Options Trading as a Derivative instrument is of prime importance to traders as it gives them the power to express their Bullish/Bearish views in the market by paying a small amount of premium. If you are a buyer of the option and want to express your bullish view, then you could do so by buying a Call Option and similarly the bearish views could be expressed by buying a Put Option. In this article, we will look at what is a put call ratio in options trading and how it can be used to analyze options data and improve trading in options. We will also understand the importance of the put call ratio and its calculations.
A Complete Option Trader
To be a complete options trader, one needs to be able to understand a lot more than just having a simple understanding of Call Options and Put Options. An in-depth understanding of the various facets of the Option Chain like Open Interest, Implied Volatility, last traded price, various Option greeks, Put Call Ratio etc is very important.
Through this discussion of ours, we will try and understand, what Put Call Ratio is and how can one interpret it to use it to make an informed trade decision.
What is Put Call Ratio in Options Trading?
Put Call Ratio (PCR) is a tool that is used by traders to gauge and understand the overall sentiment of the market. Bearish views in the market can be expressed by buying a “Put” option and Bullish views can be expressed by buying a “Call” option.
So, if we see more Puts being bought in the market than Calls, then it can be assumed that the sentiment in the market is bearish and vice versa if we see more Calls being bought than Puts in the market.
QUICK READ – How can Investors use Derivatives for Hedging?
How to Calculate Put Call Ratio (PCR)?
To calculate the PCR is very easy. All we have to do is divide the total Put option traded (or OI) by the total Call option traded (or OI). The resulting value will give us the value of PCR and help us in understanding the sentiment of the market. The following example will help us understand the calculation of PCRStrike PriceCall Open InterestPut Open Interest178001050007500017850750001100001790095850850001795099000600001800085000450001805011000065000181005500075000181506500088550Total590850603550
So, the value of PCR from the above calculation would be –
PCR = 603550/590850
PCR = 1.02
Interpretation of Put Call Ratio in Options Trading
If the value of PCR is more than 1, then the sentiment can be assumed to be extremely bearish as there are more Puts being bought than Calls.
If the value of the PCR is between 0.7 to 1, then the sentiment of the market can be assumed to be neutral, and
If the value of the PCR is lower than 0.7, then the sentiment of the market can be assumed to be Bullish as more Calls are being bought than Puts.
Why is Risk Management in Trading Important?
Contrarian Views using Put Call Ratio
A lot of the time the Put Call Ratio is being used similar to the way Bollinger bands are used.
Just in the case of Bollinger bands, when the market is bullish and starts to trade near the upper Bollinger, a bearish reversal can be expected and if the market is trading near lower Bollinger, a bullish reversal can be expected.
Similarly, if the Put Call ratio value is well over 1, then the sentiment can be assumed to be bearish and that is also the time, a reversal towards bullishness in the market cannot be discounted.
Similarly, an extremely low PCR could mean that the sentiment in the market is extremely Bullish, so a contrarian bearish move cannot be ruled out.
While calculating the PCR, some analysts prefer to use the traded value and some prefer to use Open Interest (OI). In our discussion here, we have used OI as a benchmark value.
The Put Call Ratio is calculated by diving the Puts OI with Call OI
PCR of more than 1 indicates bearish sentiment in the market and PCR lesser than 0.7 indicated bullish sentiments.
A lot of times, PCR is also used as a contrarian indicator.
With the help of the PCR, one can get a feel for the market and the traders can use it to take the trade with a better risk to reward ratio. hope this article on “What is Put Call Ratio in Options Trading” has helped you, comment down below and let us know if you use this or are planning to use this strategy while trading