Put Call Ratio (PCR): Meaning, Calculation and Limitations

Analysing the stock market dynamics and the overall market sentiment is the first step towards creating a healthy investment portfolio that can meet the target financial goals. Traders have various tools to assess this market sentiment, and one of the most significant is the put-call ratio. It helps determine if the market is bullish or bearish, aiding in effective trading strategies and risk management. Learn what is put call ratio and its related details in this blog to refine your trading journey. 

What is the Put Call Ratio?

The Put Call Ratio (PCR) is a popular metric traders use to gauge market sentiment. It is calculated by dividing the number of put options by the number of call options. 

A high PCR indicates a bearish sentiment, as more traders buy puts, expecting the market to decline. Similarly, a low PCR suggests a bullish sentiment, with more traders buying calls in anticipation of a market rise. This helps traders make informed decisions to shape their trading portfolio and find suitable entry or exit points based on their trading plan. 

How to Calculate the Put Call Ratio (PCR)?

The put call ratio calculation involves the total number of put options and call options. Traders can calculate put call ratio or PCR by using two formulas given below,

• PCR Calculation Based on Open Interest

This is calculated by dividing the open interest (the number of outstanding contracts) of put options by the open interest of call options.

Put Call Ratio (OI) = Open Interest of Put Options / Open Interest of Call Options

• PCR Calculation Based on Volume

This is calculated by dividing the total volume of traded put options by the total volume of traded call options.

Put Call Ratio (Volume) = Volume of Put Options / Volume of Call Options.

Calculating the put call ratio using the above formulas can give traders insights into the market sentiment based on the trading activity or the number of existing contracts. This helps them make informed trading decisions and implement effective risk management strategies to minimise losses and capitalise on profitable opportunities. 

Example of Put Call Ratio

• Calculating PCR using open interest

Open Interest of Call Options = 5,000

Open Interest of Put Options = 8,000

PCR (OI) = Open Interest of Put Options / Open Interest of Call Options

PCR = 8000 / 5000 = 1.6

A PCR of 1.6 means that there are 1.6 put options for every call option. This indicates a bearish sentiment in the market, as more traders hold positions that bet on the market going down.

• Calculating PCR using trading volume

Volume of Call Options = 4,000

Volume of Put Options = 2,000

PCR (V) = Volume of Put Options / Volume of Call Options

PCR = 2000 / 4000 = 0.5

This PCR of 0.5 suggests that for every put option traded, two call options are traded. This indicates a generally bullish sentiment in the market.

How to Trade using Put Call Ratio?

PCR is a strong indicator of market sentiment and can be used for trend confirmation and an indicator of possible trend reversals. Here are some uses of Put Call ratio in trading -

Identifying Market Sentiment

The PCR values calculated based on the above formula can be used to interpret the overall market sentiment as follows -

• High PCR (> 1) - This indicates more put options are being traded than call options, suggesting a bearish sentiment, and traders expect the market to go down.

• Low PCR (< 1) - This indicates more call options are being traded than put options, suggesting a bullish sentiment, and traders expect the market to go up.

• PCR (= 1) - This indicates an equal number of put and call options, which reflects a neutral market or trend. 

PCR as a Contrarian Strategy  

PCR calculation resulting in extreme values can also be used as a contrarian indicator, indicating a potential trend reversal. Here’s how it is used -

• Very High PCR - Most traders are bearish if the PCR is much higher than usual. Contrarian traders may see this as a sign that the market is oversold and could start rising soon.

• Very Low PCR - Most traders are bullish if the PCR is much lower than usual. Contrarian traders may see this as a sign that the market is overbought and could start falling soon.

PCR for Trend Confirmation

PCR calculation resulting in moderate values can be used with other indicators as a trend confirmation tool. 

• Rising Market with Low PCR - If the market is rising and the PCR is low, it confirms the bullish trend.

• Falling Market with High PCR - If the market is falling and the PCR is high, it confirms the bearish trend.

Limitations of Put Call Ratio

The put-call ratio provides a snapshot of market sentiment at a given point in time; however, it may not accurately predict future market movements. The PCR can also be influenced by large institutional trades, which might not reflect the sentiment of the broader market. 

The PCR is mainly useful for indices and large-cap stocks with active options trading, making it less effective for smaller stocks that do not have available options. Additionally, it doesn't account for the reasons behind the trades, such as hedging strategies, which can distort the interpretation. Therefore, even if PCR is useful, it should be used alongside other indicators and analysis methods for a well-rounded trading strategy.

Put Option Vs Call Option

The key differences between the put option and the call option include,

Conclusion

Put call ratio is a valuable tool for assessing market sentiment. It uses a straightforward comparison of the number of put options to call options. While this measure can help gauge the market trend or trend reversal, it cannot be used as a standalone indicator as it does not account for future price movements.