The
put-call ratio is a popular tool specifically designed to help individual investors gauge the overall
sentiment (mood) of the market. The ratio is calculated by dividing the number of traded
put options by the number of traded
call options. As this ratio increases, it can be interpreted to mean that investors are putting their money into put options rather than call options. An increase in traded put options signals that investors are either starting to speculate that the market will move lower, or starting to
hedge their portfolios in case of a sell-off.
Why should you pay attention to this? An increasing ratio is a clear indication that investors are starting to move toward instruments that gain when prices decline rather than when they rise. Since the number of call options is found in the denominator of the ratio, a reduction in the number of traded calls will result in an increase in the value of the ratio. This is significant because the market is indicating that it is starting to dampen its bullish outlook.
The put-call ratio is primarily used by traders as a
contrarian indicator when the values reach relatively extreme levels. This means that many traders will consider a large ratio a sign of a buying opportunity because they believe that the market holds an unjustly bearish outlook and that it will soon adjust, when those with
short positions start looking for places to
cover. There is no magic number that indicates that the market has created a bottom or a top, but generally traders will anticipate this by looking for spikes in the ratio or for when the ratio reaches levels that are outside of the normal trading range.
This indicator can be created within a spreadsheet with relative ease. The data used for the calculation is available through various sources, but most traders will use the information found on the
Chicago Board Options Exchange (CBOE) website.
To learn more, see
Forecasting Market Direction With Put/Call Ratios.
