What is the Put-Call Ratio & Learn How to Interpret it

When you walk into a room and sense bad energy, how do you do that? Most probably, the people in the room are in a bad mood. How do you read when you sense that the stock market is in a cranky mood? There are tools for that, too. One such measurement tool is the Put-call ratio. Don’t be too surprised; we’ll tell you what it is and how to use it.

Put-Call Ratio

What is the Put-Call Ratio?

A Put-call ratio is a measurement that is broadly utilized by an investor to gauge the overall mood of the market (as mentioned earlier). A put or a put option is the right to sell an asset at a price that was already decided. A call or call option is the right way to purchase an asset at a price that has already been decided.

If traders purchase more puts than calls, it will signal a rise in bearish sentiment. If they buy more calls than puts, it will be estimated that they notice a bull market ahead of them.

Let’s Understand Put Call Ratio in Depth

Put call ratio is calculated by dividing the amount 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 buyers for puts.

However, the ratio of 1 is not an accurate beginning point to measure sentiments in the market since there are typically more investors buying calls than buying putts. So, the typical put call ratio of 0.7 for equities is known as a good primary point for evaluation.

If the rising put-call ratio is more than 0.7, it means that equity traders are purchasing more puts than calls. This indicates that bearish sentiment is building in the market. Investors are either speculating that the market will go lower or hedging their portfolios if there is a sell-off.

A dropping put call ratio, or below 0.7 and reaching 0.5 is known as a bullish indicator. It says that there are more calls bought than puts.

How to Interpret the Put and Call Ratio?

If you go through any derivatives report from a stock brokerage, you will find a lot of emphasis on the PCR. You can also find out about ratios that prevail so you can decide on trading or not. So, if you know how to interpret put and call ratios, you can decide your trades and plan for them before you get into them.

This would help you with spreading the risks to a great extent. How exactly could you interpret the put call ratio in a practical/ or real time scenario?

One of the most crucial things that you need to understand is that the PCR is typically utilized as a famous contrarian indicator. This means the conclusions are usually counterintuitive. There is nothing like a range for Put Call Ratio or an ideal level for PCR. It is the trend that is more crucial.

At times of greed or fear, they will be reflected by high or low levels of PCR. Contrarians believe that PCR is usually headed in the wrong direction when the market is oversold or overbought, and that turns out to be a guiding factor. The rule of thumb in the market is never to trade or invest when the market is at an extreme (any form of extreme).

Though some experts would not usually agree with this, if you are new to the trading horizon, it is likely you would have to steer clear of these situations.

Contrarians believe that there is too much negativity in a bad market. Here, investors and retail investors will be buying too many puts to hedge their risks.

In any F&O market, skilled traders and institutions often write put options. A high PCR ratio indicates active put purchasing by small and medium-sized investors, as well as aggressive selling by more experienced traders. Typically, skilled traders sell when they feel the downside is minimal. This might indicate that markets are bottoming out.

The opposite is true when markets have risen, but the PCR has fallen. This indicates that small and medium-sized investors are purchasing calls massively while savvier investors are selling them. This suggests that markets may have reached their peak.

Why Is Put Call Ratio Important?

There is a key significance in put call ratio, and that is:

  • It can be a good tool to assist you with determining the market sentiment in a particular time period.
  • It will aid you in understanding the direction of the price changes of the underlying securities. In turn, it will enable you to organize directional bets on orders.
  • This ratio will be useful to analyze the overall trading behaviour of the market participants.
  • It is essential to help traders escape the herd mentality when it comes to trading in a provided market.

Does PCR have drawbacks? Of course, it does!

What are the Limitations of PCR?

The limitations of this ratio are:

A lot of company stocks will not make options available. This will make it impossible to tally the PCR on most stocks.

  • In order to come out with effective outcomes, one needs to use this ratio with several other technical indicators, too.
  • Though it is a contrarian indicator, investors need to weigh in other prominent attributes before they can bet on prevailing market sentiments.
  • Investors need to know how to read the put call ratio chart in precision, even a small change will serve as an essential indicator of the market movements and moods.

Conclusion

That is a wrap! It could be hard to understand what the market situation is, and if you can dive into making investments or trades at the moment. One such useful way of getting this done is through PCR. Hope you understood all the important attributes of this ratio, and how to interpret it with perfection.

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