Prospective investors, prior to investing their funds, utilise certain financial tools to evaluate the temperament of the financial marketplace. One such tool is the put-call ratio, which helps individuals to analyse the market in multiple ways. However, to use the put call ratio appropriately, one must be clear with the basics and have a thorough understanding of the phenomena. Thus below, we have provided a comprehensive guide that will give you a clear understanding of this distinctly useful financial tool.
Pull call ratio: defined
Put call ratio or PCR is a typical indicator of derivate. It is developed to help traders effectively evaluate the temperament of the options market. The ratio is calculated in either of the two ways:
Put call ratio is used as a contrarian indicator which is particularly responsible for options build up. An indicator so important assists the individuals in examining the degree of bearish or bullish trends present in the financial market. In layman’s language, it enables investors to comprehend whether the latest decrease or increase in the financial market is extreme or not. Depending on this detail, investors determine if they should go for a contrarian call in the existing market. This investment plan entirely depends on the selling and buying of investment segments against the existing market situation to overcome pricing manipulations in the current securities market.
Calculation of put call ratio
It is important to have a thorough understanding of the various elements of the ratio before going any further with the formula. The put option gives traders the liberty to buy assets at prefixed rates while the call option allows the traders to buy assets at the present market rate. Put call ratio is computed using the two ways given below.
On the basis of open interest of a particular day
To calculate PCR using this formula, the trader needs to divide the open interest present in a put contract of a particle day by the open call interest of that same day. Hence, the formula is as following:
Put call ratio (open interest) = put open interest ÷ call open interest
On the basis of options trading’s volume
To use this formula, the trader needs to divide the put trading volume of a particular day by the call trading volume of the same day. Hence, the formula is as following:
Put call ratio (volume) = put trading volume ÷ call trading volume
In the formula, the put volume signifies the gross put options that are initiated in a particular time period. On the other hand, call volume signifies the gross call options that are initiated over a particular time period. However, the understanding of this type of ratio totally differs depending on the kind of investor.
Below we have provided a simple example of a put call ratio for better understanding. An investor named Mr. Bhagat decides to use the PCR to gauge the market sentiment of a specific security. The calls and puts undertaken are given below.
Put call ratio= gross put open interest ÷ gross call open interest
= 1100 ÷ 1500
As the result is below 1, it signifies that investors are purchasing call options more than put options. If you take a closer look, it can be interpreted that investors are predicting a bullish influence in the upcoming future.
Put options have proven to be beneficial for limiting risks related to market fragility. Besides, it may also assist traders in venturing into the declining market. On the contrary, call options are broadly used to limit risks of the financial assets against the sturdy suit of the financial market or they can also be used to gamble on its advances. Based on the put call ratio analysis, the following can be conjectured.
A put call ratio of more than 1 signifies that put volume has surpassed the call volume. This indicates a growth in the bearish temperament.
A put call ratio that is less than one signifies that the call volume has surpassed the put volume. It indicates a bullish trend in the market.
In spite of this, it should be remembered that a put call ratio that is exactly 1 is not reliable enough to gauge the market temperament as traders are more into purchasing call options when compared to put options. The market sentiment can be appropriately evaluated if the average put call ratio is at least 0.7. Having said that, a put call ratio above 0.7 or 1 indicates that traders are mostly buying put options than call options. As this indicates a bearish temperament, a significant number of investors limit the financial assets of their portfolios due to sell-offs or go ahead and invest in a declining market. On the contrary, a dwindling put ratio less than 0.7 and 0.5 indicates bullish sentiments.
Put call ratio as the contrarian indicator
PCR is utilised as a contrarian indicator by traders at that time when the values are unusually high. For instance, if the PCR is 1.5, the traders use this as a lucrative opportunity for purchasing as the common belief in such a situation is that the market temperament is excessively bearish and will adjust soon. Nevertheless, there is no particular figure that can truly signify whether a market is about to hit the bottom or reach the top. However, traders try to predict this by speculating the leaps in the ratio or if the ratio goes above the regular trading levels.
Put call ratio and its limitations
Put call ratio as a financial tool for measurement bears certain limitations such as the ones given below.
It is not always capable of representing the essential nuances related to the market temperament.
Most of the companies do not illustrate their options to the investors, which makes it difficult to calculate the put call ratio of the stocks.
Although PCR is a contrarian indicator, investors should study other crucial aspects prior to gambling on the existing market temperaments.
The resultant outcomes will prove to be effective only if several other important indicators are used along with PCR.
Investors have to know the appropriate way to read the PCR chart. This is because even a minute shift can signify a plausible movement in the financial market.
Keeping all these aside, investors must have a clear idea of the place where the PCR ratio is positioned to make the best use of it. Besides all these, the most important factor that any investor must take into consideration is their financial objectives and their risk-bearing ability prior to choosing market sentiments over security.