Introduction to Put-call Ratio
Put-call ratio is a financial ratio that can be used as an indicator of relative trading volume of put options to call options. A put is a derivative instrument which gives the holder of a security the right but not an obligation to sell the bond or share known as an underlying asset or security. Similarly a call is an instrument or financial contract that gives the holder the right but not an obligation to buy the underlying asset.
This ratio helps to indicate the investor sentiments towards the market. In simpler terms this means, the put-call ratio or PCR determines the mood of the options market. The put holders expect the price of the underlying security to go down while the call holders expect it to go up. The PCR indicates the trading volume of a security’s put options to call options.
The put-call ratio helps the traders to understand whether a recent rise or fall in the market is excessive and decide if the time has come to take a contrarian call. This is why the put-call ratio is also known as a contrarian indicator.
The put-call ratio looks at the options buildup and is calculated either on the basis of trading volumes or on the basis of options contract on a given period of time.
Calculation of the Put-Call Ratio
By using the Put-call ratio or PCR we calculate the underlying security’s put volume to the underlying security’s call volume over a specified period of time. This calculation of the put-call ratio is done simply by dividing the put volume by call volume. And the formula is as follows:
Put-Call Ratio = Put trading volume / Call trading volume
Another way of calculating the put-call ratio is by dividing the open interest in the put contract by open interest in the call option at the same strike price and over the specified given time. The formula is as follows:
Put-call Ratio = Put open interest on given day / Call open interest on the same day
When the put trading volume is higher than the call trading volume, the put-call ratio is above 1, whereas when the call trading volume is higher, the ratio is less than one.
Interpretation of the Put-call Ratio
After calculating the put-call ratio by the above formula, the ratio comes out as 1 or above one, it interprets that it is the time to sell the underlying security, whereas when the ratio is lower than 1, it interprets that it is time to buy the underlying security.
