The put-call ratio is the ratio of total trading volume of put options divided by the total trading volume of call options. For example, if the total trading volume of put options was 4 and the total trading volume of call options was 2, then the ratio would be 2.
Put-Call Ratio in Trading
The put-call ratio is used as a supporting market sentiment indicator to gauge the market’s current attitude toward a security or index.
For example, a high put-call ratio indicates a high relative volume of puts to calls, which means that traders are interested in profiting from a downward movement in the price of the security.
However, options are also often used as a form of insurance, so a high put-call ratio may indicate that many traders have taken a long position in the underlying security and have purchased relatively cheap out of the money put options to protect against an unexpected and substantial downward price movement.
Since the ratio as an indicator of market sentiment is so open to interpretation, it is most often used as part of a broader basket of market sentiment indicators.
Final Thoughts
The put-call ratio is a very useful market sentiment indicator. The further the put-call ratio is from parity, The greater the likelihood that the market perceives some significant price event in the security’s future.
As day traders are constantly looking for securities that have the potential for sudden sharp price movements, the put-call ratio is an excellent tool for identifying and sorting potentially profitable trades.
However, the put-call ratio is a rather vague measure and open to a wide degree of interpretation, so it is best used as part of a broader basket of market sentiment indicators.
Furthermore, market sentiment in general is insufficient in itself for identifying profitable trades, and further analysis of each potential trade is required.