Put Call Ratio: A Beginner’s Guide

If you follow the Indian stock markets, you may have heard analysts refer to the put-call ratio, or PCR, when assessing market sentiment. In simple terms, the PCR measures the volume of put options traded relative to call options. By observing how many puts versus calls traders are buying, the ratio can provide a potential indication of whether market participants may be leaning more bearish or bullish at a given time.

In this article, we explain what the put-call ratio is, how it is calculated, and how one may interpret it.

Table of contents

• Understanding put and call options
• What is a put-call ratio?
• How to calculate the put call ratio?
• Analysis of put-call ratio
• Example of put-call ratio
• How to trade using a put-call ratio?
• Interpretation of PCR
• Significance of put call ratio
• Limitations of put call ratio
• PCR - The contrarian indicator

Understanding put and call options

• A call option gives the buyer the right (but not the obligation) to purchase an asset—like a stock—at a predetermined price within a specific period. Call options generally tend to gain value when the underlying asset's price rises, though other factors like time decay, volatility, and interest rates can also affect option pricing.
• A put option gives the buyer the right (but not the obligation) to sell an asset at a predetermined price within a set timeframe. Put options tend to gain value when the underlying asset's price declines, though other factors like time decay, volatility, and interest rates can also influence option pricing.

What is a put-call ratio?

The put-call ratio is an indicator used to determine market sentiment by comparing put option activity to call option activity. Traders and analysts track PCR to see if more puts are being traded (indicating bearish sentiment) or more calls (indicating bullish sentiment).

For example, PCR is equal to 1 means equal puts and calls. A PCR above 1 indicates relatively higher put volume (which may signal bearish sentiment), while a PCR below 1 indicates higher call volume (which may signal bullish sentiment).

In summary, PCR may provide potential insight into market sentiment by quantifying the balance between bearish bets (puts) and bullish bets (calls) in the market, though it should be used alongside other indicators for a more complete market analysis

Read Also: Understanding Call And Put Options

How to calculate the put call ratio?

Calculating the put-call ratio is straightforward. The formula is:

PCR = Number of Put Options ÷ Number of Call Options

For instance, if 10,000 put options and 15,000 call options were traded in a day, the PCR would be 10,000 / 15,000 = 0.67.

*Example for illustrative purposes only.

Analysis of put-call ratio

Understanding PCR values in context is important. A PCR greater than 1.0 indicates that put option activity exceeds call option activity, which may suggest that traders are turning cautious, bearish, or looking to potentially manage downside risk.

Conversely, a PCR below 1.0 means call option activity is higher, which may imply a more optimistic or bullish outlook among traders.

In summary, to analyse PCR, To analyse PCR effectively, it helps to look at:

• Where it stands relative to 1, and
• How it compares with its own historical extremes.

Moderate fluctuations are generally normal, but an unusually high or low PCR may signal that market sentiment has shifted sharply in one direction. Such extremes are sometimes interpreted as potential warning signs, though they do not guarantee any specific outcome

Example of put-call ratio

Let’s illustrate the put-call ratio with a simple example. Suppose in a trading session, 50,000 put option contracts were traded on an index, and 40,000 call option contracts were traded, the PCR would be –

PCR = 50,000 /40,000

= 1.25.

A PCR of 1.25 (which is above 1) means puts traded exceeded calls, indicating a bearish bias among traders for the day.

Consider another scenario—in the next trading session, 20,000 puts and 40,000 calls are traded. Here,

PCR = 20,000/40,000

= 0.5.

This PCR of 0.5 (well below 1) would signify a bullish bias, significantly more calls were traded than puts, reflecting that traders were largely optimistic about the market at that point in time.

Example for illustrative purposes only.

How to trade using a put-call ratio?

The put-call ratio is frequently used by traders to guide their approach, especially when they are taking a contrarian stance. Contrarian traders may view an extreme high in PCR compared to its normal range as a sign of excessive bearishness and may wait for a potential rebound as fear peaks.
Conversely, an extremely low PCR can signal excessive bullishness, and contrarians may consider selling or hedging, expecting that excess optimism could lead to a downturn.

Trading only on the basis of PCR is not recommended, though. The PCR is one indicator of market sentiment and can occasionally produce false, lagging, or misleading signals. Traders may combine PCR with other analysis—such as validating with technical chart patterns, price trends, volatility indicators, or relevant fundamental news—to form a more balanced view and avoid relying on sentiment indicators in isolation. No indicator can predict market movements with certainty.

Read Also: Futures and Options Trading: Meaning, Types and Example

Interpretation of PCR

PCR > 1.0 - Bearish sentiment, more puts being traded than calls.

PCR < 1.0 - Bullish sentiment, more calls being traded than puts.

PCR around 1.0 - Neutral Sentiment, roughly equal number of puts and calls are being traded.

The prevailing sentiment becomes more extreme the farther the ratio deviates from 1 in either direction.

Significance of put call ratio

• Market sentiment gauge - PCR offers a quick assessment of the possible state of the market. A low PCR may indicate optimism or bullishness, whereas a high PCR may represents a bearish outlook – though this is not guaranteed.
• Contrarian indicator - PCR may also identify instances of highly biased sentiment. These extremes may provide contrarian opportunities or warnings, but they do not guarantee any outcome and may or may not coincide with future market turning points.
• Risk management - PCR can be used as a risk-assessment tool that provides insight into how market participants may be perceiving risk. A high PCR may indicate more investors are positioning defensively through put options. On the other hand, a low PCR may sometimes indicate complacency; when the market appears overconfident, a risk-averse investor may proceed with caution. PCR alone, however, should not be relied upon for risk management decisions.

Limitations of put call ratio

• Simplistic measure - PCR is a tool and doesn’t capture everything. It doesn’t explain why traders are buying puts or calls.
• Not a standalone predictor - The put-call ratio should not be relied upon as the sole basis for investment decisions. It is one indicator among many. A high or low PCR does not guarantee the market will reverse or continue, it simply reflects sentiment at that moment.

Read Also: 16 Options Trading Strategies for Traders

PCR - The contrarian indicator

The PCR is often called a contrarian indicator. At extremely high PCR values (far above 1), bearish sentiment is pervasive, and some contrarians may suspect the market may soon rebound. Similarly, an extremely low PCR (far below 1) may signal high optimism and contrarian investors may believe that such scenario could precede a downturn.

In conclusion, the reason that PCR has been branded a contrarian indicator is because it reveals crowd extremes. Contrarian traders who look to go against the crowd sentiment associated with an extreme PCR hope to potentially gain from the idea that after an extreme is reached, the market might reverse direction when most participants are aligned on the same sentiment. However, this strategy carries significant risk, as market extremes do not guarantee reversals even when most participants share the same sentiment.

FAQ

What is the put-call ratio (PCR)?

It is a financial indicator that compares the number of put option contracts to the number of call option contracts. The PCR reveals market sentiment by showing whether traders are buying more puts (bearish bets) or more calls (bullish bets).

Formula:

PCR = Number of Put Options ÷ Number of Call Options

How is the PCR calculated?

The PCR is computed by dividing the total number of puts by the number of calls. For instance, the PCR is 1,000/1,500 ≈ 0.67 if 1,500 call options and 1,000 put options are traded.

What is indicated by a PCR greater than 1?

Put option volume is higher than call volume when the PCR is above 1 which indicates a bearish market sentiment.

How can traders use PCR to gauge market sentiment?

Traders use PCR as a gauge of crowd sentiment and potential contrarian signals. If the PCR is rising or at high levels, it tells them the market may be getting more bearish, whereas a falling or very low PCR may signal increasing bullishness. By watching PCR, traders can sense if sentiment is reaching an extreme, although sentiment extremes do not necessarily lead to any specific market outcome and PCR should not be used in isolation.