Ask any F&O trader and a commonly used metrics is the Put Call Ratio (PCR). As the name suggests, it is the ratio of the puts to the calls but we shall look at that in detail later. The bigger question is how to find put call ratio for a stock and understanding the concept of put call ratio options. It is also essential to know how to read put call ratio charts as the shifts are critical indicators of the likely market movement. Most traders use the PCR as a fairly reliable indicator of the direction of the market.
What exactly is the put call ratio (PCR)?
PCR measures the ratio of the put open interest on a given day to the call option open interest on the same day.
Thus PCR (OI) = Put open interest on given day / Call open interest on given day
Now open interest in options is the value of all positions that are open in the market and represents the stock in the market. PCR can also be interpreted in terms of volumes on a day. While OI represents the stock, volumes represent the flow in the market. While both are used, the PCR (OI) is normally the stronger indicator of trends in the market and the PCR (Volumes) is normally used to ratify the conclusions that we reach with PCR (OI).
PCR of open interest and volumes can be calculated for individual stocks, indices and for the aggregate market as a whole. Of course, PCR is only relevant in case of stocks that are available for trading on the F&O and not otherwise. Additionally, PCR becomes more meaningful when the contract has been liquid for a sustained period of time Calculating PCR based on sudden spurts in volumes can be misleading and lead you to wrong conclusions.
Understanding PCR (Vol) and PCR (OI) with illustrations
The calculation of PCR for volumes and for open interest is quite simple. Remember, PCR is also calculated with respect to a specific strike. Let us look at PCR of volumes first.
Assume that the put volumes in the Nifty 10,700 strike is 85,000 contracts and the call volumes in the same contract for the same expiry is 1,28,000 contracts. In that case,
PCR (Vol) = 85,000 / 128,000 = 0.66
More than the PCR at a point of time, it is the trend of PCR over a period of time that is a more reliable indicator. Let us also look at PCR of open interest…
Assume that the open interest of puts the Nifty 10,700 strike is 38,00,000 contracts and the open interest of calls for the same contract and expiry is 49,00,000 contracts. In that case,
PCR (OI) = 38,00,000 / 49,00,000 = 0.78
Again in this case also, the trend of PCR (OI) movement is more critical than the absolute numbers. One can also calculate the PCR based on incremental OI to get a clearer picture
How to interpret the Put Call Ratio to take a view on markets
If you browse through any derivatives report put out by a broker, you will find a lot of emphasis on the PCR. So, how exactly do you interpret the Put Call ratio in practical terms?
One of the most important things that you need to understand is that the PCR is normally used as a popular contrarian indicator. That means the conclusions are actually counterintuitive. Let us understand this point in greater detail. There is nothing like a range for PCR or an ideal level for PCR. It is the trend that is more important. Here are a few key pointers pertaining to PCR interpretation..
Normally, times of greed and fear are reflected by significantly high or significantly low levels of PCR. Contrarians believe that PCR is normally headed in the wrong direction when markets are overbought or oversold and that becomes a key guiding factor.
Let us assume that the PCR (OI) has gone up sharply in the last few days and the market index has also corrected by 15% during the last 1 month. How do we interpret this situation? Contrarians believe that there is too much pessimism as small and retail investors are just buying too much of puts to hedge their downside risk. In any F&O market, the put writing is typically done by savvy traders and institutions. High PCR means aggressive put buying by small and medium investors but it also means aggressive selling by more savvy traders. Typically savvy traders sell only when they believe that downside is limited. That could be an indication that markets are bottoming out.
The reverse situation holds when markets have shot up and the PCR is falling. It means small and medium investors are heavily buying into calls but it also means that savvier investors are selling calls. That is an indication that markets may be topping out.
Combining PCR with Implied volatility (IV)
A smart way of interpreting PCR is by combining it with IV. Remember, IV is the volatility that is implied in the option price and it reflects the risk perception in the market. Here are a few pointers..
If the PCR increases with an increase in IV, it indicates that the put activity is increasing with a heightened sense of risk. That is a bearish signal.
If the PCR increases with a decrease in IV, it indicates that put activity is increasing with a falling sense of risk. That means more writing of puts and is a bullish signal.
If the PCR decreases with decrease in IV, it is indicative of unwinding of Puts and can be interpreted as a signal that markets may be bottoming out.
If the PCR decreases with an increase in IV, it means that puts are just being covered and the markets will again fall once the covering is done with.
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