• Feb, 2024
• By SmartBulls Team

What is Put Call Ratio?

The Put-Call Ratio is a commonly used indicator in options trading that compares the number of put options to call options traded in the market. It is calculated by dividing the total number of outstanding open interest of put options by the total number of outstanding open interest of call options.

How to calculate the Put Call Ratio?

The Put-Call Ratio compares the total number of outstanding open interest of put options to that of call options traded in the market. It provides a snapshot of investor sentiment and helps traders gauge prevailing market dynamics.

To calculate the Put-Call Ratio:

1. Determine the total open interest of put options for a specific expiration date.

2. Determine the total open interest of call options for the same expiration date.

3. Divide the total open interest of put options by the total open interest of call options.

How to Interpret the Put Call Ratio

1. Bullish vs. Bearish Sentiment: Put-Call Ratio BELOW 1 suggests bullish sentiment, indicating a higher trading volume in call options compared to put options. This implies that more traders are anticipating rising prices. Where as Put-Call Ratio ABOVE 1 indicates bearish sentiment, signifying a higher trading volume in put options relative to call options. This suggests that more traders are speculating on falling prices.

2. Extreme Levels and Market Reversals: Extreme readings in the Put-Call Ratio, whether exceptionally high or low, can signal potential market reversals or overbought/oversold conditions. Very high readings may indicate excessive bearishness, potentially signaling a contrarian buying opportunity. Conversely, very low readings may suggest excessive bullishness, potentially signaling a contrarian selling opportunity.

3. Contrarian Indicator: The Put-Call Ratio is widely used as a contrarian indicator, meaning that extreme readings often precede market reversals. When sentiment becomes overly optimistic or pessimistic, it may signal a reversal in market direction.

Importance and Example

Consider a scenario where the Put-Call Ratio for a particular stock's options reaches 0.8. This indicates that the total open interest of put options is 80% of the total open interest of call options. As the ratio is below 1, it suggests a bullish sentiment, with more traders betting on rising prices.

What is a Good Put/Call Ratio?

While there is no universally defined threshold for a "good" Put-Call Ratio, traders often look for extreme readings to identify potential trading opportunities. Extremely high or low ratios relative to historical averages or market norms may signal significant shifts in sentiment and potential trading opportunities.

The Put-Call Ratio serves as a valuable tool for options traders, providing insights into market sentiment and potential trend reversals. However, it should be used in conjunction with other technical indicators and analysis techniques for comprehensive decision-making. By understanding and interpreting the Put-Call Ratio effectively, traders can gain a deeper understanding of market dynamics and make informed trading decisions.