The Importance of the Put-Call Ratio

Whatever the result of a fundamental analysis, you should never open a position in an asset without first gauging the market sentiment. Successful investments have three ingredients: a good assessment of the economic or fundamental situation; allowance for leverage; and good timing. If you have a proper assessment and leverage is involved but timing isn’t correct, you’re set for heavy losses. Timing is almost everything.

Among the tools to measure timing, guiding you on the best time to enter and exit the market, there is a simple indicator that can be easily calculated or obtained: the put-call ratio.

The put-call ratio is calculated as the volume of put options traded on a given day divided by the number of calls traded on that same day. It gives you the proportion of traded puts in terms of traded calls. A number above one tells you that more puts than calls were traded while a number below one tells you the opposite.

The put-call ratio is a gauge of market sentiment. Consider what you do when you’re bullish on a stock; do you buy a call or a put? You should buy a call option because it increases in value with an increase in the price of the underlying stock. Now imagine traders are collectively bullish. In this case, the number of calls traded is expected to be higher than the number of puts traded, so the ratio should be below one. The lower the ratio, the more bullish traders are. The inverse is also true: the higher the ratio, the more bearish investors are.

For smarter trades subscribe to Tradespoon!

Unlike many other indicators, which measure sentiment by intentions (such as a survey), the put-call ratio measures sentiment by an effective action. It is not just about what investors feel will happen but what they have done in relation to what they feel would happen. In that sense it is much more powerful for indicating overall sentiment about the market.

But the put-call ratio is usually considered a contrarian indicator, meaning that it is used as a measure to indicate an action against the crowd. If it is high it means that investors are too bearish; that could indicate a market bottom and thus an opportunity to enter the market. By similar reasoning, if the ratio is low then investors are too bullish, meaning the market may be forming a top and a sell opportunity is opening.

There are other ways a put-call ratio can be used. You can calculate it for the whole market to retrieve the general sentiment, or you can use it to identify the sentiment on a particular stock. You can also compute it using the number of puts and calls or their traded volume instead.

No matter what, always be careful when interpreting the ratio. You should graph historical values to identify the range of variation for a particular stock.  While a value of 0.7 could be a good trigger for bottoms for a particular stock, a different value could be better for another. As an example look at the chart below with put-call ratio data for S&P 500 since 2006.

For the S&P 500, the range would be properly defined between 0.6 and 1.2: thus, a ratio of 0.6 is a good selling indicator while a ratio of 1.2 is a buying signal.

This tool is valuable, but best as a complementary tool and should never be used alone. Timing is almost everything, but it is mostly a fine-tuning tool, you still need the good assessment of the fundamental picture.

For smarter trades subscribe to Tradespoon!