A Complete Guide to Put/Call Ratio | Motilal Oswal

What Is a Put-Call Ratio?

Ask any F&O trader and they will tell you that a commonly used metric 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 ratio as a fairly reliable indicator of the direction of the market. Where the stock markets are concerned, traders and investors can use the PCR Bank Nifty to gauge the movement of markets, as well as other indications in indexes. 

What exactly is the put call ratio (PCR)?

Investors and traders in the stock markets today have to use whatever arsenal and means they have to gauge stock markets. While gauging the general moods of the markets, the put and call ratio helps stock traders to determine how markets are going to move. The put and call, or PCR of NIFTY and other indices is commonly used by traders on a daily basis. Before you can fully understand how this ratio helps estimate market movements, you should be able to grasp the understanding of a put and a call in terms of market functions.

Explained simply, a put, or a put option gives an investor a right to sell any asset at a fixed price, determined in advance. A call, or a call option, gives an investor the right to purchase any asset at a price that is predetermined. In both cases, there is no obligation on the investors part to carry out either of the activities on a predetermined date. In case traders purchase more puts relative to calls, the sentiment of the market is bearish, overall. If traders and investors are purchasing more calls than puts, the implied mood of the markets is bullish going ahead. Significantly, the put call ratio, Nifty-centric, gives investors a fairly decent picture of market trends. 

What the PCR Ratio, NSE-Wise Means

The PCR measures the ratio of the put open interest on a given day to the call option open interest on the same day. The put call ratio is calculated by dividing the amount of traded put options by the amount of traded call options. The calculation is simple enough. Let’s say, by the calculation, we get a ratio of just 1. This implies that the amount of buyers for calls is the same as that for puts. Nonetheless, the ratio of 1 is not the starting benchmark to gauge the sentiment of the market accurately. This is because investors already know that more investors tend to buy calls than they buy puts. Therefore, if an average PCR (put call ratio) for equities is 0.7, then this is believed to be a good starting point to evaluate market sentiment. 

When you are measuring the PCR with an equation, you must consider the OI, or open interest factor. This is simply the total amount of derivative contracts which are outstanding, like those futures and options which have not been settled yet. The OI is the total number of contracts bought and sold, but not the total of both these added together. 

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 ratio 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 PCR can help traders and investors invest near-accurately to gain rewards in the markets today. When traders are engaged in trading indexes, the NIFTY PCR ratio today, for instance, may inform a trader or investor about volumes of stocks traded. This way, any trader can come to the decision of trading in a particular sector or stock of a certain industry with some backing of knowledge in terms of the PCR. 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 on 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 and 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.  You can also get to know about ratios that currently prevail so you can decide whether to trade or not. For instance, the PCR ratio Bank NIFTY today can tell you whether you should trade in this index at all. Therefore, if you know how to interpret put and call ratios, you can determine your trades and plan for the same before you plunge in. This may help you in risk mitigation to a substantial extent. 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. The rule of thumb in the markets is never to trade or invest when markets are at any extreme. Although some experts may not agree with this contention, if you are a newbie at trading, it's likely that you may wish to steer clear of any risks in your initial trades.

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 ratio 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 put call ratio 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.

Characteristic Considerations

The put and call ratio has tremendous significance for traders and investors in the stock market. For one thing, it helps to effectively gauge the sentiment of any market before any turning of the market occurs. Nonetheless, something important to note is to view the demand for the puts (the numerator in the equation of calculation), and the calls (the denominator in the equation of calculation). 

The amount of call options can be found in the denominator in the ratio. What this means is that any reduction in the amount of traded calls increases the ratio value. Why is this important? This is crucial because fewer calls being purchased can effectively propel the ratio higher irrespective of the increased amount of puts being bought. In simple words, you do not need to see a large amount of puts being bought in order for the ratio to increase. 

Evaluating Sentiment

When bullish traders do not actively trade, this means that bearish traders are filling the markets with trades. This does not necessarily imply that the markets themselves are bearish, but perhaps it translates to the fact that the bullish investors and traders are patiently waiting for any potential event (like an election, or release of some important economic information) to see markets move in positive directions again. It can only help traders and investors when they avidly keep a watch on the PCR in order to view how markets interpret earnings or events. If the ratio hits levels which are extreme, the indication is a massively bearish sentiment or a hugely bullish one. This is the main reason why some investors are of the opinion that the PCR is an indicator, which may be useful, but is also contrarian. 

Trading with Care

To be sure, there is no singular indicator that can act as a surefire way to tell traders if a market is at its ebb or the tide is rising. As a savvy trader, you must realize that there is more to trading than just dependence on the PCR. Even if levels of the put and call ratio are on extreme ends of the stick, these are not indications that are cast in stone and can change over a long period. 

In a calculated way, good investment demands that you compare present levels of ratios to the average ratios over a period. This may help to gauge any change in sentiments taken place recently. If the PCR has seen fluctuations within a tight range, and jumps high suddenly, traders can view this as a startling increase in bearish sentiments and act in accordance. 

 

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