The put-call ratio is a calculation that investors often use to determine the market’s mood. A ‘put’ option gives a trader the right to sell an asset at a predetermined price whereas a ‘call’ option provides a trader with the right to buy an asset at a predetermined price. The market can be said to have a bearish sentiment when traders buy more puts than calls.
On the other hand, when they are buying more calls than puts, a bullish sentiment can be observed in the market.
Understanding the Put-Call Ratio
The PCR ratio formula is all about the number of traded put options that must be divided by the number of traded call options.
What different PCR ratios indicate:
- PCR value below 1: Indicates that more call options are being bought, compared to put options. This further shows that the investors or traders expect the market to follow a bullish trend ahead
- PCR value above 1: Indicates that more cut options are being bought, compared to call options. This further shows that investors or traders expect the market to follow a bearish trend ahead.
- PCR value equal to 1: Indicates that both the purchased call put option is roughly the same in number. This further shows that investors or traders expect the market to follow a neutral trend ahead.
Analysing a Put Call Ratio
Upon considering the option sellers, it is important to analyze how PCR should be interpreted. Option sellers play a major part in the market, and are different than the retail public as the latter is usually the buying side of the trade.
PCR or Put Call Ratio SituationsThe Interpretation
When PCR grows or increases as minor dips getting bought in when the market is facing an upward trend.When this happens, it indicates that the market is facing a bullish trend. This further indicates that the option sellers are constantly selling put options keeping the dips in mind as they expect the market to keep moving upwards.
When the PCR falls or decreases when the test of the market for the resistance levels is happening When this happens, it indicates the market undergoing a bearish trend. This further shows that call option sellers are occupying fresh positions mostly because they expect finite upward growth in the market.
When the PCR falls or decreases as the market is also trending downwards.When this happens, this also indicates a bearish trend. This further means that option sellers are constantly selling the call option strikes.
Importance and Limitations
As important as the put-call ratio or PCR is, it also has certain limitations that need to be looked into. Here are a few details about both these aspects of the calculation.
Importance:
- The Put Call Ratio or pcr ratio formula plays a major role in determining the direction the market is heading towards and its mood at a particular time
- The PCR helps the traders figure out when the best time is to place bets on the stocks
- Since the PCR helps with trading in a contrarian manner, it is used to analyze if a certain rise or fall in stocks in the market is too much or if a contrarian call can be made.
Limitations:
- The low awareness about the existence of a measurement like the PCR is one of its biggest limitations. A small market shift also serves as an important indicator.
- It is not a great idea to solely depend on the PCR when trading according to the prevailing market trends. It is important to also take other factors into account before making any such calls.
