We all know that a call option is a right to buy and a put option is a right to sell. Thousands of lots of puts and calls of various strikes are traded on each day. PCR is about trying to make sense of what these trends are really throwing up. Let us look at what is put call ratio and what does put call ratio tells you. To get a real perspective, it is essential to understand what does put call ratio indicate? PCR is one of the key parameters in evaluating F&O data.
PCR of Volumes and PCR of OI
PCR measures the ratio of the puts to the calls. There are two ways to look at PCR; the PCR of volumes and the PCR of OI. Let us look at the PCR of OI first.
PCR (OI) = Put open interest on given day / Call open interest on given day
PCR of open interest can be calculated for individual stocks, indices and for overall market. PCR is meaningful when the contract shows sustained liquidity and the basis risk is very low.
For example, if the open interest of puts on the Nifty 10,800 strike is 27,00,000 contracts and if the OI of calls for the same contract and expiry is 54,00,000 contracts then the
PCR (OI) = 27,00,000 / 54,00,000 = 0.50
Another way to interpret PCR is in terms of volumes on a day. OI captures the stack at a point of time whereas volumes capture the flow.
For example, if the put volumes in the Nifty 11,000 strike is 75,000 contracts and the call volumes in the same contract for the same expiry is 1,25,000 contracts. In that case,
PCR (Vol) = 75,000 / 128,000 = 0.60
Can one look at PCR in isolation?
There is nothing like a range for PCR or an ideal level for PCR so any number of PCR in isolation can only tell you so much. Normally you can check the time-wise trend, which is a little more illustrative. Here is what you can do with PCR data.
Greed and fear are reflected by significantly high or significantly low levels of PCR.
If the PCR has gone up sharply with a sharp market correction, then it can be interpreted as too much pessimism. If puts are being written, then it could be a sign of bottoming.
If the PCR has fallen sharply with a sharp market spurt, then it can be interpreted as too much optimism. If calls are being written, then it could be a sign of topping out.
It is better to combine PCR with Implied Volatility for a better picture
Implied volatility (IV) has to be understood with reference to the Black & Scholes Model. The model is normally used to calculating the intrinsic value of an option to determine whether it is overpriced or under-priced. Key factors used in the Black & Scholes are strike price, market price, interest rates, time to expiry and volatility. What IV does is to take the market price of the option as the intrinsic value and then uses the Black & Scholes to calculate the implied volatility by the option price. That is what IV is all about and shows the volatility that the option price if implying. The real value of interpretation of options data comes when you combine IV and PCR data. Here is how to go about it.
If PCR increases with an increase in IV, it indicates that the put activity is increasing with a heightened sense of risk. That is considered to be 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 since put writers are mostly well informed institutions.
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.
Normally, it is this combination of PCR and IV that gives you real insights into the futures and options market.