Are you a contrarian trader? Here’s what you should understand of put-call ratio
The Put Call Ratio can be used to determine when the crowd is getting either too bullish or too bearish
Put-call ratio (PCR) is one of the important concepts used by options traders. By tracking PCR, traders can gauge an overall sentiment of the market. The ratio is calculated either on the basis of options trading volumes or on the basis of options open interest on a given day or period.
PCR (in terms of open interest) is calculated by dividing the total number of put options open interest of all the strikes to the total number of call options open interest of all the strike prices. We can apply same formula using total volumes of options to calculate put call ratio in volume terms.
A PCR less than one hint that traders have accumulated more of call options than put options. There are two possibilities in the above case, either position formed in call options are longs as majority of the participants are expecting market to remain bullish going forward or it can be due to writing (selling) of call options. On the flip side, if the PCR is above one suggests that traders have accumulated more of put options than call. Again, there are possibilities of these positions being on longs side expecting market to remain under pain going ahead or can be because of writing (selling) of put options.
Rising PCR suggests that market participants are shifting towards put options; while fall in PCR hints a shift towards call options. To have better understanding one should also know what positions are forming during such shift in options. There is an important thumb rule that helps analyzing whether the positions formed in options are long or short.Build-up in options along with increase in IV’s (Implied Volatility) suggests long formation in the particular option
Build-up in options along with fall in IV’s (Implied Volatility) suggests short formation in the option.
Thus, as per the above rules, if PCR rises due to build-up in put options along with surge in IV’s indicates long formation in puts. While, rise PCR due to build-up in put options along with fall in IV’s indicates short formation in puts. Similarly, fall in PCR due to build-up in call options along with rise in IV’s suggests long formation in call option. While, fall in PCR due to build-up in call options along with fall in IV’s suggests short formation in calls.
The put-call ratio is primarily used by traders as a contrarian indicator when the values reach relatively extreme levels. This means if the ratio rises/falls to certain extend market is expected to give a reversal as this high/low Put Call Ratio suggests market being either in over-bought or over-sold territory.
In the above graph, we have taken historical data of Nifty (Future) and PCR-OI for last 3 years. In case of Nifty, we have observed PCR-OI is at its peak between 1.35 - 1.40 and is lowest around 0.65-0.70 levels. As and when we see Put Call Ratio entering these zones, we tend to see reversals in Nifty. On January 2015, PCR-OI reached the peak (1.37) which resulted into a correction (in Nifty) thereafter. Similarly, during February 2016 we witnessed PCR-OI near the lower range (0.68) which led to bottoming for that time-zone.
Thus, for the traders, the Put Call Ratio can be used to determine when the crowd is getting either too bullish or too bearish. Hence, option traders should keep a close eye on this ratio to take contra-calls on the market.The writer is equity derivative analyst of Angel Broking & the opinion is for reference only.