Put Call Ratios : Their Importance

      No Comments on Put Call Ratios : Their Importance

Last year, during January 2018, the PCR was at a seven- year high (1.75x – last time seen in September 2010), – from a contrarian perspective, this was signalling therefore that a large move may be coming – and that , given the levels, the stock market was severely overbought. Even In the last one month, Nifty PCR has fluctuated wildly but may have gone unnoticed as most traders overlook its importance. This piece highlights what one should about the PCR and  its relevance as one of the key measures of market sentiment.

Calculating PCR

PCR is simply the volume in puts divided by the volume of calls traded. Example, if 100 calls and 100 puts were traded today in the Nifty, the put/call ratio is 1.00. If 200 puts have traded and 100 calls have traded, the put/call ratio is 2.00.

While the calculation of PCR may be applied to Open Interest as well as options  Volumes, people normally use the ratio of the trading volume to gauge possible market direction.

NSE India provides the option chains of Nifty and its various stocks on its portal – for instance at https://www.nseindia.com/live_market/dynaContent/live_watch/option_chain/optionKeys.jsp?symbolCode=-10000&symbol=NIFTY&symbol=NIFTY&instrument=-&date=-&segmentLink=17&symbolCount=2&segmentLink=17

Alternatively, one can see the summary info at https://www.bloombergquint.com/markets/option-chain/put-call-ratio#gs.V9VNh8l1

Why look at PCR

As per conventional definition, a PCR ratio below 1 suggests that traders are buying more Call options than Put options. It signals that most market participants are betting on a likely bullish trend going forward. In the other scenario, if the ratio is higher than 1, it suggests traders are buying more Puts than Calls- the market sentiment is deemed excessively bearish when the PCR is at a relatively high level and the market may soon bottom out. On the other hand, when the ratio falls to a very low level, it is deemed excessively bullish and suggests a market top is in the making.

However, as the chart shows below, the ratio may fluctuate wildly and its day to day information may not be of much help except for shorter term traders who look at this indicator as one additional nugget to guess the continuity of the trend.

The Contrarian Nature of PCR

Nifty charts suggest that a contrarian view might help much more – remember, buying activity is typically done by retail – which loses most times – while sales are controlled by “smarter pockets”. The chart below shows the movement of Nifty (Blue Line) versus the  PCR Nifty- see the spikes and the consequent falls as the PCR fell or rose. Note : PCR , after a large move and then stability, subsequently brings about a reversal as well- as we may be experiencing  now at the time of writing this piece.

According to us therefore, PCR is much more useful as a powerful contrarian indicator.

PCR – Watch but Not Alone!

When constructing a trade, the PCR should be used cautiously in conjunction with other directional indicators. Of course an extreme level of the PCR can reinforce a bullish or bearish bias, and can assist with timing a trade entry or exit but this may happen only at extremes. These spikes can often signal reversals and are more important than day to day activity.

Whats more difficult is defining what is an extreme. This may depend on stock to stock and time to time – traders therefore often look at the recent 1 year data to define what could be considered extremes as well as spikes. Usually Nifty PCR is in the range of 0.6-0.7 on the lower side and 1.4-1.5 on the higher side and extremes above this could mark a reversal.
Also there is another thought that needs to be kept in mind – Index PCR will always be higher than stock PCR because institutions typically buy puts for hedging portfolios so put activity is permanently higher.

Mail us at advisory@plindia.com to share your views or open an account or just simply to find out whats new at PL!

[erforms id=”763″]

Leave a Reply