What Is a Put-Call Ratio?
The put-call ratio is a measurement that is widely used by investors to gauge the overall mood of a market.
A "put" or put option is a right to sell an asset at a predetermined price. A "call" or call option is a right to buy an asset at a predetermined price.
If traders are buying more puts than calls, it signals a rise in bearish sentiment. If they are buying more calls than puts, it suggests that they see a bull market ahead.
- A put option gets the trader the right to sell an asset at a preset price.
- A call option is a right to buy an asset at a preset price.
- Traders buying more puts than calls indicates a bearish market.
- If they are buying more calls than puts, watch out for a bull market ahead.
Understanding the Put-Call Ratio
The put-call ratio is calculated by dividing the number of traded put options by the number of traded call options.
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 sentiment in the market because there are normally more investors buying calls than buying puts. So, an average put-call ratio of 0.7 for equities is considered a good basis for evaluating sentiment.
- A rising put-call ratio, or a ratio greater than 0.7 or exceeding 1, means that equity traders are buying more puts than calls. It suggests that bearish sentiment is building in the market. Investors are either speculating that the market will move lower or are hedging their portfolios in case there is a sell-off.
- A falling put-call ratio, or below 0.7 and approaching 0.5, is considered a bullish indicator. It means more calls are being bought versus puts.
The put-call ratio can be an indicator of how the market views recent events or earnings. A ratio at either extreme suggests an overly bearish or overly bullish sentiment.
The data used to calculate put-call ratios are available through various sources, but most traders use the information found on the Cboe Options Exchange website.
The put-call ratio helps investors gauge market sentiment before the market turns. However, it's important to look at the demand for both the numerator (the puts) and the denominator (the calls).
The number of call options is found in the denominator of the ratio. That means 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, the result by default is that there are more bearish traders in the market. It doesn't necessarily mean the market is bearish, but rather that bullish traders are in a wait-and-see mode until an upcoming event occurs like an election, a Fed meeting, or a release of economic data.
The average put-call ratio for equities that is considered a good basis for evaluating sentiment.
It's helpful to watch the put-call ratio to see how the market views recent events or earnings. When the ratio is at extreme levels, it might indicate an overly bearish or an overly bullish sentiment.
For this reason, some investors use the put-call ratio as a contrarian indicator.
A Contrarian Indicator
Contrarian investors use the put-call ratio to help them determine when market participants are getting overly bullish or too bearish.
An extremely high put-call ratio means the market is extremely bearish. To a contrarian, that can be a bullish signal that indicates the market is unduly bearish and is due for a turnaround. A high ratio can be a sign of a buying opportunity to a contrarian.
An extremely low ratio means the market is extremely bullish. A contrarian might conclude that the market is too bullish and is due for a pullback.
No single ratio can definitively indicate that the market is at its top or its bottom. Even the levels of the put-call ratio that are considered extreme are not set in stone and vary over the years.
Typically, investors compare current ratio levels to the average over some period of time to gauge if sentiment has changed recently. If the put-call ratio has fluctuated in a tight range and suddenly bumps higher, traders might see this as a sudden increase in bearish sentiment and make their moves accordingly.