The Hindu Business Line : What the put-call ratio signals

If you are a regular viewer of the business news channels, it is unlikely that you would not have heard of PCR (put call ratio), a term that is most tossed around when markets move up and down quickly. So, what is PCR and how does it capture market sentiment? Read on to find out what signals you can interpret from this market indicator.

What is PCR?

PCR, alias put-call ratio, simply put, is the ratio of trading volume of put options to call options. Changes in this ratio are indicative of the prevailing market sentiment.

For instance, a higher PCR, which arises when put volumes are relatively higher than that of calls, signals a bearish sentiment.

As traders usually use put options to fix a sell price for their securities when they anticipate a fall in price, a rise in put volumes is usually an indicator of the bearish mood in the market.

Put options are contracts that give the holder the right to sell a specific quantity of the stock at a specified price on or before the expiry of that contract.

On the contrary, increase in volumes of call options, by the virtue of its definition, can largely be assumed as an indicator of a build up in bullish sentiment.

This is so because holders of call options have the right to buy a specific quantity of the stock at a specified price on or before the expiry of that contract.

How to read it?

However, history suggests that options traders lose money most of the times. Their collective judgement of market direction is usually wrong. It is precisely for this reason that a high put call ratio usually precedes a rising market and a low ratio is followed by falling prices.

For instance, in January 2008, the volume-based put-call ratio for nifty options had fallen from over 1.5 in early January to under 0.7 by mid-week. However, the markets turned in the deep correction mode only by mid-January — a time when greed ruled high in the markets as captured by the relatively low PCR. To give another example, in July 2007, the PCR had risen to over 2; broad markets, on the contrary rose by over 4 per cent that month.

Markets in the short-term are driven more by emotions than fundamentals. Times of greed and fear in the market are reflected by the significantly low or high PCR. This makes PCR an effective contrarian speculation tool that assesses the general herd mentality in the markets. While, typically, PCR above one indicates a higher put volume vis-À-vis call volumes, for Indian stock markets we can peg the optimal level at 1.2 to 1.5. This is because in our markets puts are used more for hedging than speculation and, hence, PCR only above or below this level may be construed as an effective indicator of an overbought or oversold market.

However, PCR as an indicator has its own flaws. PCR levels in a highly volatile market can be misleading as, typically, during such times, traders tend to sell puts instead of buying calls. So, while on an overall basis, put call ratio can be used as a market indicator, it could prove costly you if time markets solely based on put-call ratio.

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