Options traders and those frequently observing the markets often speak about the Put-Call ratio. Although you might be able to determine what it means by the name, what does the Put-Call ratio tell us? Is it even helpful? This article will discuss this ratio and how we can use it when trading.
The Put-Call ratio is an indicator that can provide traders with an idea of overall market sentiment. As with most financial ratios, it is a rather simple metric. However, many traders use it to help them make informed decisions about the market’s near-term direction.
The ratio measures the volume of call options to the number of put options for a given asset, whether a stock or ETF.
Is it helpful? As always, this is up for interpretation; different traders will tell you different things.
Options trading is a complex organism that has many different aspects to it. As always, the put-call ratio is up to your interpretation. And you may or may not find that it helps your trading!
Options Contract Review
What are options? Options are a financial derivative that can provide traders with the right, but never the obligation, to buy or sell an asset at a particular price by a specified expiration date. These derivatives use contracts that will rise or fall in value relative to the underlying asset’s price.
You can trade options on most market assets, including stocks, ETFs, and the major indexes. These are calculated bets on the direction of the price of these assets over a specified time. Let’s look at the two types of options contracts you can trade.
What Is a Call Option?
Call options are often seen as bullish trades. Although, as you will see, both calls and puts can be bullish or bearish, depending on the trade. These contracts give the buyer the right to buy the underlying asset at the pre-determined strike price.
Buying a call option comes with paying a premium to the option seller. When buying call options, you are betting that the underlying asset’s price will rise above the strike price by the expiration date, which will provide a profitable trade even when including the cost of the premium.
What Is a Put Option?
Take everything you just read about call options and apply the opposite. Well, sort of. Buying put options is generally seen as a bearish trade. You’re betting that the underlying asset’s price will fall by expiration. If you sell a put option, you anticipate the asset’s price will remain above the strike price until the expiration date.
Just as with call options, when you buy a put option, you pay a premium to the put seller. Following the logic, you will realize that buying a put is usually bearish, and selling a put is usually bullish!
Deciphering the Put-Call Ratio
With that rudimentary understanding of options trading, it’s pretty easy to see why the put-call ratio is important. Let’s look at how it’s calculated and how to interpret it.
On the surface, calculating the put-call ratio might seem pretty easy. This calculation can be used for any asset of the overall options markets. Here is a visual representation of the formula used to calculate it:
Put-Call Ratio = Total Put Options / Total Call Options
If we plug in some real-life numbers, let’s see what this gives us. Let’s say that for Tesla Stock (NASDAQ: TSLA), 5,000 put options and 10,000 call options traded in a single session. The calculation would look something like this:
Tesla Put-Call Ratio = 5,000/10,000 = 0.5
Now, if the reverse were true, we would see this:
Tesla Put-Call Ratio = 10,000/5,000 = 2.0
What Does the Put-Call Ratio Tell Us?
Generally, a put-call ratio of 0.7 and lower is considered a bullish sentiment. Although, to be fair, anything lower than 1.0 means a higher call interest than put interest for that asset.
The overall sentiment is bearish if the put-call ratio is greater than 1.0. Most are betting on a decline in the price. High put-call ratios are seen as most market participants having a pessimistic outlook.
When the put-call ratio is flat, or around 1.0, it indicates that the market has a good balance of bullish and bearish traders. This usually means it will be a period of sideways trading aside from the potential of a global event affecting the market equilibrium.
If the put-call ratio is at its extremes, it can be a sign of overbought or oversold territory. This can act as an interesting contrarian indicator. This can gauge an overshoot of market sentiment in one direction. Remember that the market is efficient and generally regresses to the mean. If it moves too far in either direction, it usually snaps back sooner rather than later.
The history of the put-call ratio is a fairly long one. It’s unclear when it started to be used by traders. However, it has likely been used since the introduction of options trading in 1973. The put-call ratio has seen a spike in usage when markets find themselves at one extreme or another.
For example, when put-call ratios are off the charts, it usually forebodes a swift move in one direction. This happened during the infamous Black Monday market crash in 1987 when the put-call ratio was extremely skewed in favor of puts.
This also occurred during other crashes, such as the dot-com bubble, when many investors began to bet against the sudden surge in prices of internet stocks. With the put-call ratio near all-time lows, savvy investors took the opportunity to hedge against the overwhelmingly bullish sentiment.
How to Use the Put-Call Ratio in Trading
There are several practical applications of the put-call ratio for traders to use. But, like any indicator, it should not be used as the final trade determinant. Think of it as another data point in your ongoing research and analysis of the markets.
It can be used as a way to gauge market sentiment. Of course, market sentiment should not be something you strictly trade by, but it can help determine the current bias in the markets.
This can help traders position themselves accordingly and even build hedges against a potential swing in the other direction.
You can also use it to gauge if option contract prices are mispriced. A surge in demand for call or put options could mean that playing the other side of the trade as a contrarian could be a savvy move. It could also be an opportunity to sell options to earn the premium rather than pay it.
Limitations of the Put-Call Ratio
The biggest limitation is that there is simply no evidence behind why more investors are bullish or bearish. A simple put-call ratio figure does not consider macroeconomic factors, global conflicts, or seasonality. It also does not provide any information about whether investors are bullish or bearish or if they are hedging long positions.
There is also no proof that an extreme reading on the put-call ratio would indicate an imminent market reversal or direction. Traders should not use the put-call ratio with a specific timeframe, especially if they use it to action trades or strategies.
The put-call ratio is a useful financial indicator for many traders. Should it be the reason you enter a trade or change your sentiment? Of course not.
But it can provide insight into what the overall market is feeling, and we all know that market sentiment can also be a powerful tool. If you found this article helpful, check out the Bullish Bears trading community for tips and the best financial education!