What is Put Call Ratio?

We know that a call option is a right to buy and a put option is a right to sell. Here we look at the put-call ratio meaning and interpretation. The put-call ratio tries to make sense of loads of puts and calls of various strikes that get traded and make sense of what these trends are throwing up. That is the gist of the put-call ratio meaning. Let us break up the put-call ratio meaning further into PCR of volumes and PCR of OI or open interest. Here is how to go about doing it.

Breaking up the put-call ratio of Volumes and the put-call ratio of OI.

The put-call ratio measures the ratio of the puts to the calls. There are broadly two ways to evaluate and interpret the put-call ratio or the PCR; the PCR of volumes and the PCR of OI. We will look at the static PCR of OI first.

PCR (OI) = Put open interest on given day / Call open interest on a given day

You must be familiar that open interest is the value of all the positions that are initiated but not closed out in a particular contract. PCR of open interest can be calculated for individual stocks, indices, or for the market as a whole which gives a macro perspective. PCR has one condition in that it is meaningful only when the contract shows substantial and sustained liquidity and the basis risk is very low, otherwise the entire purpose gets defeated.

Let us consider an illustration. if the open interest of puts on the Nifty 15,800 strike is 3.6 million contracts and if the OI of calls for the same contract and expiry is 5.4 million contracts, contracts then the calculation would work out as under.

PCR (OI) = 3.6 million / 5.4 million = 0.75

Another way to interpret the put-call ratio is in terms of volumes in a particular day or you can also use any other appropriate time frame to capture this data like a week, month, etc.

Let us now illustrate. If the put volumes in the Bank Nifty 15,600 strike is 60,000 contracts and the call volumes in the same contract for the same expiry is 90,000 contracts. In that case, the calculation will be as under.

PCR (Vol) = 60,000 / 90,000 = 0.67

How do we look at the ideal put-call ratio in isolation?

There is nothing like a range for PCR or an ideal level for PCR so any number of PCR in isolation can only tell you so much. The moral of the story is don’t go by absolute numbers but by the trend over some time. Normally, the time-wise trend can be fairly illustrative. From an analytical perspective for a market observer, trader, or even an investor, here is what you can do with PCR data.

• A high level of PCR can be seen as a signal of too much fear while a very low level of PCR can be interpreted as a sign of too much greed in the market. Such levels can be taken as a veritable indicator of a turnaround in market conditions.
• If the put-call ratio has gone up sharply combined and accompanied with a sharp market correction, it can be interpreted as too much pessimism built into the markets. If puts are being written aggressively, then it could be a sign of bottoming since put writing is normally done by the more informed institutional investors.
• There is one more interpretation of the put-call ratio. If PCR has fallen sharply with a sharp market spurt, it can be interpreted as too much optimism. In such situations, if the calls are being written, then it could be interpreted as a signal of topping out.

Combining the put-call ratio with implied volatility (PCR with IV)

Implied volatility (IV) can be interpreted as the volatility that is implied in the option prices of the Nifty at a point in time. It has to be understood concerning the Black & Scholes Model. Let us cut down this long story. In calculating the value of the option using Black & Scholes, you normally use historic volatility to estimate the option price. Instead of that, you take the option price as the intrinsic value and then calculate the implied volatility instead of historic volatility. IV is one of the most important parameters in the futures and options market and you get the best results when you combine this put-call ratio with the IVs. Here is how to do it.

• If PCR is increasing with an increase in IV, it indicates that the put activity is increasing with an elevated sense of risk. It is considered to be a strongly bearish signal.
• If the put-call ratio increases with a decrease in IV, it implies that put activity is increasing with a falling sense of risk. That means puts are being written and since it is informed investors and traders that write puts, it is a clear bullish signal.
• If the PCR decreases and it is accompanied by a fall in the IV, it can be interpreted as a signal of unwinding of Puts and a signal that markets may be bottoming out. This is the time that even investors use to plan long-term investments.
• If PCR decreases with an increase in IV, it implies that puts are being covered and the markets will again fall once the covering is done and dusted. Here you have to be careful and trade for very short term only.

How is the put-call ratio calculated?

Put call ratio can be calculated as the PCR of volumes or the PCR of open interest. Both methods can be used although the open interest method is more popular and also suggestive. This is just an indicative approach.

Significance of put-call ratio

If the put-call ratio has spurted sharply accompanied by a sharp market correction, it can be interpreted as too much pessimism built into the markets. If puts are also being written aggressively, then it could be a sign of bottoming since put writing is normally done by informed institutional investors.

Alternatively, if PCR has fallen sharply with a sharp market spurt, it can be interpreted as too much optimism. In such situations, if the calls are being written, then it could be interpreted as a signal of topping out