration date. They will earn $20.

Many individuals utilize the put/call ratio as a contrarian indicator of market direction. As more calls are being purchased than puts, a PCR value below 0.7 and close to 0.5 typically indicates a strong bullish market attitude. On the other hand, a PCR value greater than 1.0 indicates a strong bearish market mood, with more put options being purchased than call options. Such Put-Call Ratio values typically suggest that participants are trying to hedge their portfolios to limit potential losses in the case of a large sell-off or that investors are speculating that the markets will drop.

Why Should Traders Use the Put-Call Ratio?

Contrarian investing is a strategy that emphasizes going against the current market sentiment. The put-call ratio is a contrarian indicator that traders should use. During significant events like earnings calls, it is typically advantageous to analyze the put-call ratio to see how the market interprets the future picture. When the ratio reaches extreme levels, it typically means that the market's current attitude is either extremely bullish or overly bearish. Briefly, the following suggestions underline the main reason traders should use the put-call ratio.

• The put-call ratio works well as a tool for figuring out the current state of market sentiment. It helps traders comprehend the direction of the underlying security's price movement. They can then organize directional bets on orders as a result.

• Writers who write aggressively during market declines are signs of impending bullishness. The value of the put-call ratio is rising during a correction in an up-trending market while the implied volatility is falling.

• When the put-call ratio rises with an abrupt rise in implied volatility as the Nifty Spot is getting close to its resistance levels, this may signify a possible bearish outlook.

• Put-Call Ratio is a contrarian signal that helps traders avoid herd mentality when investing in a specific market. This ratio is effective in analyzing market participants' overall trading patterns.

Nevertheless, this derivative indicator has its challenges. If investors want to successfully counter market sentiment concerns, they must learn more about them. Traders should utilize the put-call ratio as its trend and interpretation govern investors' decision-making.

How to Trade with a Put-Call Ratio

Put-Call Ratio, sometimes known as PCR, is a straightforward ratio. Both traded volumes and outstanding open interest are used in its calculation. Due to the nature of derivatives' leverage, most traders utilize the Put-Call Ratio based on Open Interest (PCR OI), which gives OI a greater weight than traded volumes. The PCR OI is determined by dividing the number of puts open interest by the number of open calls interest on a given day.Total number of puts minus the total number of calls equals the PCR OI.

The Put-Call Ratio increases when total open interest in puts is greater than total open interest in calls, while it decreases when the reverse is true. The PCR cannot be examined in isolation; rather, it should be considered in relation to its range or in light of the start of new series. A rising PCR implies that the markets appear bullish because more puts than calls were traded, but a decreasing PCR shows the exact reverse, or a bearish viewpoint.

Let's explore this point in more detail. There isn't anything comparable to a PCR range or optimum level. The trend itself is more significant to traders. Here are some important guidelines for PCR interpretation utilized by traders. 

• Normally, substantially high or significantly low levels of PCR indicate periods of greed and fear, respectively. According to contrarians, when markets are overbought or oversold, PCR typically moves in the opposite direction and becomes a significant guiding factor.

•  Never trade or make an investment while the markets are at an extreme is the general rule in the markets. Although some experts would disagree with this assertion, if you are new to trading, you may want to avoid it. The general rule in the markets is never to trade or make an investment while the markets are at an extreme. 

• Although some experts could disagree with this assertion, it is likely that you will want to avoid taking any risks in your initial trades if you are a novice trader. Assume that the market index has corrected by 15% during the past month, and that the PCR (OI) has recently increased substantially. What do we make of this circumstance?

For example, derivatives analysts may use Open Interest, Option Concentration, Volatility, Volatility Smile/Skew, Rollover, Rollover Cost, Basis, Cost of Carry, Put Call Ratio, and Call Put Ratio to understand market action. All of them are significant indicators, but Put-Call Ratio has its own rationale to predict market movement more accurately.

Final Thoughts

We have understood the straightforward tool for determining market sentiment ie the put-call ratio. As you begin trading options, the Put-call ratio is one thing you may consider. Investors can utilize the PCR on individual equities, even though it is frequently employed on large market indexes. It can be calculated by simply dividing the market's volume of puts by that of calls for security.You may begin trading options on many platforms, websites, and apps. Investors can also consult a collection of books and other instructional materials concerning this tool.

Overall, it is recommended that one employ more than just the Put-Call ratio when making trading decisions because it is improbable that any one ratio can accurately identify when the market is at its top or bottom. When deciding whether to buy, sell, or hold a security, the PCR should be utilized in conjunction with other market indicators rather than on its own. Everybody is aware that traders in the options market, particularly those who purchase options, are not known for their high success rates. As a result, some traders think it is perfectly rational to engage in trading that is at odds with such options trades. Trading must be wrong if it has such a poor track record, right?  It suggests that traders may succeed in the markets if they depart from the "typical" options trading herd. After all, historically, the options trading community tends to make most of its trades incorrectly. It wouldn't be inaccurate to state that these option buyers lose about 90% of the time while trading. Not all option traders experience failure, though.