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.
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.
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.
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.