BREAKING DOWN 'Put-Call Ratio'
Puts and Calls
A put is a derivative instrument that gives the holder the right, but not the obligation, to sell a security. A call, on the other hand, is a derivative instrument that gives the holder the right, but not the obligation, to buy a security. Holders of puts are expecting (or hedging against) the price of the security to go down. Owners of calls are expecting (or speculating on) the price of the security to go up.
The put-call ratio shows a underlying security's put volume relative to its call volume over a period of time (typically a day or week) and is calculated simply by dividing put volume by call volume. When there are more open positions in puts than calls, the ratio is calculated to be above 1. Likewise, when call volume is higher, the ratio is less than 1. Analysts use the ratio to measure market sentiment.
The put-call ratio is a popular tool used by investors to gauge the overall sentiment (mood) in the market. The ratio measures how many put options are being traded relative to call options. The put-call ratio is calculated by dividing the number of traded put options by the number of traded call options.
How The Put-Call Ratio Is Interpreted
A put-call ratio of 1 indicates that the number of buyers of calls is the same as the number of buyers for puts. However, a ratio of 1 is not an accurate starting point to measure the sentiment in the market, since most investors buy calls rather than puts. As a result, an average put-call ratio of .7 for equities is a good basis for sentiment.
A rising put-call ratio or greater than .7 or exceeding 1 means equity traders are buying more puts than calls and indicates a bearish sentiment is building in the market. An increase in traded put options signals that investors are either speculating that the market will move lower or are hedging their portfolios in case of a sell-off.
A falling put-call ratio or below .7 and approaching .5 is considered bullish since it means more calls are being bought versus puts. In other words, the market has a bullish sentiment.
Why Pay Attention to The Put-Call Ratio?
An increasing ratio is an indication that investors are getting bearish or perhaps are thinking the recent market moves higher might be overdone. As a result, the put-call ratio can help investors gauge market sentiment before the market turns. However, it's important to look at demand for both the numerator (puts) and the denominator (calls).
Since the number of call options is found in the denominator of the ratio, a reduction in the number of traded calls will increase the value of the ratio. This is significant because fewer calls being bought can push the ratio higher without an increased number of puts being purchased. In other words, we don't need to see a large number of puts being purchased for the ratio to rise. As bullish traders sit on the sidelines, by default, the result is there are more bearish traders in the market. It doesn't necessarily mean the market is bearish, but rather that bullish traders might be in a wait-and-see mode until an upcoming event like an election, a Fed meeting, or an economic data release.
It's helpful to watch the put-call ratio to see how the market views recent events or earnings, particularly when the ratio is at extreme levels as it might indicate an overly bearish or an overly bullish sentiment. For this reason, investors use the put-call ratio as a contrarian indicator.
A Contrarian Indicator
Contrarian investors use the put-call ratio to determine when market participants may be getting either overly bullish or too bearish. An extremely high put-call ratio (the market is bearish) would be seen by a contrarian as a bullish signal since it would indicate the market is too bearish. In other words, a high ratio would be a sign of a buying opportunity because contrarians would see that the market is unjustly bearish and would expect the market to adjust and bounce higher.
Conversely, when the ratio is extremely low, contrarians might get worried that the market is too bullish or that the recent bullish moves are overdone. As a result, they would position themselves for a market pullback by either buying puts, placing stop-loss orders, or placing take-profit orders in the event the market comes back down.