The put-call ratio is a very popular tool and one of the more reliable measures of sentiment for predicting future market direction. The put-call ratio looks at the difference in trading volume between puts and calls. It is a ratio of the trading volume of put options to call options. If the number of traded call options outpaces the number of traded put options this signals a bullish sentiment, and vice versa. The ratio is calculated by dividing the number of traded put options by the number of traded call options. If this ratio increases, one understands that investors are investing more into put options, as compared to call options. Increase in put options trading indicates that the investors are projecting the market to fall or are beginning to hedge their portfolios in case of a sell-off.
When the put-call ratio is close to or greater than 1.00, the sentiment is bearish. This means that more traders are betting against the underlying. And when the ratio is near 0.50 or lesser, it implies that the sentiment is bullish. However, contrarian investors think otherwise. Contrarians will be bearish if PCR is low and bullish if PCR is high. This interpretation seems to work, probably because smart investors use hedging. For a contrarian investor, the put-call ratio aids in understanding when the investing crowd may be getting too bullish or too bearish. Fund managers use a very popular strategy where they buy index put options to protect their portfolios. As an outcome of such buying, the put call ratio for index options is generally higher than that for equity options. Hence, the equity put call ratio is considered a better indicator of the sentiment of the crowd.