How to use put/call ratios to predict markets
Derivatives Analyst uses many indicators and tools to understand the market movement like Open Interest, Option Concentration, Volatility, Volatility Smile/Skew, Rollover, Rollover Cost, Basis, Cost of Carry and Put Call Ratio. All these are important indicators while Put Call Ratio has it its own set of logic to predict the market move with higher probability.
Put Call Ratio commonly called PCR is a simple ratio. It is calculated on traded volumes as well as on outstanding open interest basis. Most of the experts uses Put Call Ratio based on Open Interest (PCR OI) as in Derivatives OI has more weightage than traded volumes because of its leverage nature.
PCR OI is calculated by dividing total number of puts open interest by the total number of calls Open Interest on a particular day.
PCR OI = Total number of Puts OI / Total number of Calls OI
Put Call Ratio moves higher when total OI of Puts are higher than total OI of Calls while its goes down when total OI of Puts are lower than the total OI of Calls. The PCR cannot be looked at in isolation as one should typically look at the PCR in conjunction with its range or in comparison to the beginning of new series. Rising PCR means that the number of puts traded are more than the calls traded, which indicates that the markets seem Bullish and a falling PCR indicates just the opposite and the Bearish view.
How to understand Put Call Ratio and why rising PCR is bullish sign?
Let’s assume that Total Put OI = 1, 50,000 and Total Call OI = 1, 00,000
Put Call Ratio will be 1.50 and it will have a positive outlook
Many Derivatives new comer surprises that why more Puts have positive sentiment
If Put Call Ratio moves higher then it will have a bullish view for market as we understand that most of the time option writers makes money in the market and more Puts than the Call means more Put writers than the Call writers.
Second logic for Put Call Ratio is that more Puts mean more Long Hedge while More Call means more Shorts hedge. That is why higher Ratio suggests bullish bias while lower ratio suggests negative bias.
How to calculate Put Call Ratio by using Bhav Copy?
Put Call Ratio can be simply calculated by a Bhav Copy file which is available at exchange web portal. One can extract the entire option data base to find Total Put OI and Total Call OI. Usually we follow two types on Put Call Ratio based on open interest.
1. Current Month Put Call Ratio : Total Put OI / Total Call OI (All the strikes of current month expiry)
2. Combined Put Call Ratio : Total Put OI / Total Call OI (All the strikes of all the available contract months at exchanges)
Put Call ratio has been moving in between 0.65 to 1.98 from last eight years and this range has been narrowed down in between 0.65 to 1.60 in last six years. Few experts use Put Call Ratio as an overbought or oversold indicator while other use it as a directional indicator by it’s up or down movement. Some time we find meaningful reversal in the market by using Put Call Ratio especially by its positive divergence when index is going down while Put Call Ratio is holding or moving upwards.
If index is going down while Put Call Ratio is going up which suggests that even after the market decline Put Writers are continuously selling Puts thus not expecting much declines or decline could be bought by market participants.
Experts also use Put Call Ratio with Volatility to understand the market behaviour
Rising Put Call Ratio with Rising Volatility = More hedge thus limited downside
Falling Put Call Ratio with Rising Volatility = Less hedge thus panic or more downside could be seen if it faces supply pressure
It is an important and useful indicator to understand the market as 80% volumes of the NSE F&O segment is contributed by Option (Calls and Puts) trading. Put Call Ratio is also called as a sentimental indicators thus it always play an important role in rising and developing Derivatives market.
It’s written by personal and practical market experience with actual data facts while many articles or studies show exact opposite of the same.
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