What is the 'Put-Call Ratio'
The put-call ratio is an indicator ratio that provides information about the trading volume of put options to call options. The put-call ratio has long been viewed as an indicator of investor sentiment in the markets. Technical traders use the put-call ratio as an indicator of performance and as a barometer of the overall market sentiment.
BREAKING DOWN 'Put-Call Ratio'
There are two main types of financial instruments: the actual instrument or security and the instruments that derive their value from those underlying instruments. The second group of instruments are aptly called derivatives; they don't exist without the underlying asset. Most derivative products are based on an event, and the star of the event is the underlying asset. For futures, the underlying asset is a commodity; for options, the underlying asset is a security. Two financial instruments that derive their value from the underlying security are puts and calls.
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 is a derivative instrument that gives the holder the right, but not the obligation, to buy a security. Holders of puts are expecting the price of the security to go down. Investors in calls are expecting the price of the security to go up.
The put-call ratio shows put volume relative to call volume for the general market and is calculated by dividing put volume by call volume. When there are more puts than calls, the ratio is above 1. Likewise, when call volume is higher, the ratio is less than 1. Analysts use the ratio to measure market sentiment.
One way to interpret the put-call ratio is to say that a higher ratio means it's time to sell and a lower ratio means it's time to buy. However, traders also view this as a contrarian indicator. Traders know that derivatives are used to do more than place bets; they are used as insurance. If there's a lot of insurance being placed to the sell side, it means traders are worried about prices falling. Some traders will buy when the put-call ratio is above 1, meaning the market is out of balance to the sell side, and sell when the put-call ratio is below 1, meaning the market is out of balance to the buy side. These traders are looking to make money on the correction. The interpretation of the ratio is left to the analyst's or trader's investment philosophy.