What Is a Put-Call Ratio?
The put-call ratio is a measurement that is widely used by investors to gauge the overall mood of a market.
A "put" or put option is a right to sell an asset at a predetermined price. A "call" or call option is a right to buy an asset at a predetermined price.
If traders are buying more puts than calls, it signals a rise in bearish sentiment. If they are buying more calls than puts, it suggests that they see a bull market ahead.
Key Takeaways
- A put option gets the trader the right to sell an asset at a preset price.
- A call option is a right to buy an asset at a preset price.
- Traders buying more puts than calls indicates a bearish market.
- If they are buying more calls than puts, watch out for a bull market ahead.
Understanding the Put-Call Ratio
The put-call ratio is calculated by dividing the number of traded put options by the number of traded call options.
A put-call ratio of 1 indicates that thenumber of buyers of calls is the same as the number of buyers forputs. However, a ratio of 1 isnot an accurate startingpoint to measure sentiment in the market because there are normally more investors buying calls than buying puts. So, an averageput-call ratio of 0.7 for equities is considered a good basis for evaluating sentiment.
In general:
- A rising put-call ratio, ora ratio greater than 0.7 orexceeding 1, means that equity traders are buying more puts than calls. It suggests that bearish sentiment is building in the market. Investors are either speculatingthat the market will move loweror are hedging their portfolios in case there is a sell-off.
- A falling put-call ratio, or below 0.7 andapproaching 0.5, is considered a bullish indicator. It means more calls are being bought versus puts.
The put-call ratio can be an indicator of how the market views recent events or earnings. A ratio at either extreme suggests an overly bearish or overly bullish sentiment.
The data used to calculate put-call ratios are available through various sources, but most traders use the information found on the Cboe Options Exchange website.
Special Considerations
The put-call ratio helps investors gauge market sentiment before the market turns. However, it's important to look at the demand forboth the numerator (the puts) and the denominator (the calls).
The number of call options is found in the denominator of the ratio. That means a reduction in the number of traded calls willincreasethe value of the ratio. This is significant because fewer calls being bought can push the ratio higher without an increasednumber of puts being purchased. In other words, we don't need to see a large number of puts being purchased for the ratio to rise.
As bullish traders sit on the sidelines, the result by default is that there are morebearish traders in the market. It doesn't necessarily mean the market is bearish, but rather that bullish traders are in a wait-and-see mode until an upcoming eventoccurs like an election, a Fed meeting, or a release of economic data.
0.7
The averageput-call ratio for equities that is considered a good basis for evaluating sentiment.
It's helpful to watchtheput-call ratio to see how the market views recent events or earnings. When the ratio is at extreme levels, it might indicate an overly bearish or an overly bullish sentiment.
For this reason, some investors use theput-call ratio as a contrarian indicator.
A Contrarian Indicator
Contrarian investors usethe put-call ratioto help them determine when market participants are getting overlybullish or too bearish.
An extremely high put-call ratiomeans the market is extremely bearish. To a contrarian, that can be a bullish signal that indicates the market is unduly bearish and is due for a turnaround. A highratio can be a sign of a buying opportunity to a contrarian.
An extremely low ratio means the market is extremely bullish. A contrarian might conclude that the market is too bullish and is due for a pullback.
No single ratio can definitively indicate that the market is at its top or its bottom.Even the levels of the put-call ratiothat are considered extreme are not set in stoneand vary over the years.
Typically, investors compare current ratiolevels to the average over some period of time to gauge if sentiment has changed recently. If the put-call ratio has fluctuated in a tight range and suddenly bumps higher, traders might see this as a sudden increase in bearish sentiment and make their moves accordingly.
What Is the Put/Call Ratio?
The put/call ratio is used as an indicator of overall bullish vs. bearish market sentiment using market data supplied by the relevant exchange, mostly the CBOE.
How Do I Interpret the Put/Call Ratio?
A ratio of 0.7 is considered mostly neutral, while a low ratio (below 0.5) indicates an extremely bullish market sentiment, and a reading over 1.0 indicates an extremely bearish sentiment, for example.
How Do I Make Use of the Put/Call Ratio?
Many traders use extreme put/call ratios as a contrarian indicator. For example, a put/call ratio of 0.3 indicates an extreme in bullish market sentiment, suggesting the market may be ready for a pullback lower, and that a short position may be worthwhile. A reading over 1.2, on the other hand, suggests an extremely bearish market sentiment that could see the market rebound in the near future, potentially suggesting a long position in the underlying security.
How Do I Know If a Put/Call Ratio Is Extreme?
Traders will want to look at the historical path of the put/call ratio for the underlying security to see what values constitute extreme levels. Take particular note of outlying ratios to determine if the indicator is at an extreme level, potentially suggesting a trading opportunity.
The Bottom Line
The put/call ratio is a very helpful tool in gauging whether the market outlook is bullish or bearish for a particular security or an index itself. Low ratio numbers, like 0.2-0.3, suggest market sentiment is extremely bullish, while a reading over 1.2 suggests the market is becoming too bearish and may be due for a bounce.
The put/call ratio is an excellent barometer of market sentiment and likely positioning. Contrarian traders may take such readings as the sole basis for a trade, while a longer-term investor may use extreme levels to pare back or add to existing positions. Studying the historical path of the put/call ratio of a particular security can help isolate areas of extreme sentiment, and alert traders to potential reversals amidst an ongoing trend.
