What Is the Put-Call Ratio?
- Put-call ratios are indicators of relative trading volumes of put options to call options in the options market.
- A put-call ratio above 1 is considered to be an indicator of a selloff while a put-call ratio below 1 is an opportunity to buy.
- Some traders use the put-call ratio as a contrarian indicator, buying when the ratio is above 1 and selling when the ratio is below that figure.
Understanding the Put-Call Ratio
A put is a derivative instrument that gives the holder the right, but not the obligation, to sell a specified amount of an underlying security at a pre-determined price within a specified time frame. A call works in the same way, but gives its holder the right to buy rather than sell.
The put-call ratio provides information about relative trading volumes of an underlying security's put options to its call options. It has long been viewed as an indicator of investor sentiment in the markets, where a large proportion of puts to calls indicates bearish sentiment, and vice versa.
Technical traders use the put-call ratio as an indicator of performance and as a barometer of overall market sentiment. Put-call ratios on broader indexes such as the S&P 500 are also used as more general gauges of market climate.
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Calculating the Put-Call Ratio
The put-call ratio shows an 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.
Put-Call Ratio Interpretation
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. That's because when the ratio is high it suggests that people are either expecting or protecting more readily against a future decline in the price of the underlying. A put-call ratio between 0.5 and 1 is considered a sideways trend in the markets.
Some also view the put-call ratio as a contrarian indicator. Traders know that derivatives are used to do more than place bets; they are used as hedges and insurance. If there's a lot of insurance being placed to the sell side, it means traders are worried about prices falling.
Some traders 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.
Put-Call Ratio Example
Sheila is a trader who uses put-call ratios as a tool to aid in her contrarian investment strategy. She buys on days when the put-call ratio is above 1 (or a majority of traders are selling) and sells on days when the put-call ratio is below 1 (or a majority of traders are buying).