What is the Put-Call Ratio
The put-call ratio is an indicator ratio that provides information about the relative trading volumes of an underlying security's put options to its call options. The put-call ratio 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.
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.
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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, 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. However, traders may also view this 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 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.