Investors used different tools and indicators to fetch the market sentiments. These Indicators provide information about the market and its directions based on different techniques like price action etc. Put Call Ratio is one of the methods that provide useful details about the market.
What is Put?
A put option gives investors the right to sell the assets at a pre-fixed price.
What is Call?
A Call option gives investors the right to buy the assets at a pre-fixed price.
What is the Put-Call Ratio?
Put call ratio is a derivative indicator computed by the total number of put open Interest and call Open Interest.
PCR = Put Open Interest/Call Open Interest
| Put Option | Call Option |
| 7500 | 5000 |
Hence,
PCR = 7500/5000
PCR = 1.5
This indicator tells whether the market is bullish or bearish. Before moving further in PCR, let’s understand a bit of Open Interest.
In Simple Words, Open interest is the pending order put by Investors at a specific price that has not been executed yet. You can understand it with an example. Suppose you want to buy a stock that is trading at Rs. 65 but you have capital enough to buy it at Rs. 50. So you will lock your buying order at Rs. 50. You created an open Call Interest at 50.
How to derive Market direction using PCR Ratio?
- If the Put Call ratio is increasing during the correction in an uptrend then it is a very bullish signal as put writers are aggressively writing at dips.
- If the put-call ratio decreases during a rise in a downtrend market then it is a very bearish signal as call writers are aggressively writing at every rise.
- If the put-call ratio is decreasing when the market is consolidating in a range then it is a bearish signal. It means call writers are increasing their holding in the hope of an upsurge in price.
- If the put-call ratio is 1, means equal call and put writers. It means the market is confused about its direction.
Now there is a question arises in your mind.
Why do I consider it a bullish sign when the PCR ratio goes up, indicating more put writers and a potential market decrease?
Well, PCR is called a contrarian Indicator.
It means we have to follow the opposite path of what it is showing to us. In the market, around 90% of traders lose their money because they are following the normal path. So to be on the list of rest 10% traders, you will have to follow the contrary path.
So,
- If PCR is more than 1, means more put writers that call writer. More than 1 value indicates, that more people have a view of a downtrend but we can see market always moves in the contrary direction of the majority. So we will get the signal of upside momentum. In the same way,
- If PCR is less than 1, means more call writers than put writers. So we will get the signal of downside momentum.
Due to this contrary view, PCR is called a contrary Indicator.
Why PCR is Important?
- Money
We understand that the Put Call Ratio (PCR) is connected to Open Interest, and Open Interest is linked to money because a large amount of money is invested at a specific price. It’s widely known that money plays an important role in the market, and it affects significant changes. A higher level of capital flows into the market through the establishment of new positions.
- Leading Indicator
According to some analysts, PCR is considered a leading Indicator. PCR suggests potential movement in the market. A change in ratio can be monitored to anticipate shifts in market sentiments and potential changes in price trends.
- Volatility Forecasting
PCR is an important tool for forecasting market volatility. A higher put-call ratio indicates a potential signal of an increment in market volatility. Whereas a lower put-call ratio indicates a decline in market volatility.
- Market depth and Liquidity
The put-call ratio can also be used to analyze the depth and liquidity of the options market. A high Put Call ratio may indicate a strong demand for downside protection (puts), whereas a low Put Call ratio may suggest a preference for speculative bets (calls).
Practical Example of Put Call Ratio
In the above Figure, we can see a change of 0.10 in the Put Call ratio between 01:39 to 02:10. We can see during this phase price value declined but as we have already discussed “If the Put Call ratio is increasing during the correction in an uptrend then it is a very bullish signal as put writers are aggressively writing at dips“. We have seen a rally of around 60 points in Nifty with a support line.
Conclusion
Put Call Ratio is a very good indicator as compared to other indicators because it provides the potential future signal of price. Investors can also use it in equity, securities, and commodities. If You use it properly with accurate price action, it can provide massive returns.
