What The Put-Call Ratio Can Reveal About Market Action

What The Put-Call Ratio Can Reveal About Market Action

Reading time: 6 minutes

What are Puts and Calls?

Puts:

Buying a put option provides the contract holder the right to sell an underlying asset at a predefined price value – the strike price – at (or before) the option expiration date. Put options are employed to either take advantage of falling markets (speculate) or hedge against the possibility of unfavourable price action. For example, those who hold put options in a falling market will generate a return if the option's price falls below the strike price and goes ‘in the money’ (ITM) beyond the premium paid to the writer (the seller). 

You can also sell put options (or write puts), particularly if you expect the market to remain steady or rise in price. By selling a put, you essentially take a bullish-to-flat view and are obligated to buy the underlying asset at the strike price if the buyer exercises their right (this will likely occur if price is below the strike price). 

The difference between buying and selling a put is that the former has greater profit potential and limited risk, while the premium received caps the latter’s profit potential but comes with unlimited risk.

Calls:

Buying a call option provides the contract holder the right to buy an underlying asset at the strike price at (or before) the option expiration date. If the price of the option contract trades above the strike price, enters ITM, and rallies beyond the premium paid to the writer, the contract holder will be in the green. 

Selling calls (writing calls) means the investor takes a bearish-to-flat view of the market and is obligated to sell the underlying asset at the strike price if the call buyer exercises their right to buy. A call option seller generates a return through the premium paid but effectively has unlimited risk.

The Put-Call Ratio Defined

Calculating the put-call ratio is simple: divide the volume of puts by calls in the options market. This ratio is calculated either by factoring in the open interest for a defined period or based on the volume of options trading. 

Put-Call Ratio = Volume of Puts / Volume of Calls

If the volume of puts exceeds calls, the put-call ratio will be above 1, indicating a bearish view of the market. Equally, if the volume of calls surpasses the put volume, the put-call ratio will be below 1 and signal a bullish view. A put-call ratio of 1 means that puts and calls are equal; bullish and bearish bets are the same. 

With TradingView, you can easily plot the put-call ratio on your chosen market. However, note that the indicators here are largely open-source scripts. Below is the daily chart for Google (ticker: GOOG), with the put-call ratio indicator derived from the Chicago Board Options Exchange (CBOE).

Chart Created by TradingView

The Put-Call Ratio and Market Action

Although the put-call ratio can be applied in various ways, it is most commonly employed as a contrarian market sentiment indicator. 

A high put-call ratio can signal that market participants are more bearish about the future potential of the market, as investors are essentially entering into trades with a bias to the downside. On the other hand, a low put-call ratio can indicate an overall bullish narrative in the market amid a higher ratio of calls (taking a more bullish view) over puts. 

Unlike indicators like the Relative Strength Index and the Stochastics Oscillator, which have defined boundaries, the put-call ratio does not; there is no right number to indicate a high or low put-call ratio. Still, looking at past extremes or noting uncommon spikes outside their normal range can help determine potential trading opportunities/reversals. 

As illustrated in the chart below, it is not a perfect indicator that promises to identify reversal points. However, there are times when the put-call ratio is excessively north of 1 and signals that sellers are overstretched (a bullish signal – green), and when the ratio dips below 1 to indicate buyers may be overstretched (a bearish signal – red).

Chart Created by TradingView

Put-Call Ratio FAQs:

1. What is the put-call ratio?

As its name implies, the put-call ratio is a ratio of puts to calls from the options market, derived by dividing put volume by call volume.

2. How do I interpret the put-call ratio?

A put-call ratio of 1 means put and call volume is equal; above (below) 1 shows that put (call) volume is greater (less) than call (put) volume. However, it is important to note that the put-call ratio is commonly used alongside other technical analysis tools to form confluence.

3. How do I use the put-call ratio?

Most traders and investors use the put-call ratio to identify bullish and bearish sentiment and potential market turning points.

4. What markets can I use the put-call ratio in?

The put-call ratio can be used across most major financial markets, including individual Stocks, Currencies (Forex), Commodities, and more. However, you will need access to options data for each market. 

5. Where can I find the put-call ratio?

The put-call ratio can be accessed in TradingView. If you have a live trading account with FP Markets and trade using the cTrader platform, you can access TradingView and trade directly from the charting platform with FP Markets.