For those who regularly follow the business news channels, it is very like that they have a heart the term put-call ratio or in some cases termed as PCR. It is one of the most common terms used by the experts when the markets move quickly in any direction that is up or down. To understand signals related to put-call ratios, first, you need to understand what exactly put-call ratio is and how it can determine or predict the sentiment of the market.
Put-call ratio is a very effective tool that can assess the general mentality of the stock market. This speculation tool can predict the movement of the herd in the market and can help the traders to decide the next move.
What is the put-call ratio?
Put-call ratio is basically the ratio of trading of put to call options. The change in this ratio can give an idea about the market’s sentiments. For example, if this ratio is on the higher side that means the put volumes are higher in number in comparison to calling volumes. This will be a clear indication of a bearish sentiment. It is a well-known fact that the traders generally use the put options to fix the selling price of their securities. Thus when they expect the market to fall, a rise in put volumes is a clear indicator of the bearish mood in the market.
Put options can be understood as the contracts that give the owner of the options to sell a specific number of stocks at a specified price before this contract expires. On the other hand, the increase in the call options will show the indication of a build up in bullish sentiment. This is because the one who holds the call options has the right to buy a specific quality of the stock at a specified price on or before the expiry of the contract in hand.
How to understand it?
The history of the market tells that the options traders are more prone to losses in most of the cases. The collective judgment of the market direction is mostly wrong. The main reason for such wrong prediction is that a high put call ratio usually precedes a rising market and low ratio brings the fall in the prices.
If we talk about the examples, back in July 2007, the put-call ratio rose by over 2 but he broad markets rose by over 4 percent. While in January 2008, the volume-based put-call ratio for nifty options fell over 1.5 to under 7 in just a couple of weeks but the market turned in deep correction mode by mid of the month.
At the times of greed and fear in the market can reflect visible rise or fall in PCR ratio. The sentiments of the market are driven by emotions in short-terms more than the basic fundamentals. This makes the put-call ratio an effective tool to predict the movement of the market. In general put-call ratio above 1 indicates a higher put volume versus call volumes, for Indian stock market PCR such as Nifty put-call ratio the optimal level is between 1.2 and 1.5. The reason behind such difference is that the Indian markets puts are used more for hedging than speculation.
PCR has its own flaws and it can give wrong signals about the market. Thus you should not rely on it completely and work on proper understanding the market to make the right speculation so that you do not lose a major chunk of your investment.
For more on Business & Stock Market News, visit BloombergQuint.
