What is the Put Call Ratio and how does it reveal market sentiment?
What is the Put to Call Ratio?
A put option is a contract that gives the holder the right to sell a security at a specific price within a certain time frame. On the flip side, a call option is a contract that gives the holder the right to buy a security.
Because an option typically only costs a fraction of the price of a total share, option buying is a leveraged investment activity.
As a result, it allows people to potentially make outsized gains while putting up with a fixed amount of risk if the stock price moves in their direction.
Up till now, option trading has proven to be increasingly popular with retail investors.
Because of the high retail activity in options trading, the Put/Call Ratio is often used to gauge bullish or bearish market sentiment.
A high ratio indicates bearish sentiment, as investors are buying put options as a way to hedge against a decline in the stock market. Conversely, a low ratio suggests bullish sentiment, as investors are buying call options in order to bet on a rise in the stock market.
Types of Put Call Ratio
- Total Put Call Ratio
- Equity Put Call Ratio
- Index Put Call Ratio
It gives a holistic overview of options trading activity from both retail and institutional investors.
As a result of the extreme bullish sentiment during the meme-stock craze in late 2021 and call buying activity, the ratio plummeted to below 0.40.
On another occasion, with a strong bearish sentiment during the Covid crash in March 2020, the ratio spiked above 1.20.
This ratio is calculated by using only Index Options, such as Options on the S&P 500 Index. It is less of a market gauge for retail activity because Index Options are primarily traded by institutions. Thus, the Index Put to Call Ratio tends to be less fluctuating and extreme than the Equity Put to Call Ratio.
Also, due to institutional hedging, it is typically printing higher numbers than the Equity-Put Call ratio, as retail investors prefer to invest in equity options which benefit from rising stock prices. On the flip side, institutions primarily invest in Index Put Options to hedge downside risks.
All ratios are published daily by the Chicago Board of Options Exchange (CBOE). The CBOE is the most prominent option exchange in the United States and worldwide, and its statistics are the most widely followed. Its ratios also include more granular option activity ratios on Exchange Traded Products and VIX Put-Call Ratios.
Which PCR readings indicate bullish or bearish sentiment
There is no clear-cut rule as to which ratio indicates a bullish or bearish sentiment. The Put Call ratio can be very volatile, and it can surpass readings of 1.0 by far in extreme market circumstances or crashes.
As a rule of thumb, a put/call ratio above 1 indicates more put options are being traded than call options, which is generally seen as a sign of bearish sentiment. This is because there is a bias toward rising stock prices: during regular trading activity, ratios would print below 1.
An extremely bullish sentiment exists when the PCR prints way below 0.5. Such and lower readings indicate a prevalent bullish mood.
But again, these numbers are a rule of thumb and have probably been used because they are round numbers. The PCR can be used to confirm other technical indicators and can also be used to indicate market reversals.
A contrarian indicator
The main benefit of using the Put/Call Ratio is that it can be used as a contrarian indicator. Extreme high readings in the PCR can indicate that bearish sentiment is very strong, and a reversal in stock prices can become increasingly likely.
Contrarian investors look at such signals in order to enter short positions when the market sentiment is highly bullish and, on the flip side, open long positions when the mood in the market is very bearish.
Simply looking at the current reading of the Put to Call Ratio is not enough to determine if the market sentiment is bullish or bearish: as with any indicator, investors would need to look at the time series and history of the ratio to determine what levels have in the past proved to be good contrarian signals and entry or exit points.
A warning signal for market crashes?
Some market crashes have in the past been preceded by extremely bullish sentiment and extremely low readings in the Put Call Ratio.
Before the financial crisis in 2008, the Total PCR hit multiyear lows, printing below 0.50 in October 2007.
In addition, just before the Covid market rout in March 2020, the ratio dropped to values below 0.45.
Needless to say, a low ratio does not guarantee an incoming crash. As with every market sentiment indicator showing extremely bullish readings, traders should combine it with their market experience, other signals, economic indicators and their positioning before taking an incoming crash for granted.
