What Is the Put/Call Ratio?
An indicator that displays put volume in relation to call volume is the put/call ratio. Put options are used to wager on a decline or to protect against market weakness.You can wager on an advance or hedge against market strength with call options. When put volume surpasses call volume, the put/call ratio is greater than 1, and when call volume surpasses put volume, it is less than 1. This indicator is usually used to measure the mood of the market.When the Put/Call Ratio is trading at relatively high levels, sentiment is considered overly negative; when it is trading at relatively low levels, sentiment is considered excessively positive.To smooth the data and extract signals, chartists can use moving averages and other indicators.
Calculating the Put/Call Ratio
The calculation is straightforward and simple.Copy
Put/Call Ratio = Put Volume / Call VolumeOptions Exchanges
Chicago Board Options Exchange (Cboe) Put/Call Ratios are available for research on StockCharts.com.The largest options exchange is Cboe, and its statistics are the most extensively used.The options are divided into three categories by the Cboeindicators: equity, index, and total.Options traded on individual equities are the topic of the Cboe Equity Put/Call Ratio ($CPCE).Options sold on the major indices, including the Dow, Nasdaq, Russell 2000, S&P 500, and S&P 100, are the focus of the Cboe Index Put/Call Ratio ($CPCI).The Cboe Total Put/Call Ratio ($CPC) combines equity and index options.
Interpretating the Put/Call Ratio
The Put/Call Ratio is employed as a contrarian indicator to measure bullish and bearish extremes, just like the majority of emotion indicators. When too many traders are bullish, contrarians become bearish, and when too many traders are bearish, they become bullish. Puts are purchased by traders as directional bets or as insurance against a market decline. Calls are purchased as a directional wager on rising prices, even though they are not frequently utilized for insurance purposes. When the expectation of a downturn rises, so does the put volume.On the other hand, when anticipation of an advance rises, so does the volume of calls.When the Put/Call Ratio shifts to comparatively high or low levels, sentiment approaches extremes.These extremes are subject to vary throughout time and are not set in stone.Call volume would be much larger than put volume, indicating excessive bullishness in a put/call ratio at its bottom extremities.Excessive bullishness, in contrarian words, would suggest caution and the potential for a stock market fall.Because put volume would be far larger than call volume, a put/call ratio at its highest extremes would exhibit excessive bearishness. Overly pessimistic outlooks would support optimism and the potential for a bullish reversal.
Index, Equity, or Total
Chartists have to decide whether to use equity, index, or total option volume when utilizing Cboe-based indicators. Generally speaking, professional traders are linked to index options, whereas non-professional traders are linked to equity options. Even though professionals use index options for hedging or directional bets, puts garner a significant portion of total volume for hedging purposes. The chart below shows the Cboe Index Put/Call Ratio ($CPCI) with the 200-day moving average. Notice that this ratio is consistently above 1 and the 200-day SMA is at 1.41, which indicates a bias towards puts. This bias is because index options (puts) are used to hedge against a market decline.
The Cboe Equity Put/Call Ratio ($CPCE), on the other hand, consistently remains much below 1, indicating a pronounced bias in favor of call volume. Observe that the 200day moving average is far below 1 at 0.61.Because they tend to be more bullish, amateur traders maintain a comparatively high call volume.
Combining equities and index options, the Cboe Total Put/Call Ratio ($CPC) generates an oscillator that moves above and below 1. The call bias in stock options counteracts the put bias in index options. Over the past 200 days, there has been a minor bias towards call volume, as evidenced by the 200day moving average remaining below 1 (.91).The indicator does, however, demonstrate a shifting bias from put volume to call volume as it oscillates above and below 1.
If the sentiment of professional traders is reflected in index options and that of retail traders in equity options, then the combination represents “market” sentiment. This means theTotal Put/Call Ratio can be used as a sentiment gauge for the broad market. This article will focus on the CBOE Total Put/Call Ratio. Not because it is necessarily better, but because it represents a good aggregate. Chartists should look at all three to compare the varying degrees of bullishness and bearishness.
Spike Extremes
One tool for spotting spike extremes that can portend a market reversal is the Total Put/Call Ratio. When the indicator spikes above or below a predetermined threshold, it is called a spike extreme. The indicator with horizontal lines at 1.20 (green) and.70 (red) is displayed in the chart below .An increase in put volume compared to call volume, hich may be perceived as extreme bearishness, is seen in a spike over 1.20.Excessive bearishness is considered bullish as a contrarian metric. There are too many pessimistic traders. The spikes are shown by the green vertical lines, and the green arrows correspond to the S&P 500. Tradable lows were found in late October and early February by spikes above 1.20. Extremes in May and June resulted in shallow bounces or flat trading before the market continued lower. The indicator then spiked above 1.20 after the September low.
A spike in call volume compared to put volume is indicated by a value below 0.70. When players anticipate a rise in the market, they purchase calls. A bearish stock market reversal may be hinted at by excessive call volume, which indicates excessive bullishness. These spikes are indicated by red vertical lines, and the S&P 500 at the moment is shown by red arrows.The April signal was successful, the December signal was premature, and the October signal performed admirably.
Smoothing the Ratio
Because the Total Put/Call Ratio produces a rather choppy series, a short moving average can be applied to smooth the data and define trends. The chart below shows the indicator as a 10-day SMA (pink). The daily values are “invisible” to focus on the 10-day SMA. See the Sharp Charts section below for ways to make a plot invisible.
There are a few takeaways from this chart. First, notice that the indicator is much smoother with less volatility. Second, the 10-day SMA can actually trend in one direction for a few weeks. Third, the spike thresholds are set lower because of less volatility. Fourth, the 10-day SMA slows the indicator to produce a lag in the signals.
Red and green arrows indicate the S&P 500 at signal time, while red and green vertical lines indicate the signals. If the indicator rises above the bearish extreme (.95) and falls back below, it is a positive signal. When the indicator falls below the bullish extreme (.80) and then rises again, it is a negative signal. It is crucial to wait for confirmation with a move back above or below the barrier because this moving average might trend for long stretches of time. When the indicator rose above.95 in May, a long position would have been avoided if this confirmation had been obtained first. Observe how the indicator continued to rise and held steady at comparatively high levels for a long time.
Shifting Ranges
The ranges for the CBOE Total Put/Call Ratio will change over time in response to market conditions. The 10-day SMA (black) and the 50-day SMA (pink) are displayed in the chart below. At 1.00, a blue horizontal line is established. Observe how, from April 2007 and early 2009, the moving averages varied above and below 1.00. In the first half of 2007, the market was flat, and this was followed by a prolonged fall. A tilt towards put volume (downside protection or direction bet) is indicated by the comparatively high levels. The CBOE Total Put/Call Ratio entered a lower level centered around.85 when the market reversed and began to rise in March 2009, indicating a tilt towards call volume. The moving averages stayed in this range until April 2010 and then both shot above 1.00 again.
Conclusions
The Put/Call Ratio is a contrarian sentiment indicator, meaning that its signals frequently contradict the current trend. Put volume rises during a prolonged downturn, whereas call volume rises when a rally gains traction. It indicates that options traders are either very bullish or bearish when the Put/Call Ratio hits an extreme. Sometimes these contrarian signals will be too early or just erroneous, but other times they might pinpoint tops and bottoms. Not all indicators are flawless. Finding the extremes and waiting for one to be reached are crucial. The Put/Call Ratio will typically oscillate between these two extremes. It is also important to use the Put/Call Ratio in conjunction with other indicators, such as momentum oscillators or chart patterns to confirm signals. Waiting for a little confirmation can often filter out bad signals.
Put/Call Ratio on StockCharts.com
The Sharp Charts charting tool allows you to visualize the Put/Call Ratio in a number of different ways. The indicator can be positioned above or below the main window or in the main window itself. The CBOE Total Put/Call Ratio ($CPC) is displayed in the main window (gray) in the example below, with a 10-day SMA applied for smoothing (black). To conceal the daily data, users can also select “Invisible” under “Type” for the chart. By doing this, the price scale will be enlarged to match the 10-day SMA smoothed version. You can also add horizontal lines as “Overlays.” The Put/Call Ratio can be compared to index movements using a related index as a “Indicator.”
