Put-call ratio is one of the important fundas used by derivatives traders. By tracking PUT-CALL RATIO, traders can gauge an overall sentiment of the market. The ratio is calculated either on the basis of options trading volumes or on the basis of options open interest on a given day or period.
Put-Call Ratio (in terms of open interest) is calculated by dividing the total number of put options open interest of all the strikes to the total number of call options open interest of all the strike prices. We can apply same formula using total volumes of options to calculate put call ratio in volume terms.
A Put-Call Ratio less than one hints that traders have accumulated more of call options than put options. There are two alternatives in the above case, either position formed in call options are longs as majority of the participants are expecting market to remain bullish going forward or it can be due to writing (selling) of call options. On the flip side, if the Put-Call Ratio is above one suggests that traders have accumulated more of put options than call. Again, there are possibilities of these positions being on longs side expecting market to remain under pain going ahead or can be because of writing (selling) of put options.
Rising Put-Call Ratio suggests that market participants are shifting towards put options; while fall in Put-Call Ratio hints a shift towards call options. To have better understanding one should also know what positions are forming during such shift in options. There is an important thumb rule that helps analyzing whether the positions formed in options are long or short.
Build-up in options along with increase in IV’s (Implied Volatility) suggests long formation in the particular option
Build-up in options along with fall in IV’s (Implied Volatility) suggests short formation in the option.
Thus, as per the above rules, if Put-Call Ratio rises due to build-up in put options along with surge in IV’s indicates long formation in puts. While, rise Put-Call Ratio due to build-up in put options along with fall in IV’s indicates short formation in puts. Similarly, fall in Put-Call Ratio due to build-up in call options along with rise in IV’s suggests long formation in call option. While, fall In Put-Call Ratio due to build-up in call options along with fall in IV’s suggests short formation in calls.
The put-call ratio is primarily used by traders as a contrarian indicator when the values reach relatively extreme levels. This means if the ratio rises/falls to certain extent, market is expected to give a reversal as this high/low Put Call Ratio suggests market being either in over-bought or over-sold territory.
Thus, for the traders, the Put Call Ratio can be used to determine when the crowd is getting either too bullish or too bearish. Hence, option traders should keep a close eye on this ratio to take contra-calls on the market.