So what’s the put/call ratio all about?
It’s a question that comes up a lot so let’s dive in.
There are quite a few ways to measure options action and each can be used as an individual market indicator. The put/call ratio is one of the most important. It is simply the ratio of put options to call options and measures the percentage of open interest that is either puts or calls.
Since puts are used to hedge against declines and calls are use to capture advances, this ratio can be a telling indicator.When the ratio rises above one, there are more puts than calls and the market is thought to be bearish. When it falls below one, there are fewer puts than calls and the market is thought to be bullish. This number is commonly used as a market sentiment indicator when it reaches extremes.
To calculate the ratio, simply divide the number of puts by the number of calls and express in decimal form. In order to get a better perspective, the ratio can usually be added to charts as a study and will appear as an oscillator as it moves over and under one.
The put/call ratio is very important to track and is often used as a contrarian indicator. Technical analysts and options traders tend to turn bearish when too many traders are bullish, or bullish when too many are bearish. Puts and calls are both directional trades, that is, trades that profit from price movement in only one direction, up or down.
An extreme number of puts or calls would be detected in the put/call ratio. As market sentiment turns bearish, puts will increase as traders and investors buy insurance against the feared decline. Conversely, as sentiment improves and traders commit money to bullish speculation, calls will increase. When the market reaches excessive levels in one direction or the other, the chance of a reversal increases.
Because options are traded on more than one exchange, there is more than one put/call ratio. The most widely followed ratio is from the Chicago Board of Options Exchange or CBOE. Just about every online broker will have access to one or more of the available put/call ratios.
Some even have their own statistics. Since the CBOE ratio is the most widely followed, that is the one I am going to focus on here. It is calculated in three ways: index options put/call ratio, equity options put/call ratio and total options put/call ratio. It is important to understand the difference because each views the market in a distinct way.
There are different ways to view put/call ratios. Index, equity or total are only three of the ways available. Index options are generally only traded by professionals, equity options are assumed to be the average investor, and total options combines both into one ratio.
Since index options are used heavily to hedge other investments, the put/call ratio in this market is usually higher than one, showing the bias towards protective puts. Equity options tend to be traded by the average investor. This ratio usually stays below one due to the inherently optimistic nature of traders in this market. The total put/call ratio combines the two types of options into one indicator representing the broader market.
The total put/call ratio works similarly to an oscillator by fluctuating over and under one. On any given day, each of these numbers can change and move through a wide range. By monitoring levels and staying alert for spikes in puts or calls, trade signals can be detected.
The total put/call ratio is best used to determine extremes of sentiment. This is achieved by monitoring the ratio and identifying when the ratio crosses certain thresholds, warning of impending market reversals. Thresholds are determined by historical data.
If during the course of a “normal” bull market the put/call ratio fluctuates between 0.60 and 1.40, then these numbers can be said to be the extremes for the market and used as threshold levels. If the put/call ratio spikes above or below these levels, then a spike extreme has occurred and reversal is imminent.
A spike above 1.40 would indicate excessive bearishness and a spike below 0.60 would be excessive bullishness.
Most traders find it useful to smooth the put/call ratio with a moving average. Because of the volatile nature of options trading, the ratio can have wild movements from day to day. These movements can result in a very choppy chart that is hard to read.
By applying a short moving average, such as a five or ten day simple moving average, you can get a much smoother line and eliminate possible false signals. By viewing the smoothed put/call ratio, you can determine ranges and thresholds for spikes and even spot trends in options buying that can help to pinpoint trade signals.
It is ideal to keep a close eye on the put/call ratio when considering long or short trades. Over time market conditions change and so does the put/call ratio. When the markets are calm, the ratio may remain within a tighter range than when the markets are more volatile.
In this way, the put/call ratio can be used as a measure of volatility. Also, as the ratio’s range changes so do the threshold levels. Remember, the thresholds are relative to historic levels and what is extreme today may be commonplace next year. In order to prevent false signals, you need to keep close watch and adjust the threshold levels as needed.