The Put/Call Ratio is a sentiment indicator used to assess whether stock market buying or selling is at an extreme. The ratio is based on put and call option volume, the former bets on a decline in stock or index prices, and the latter is used to bet on a rise in stock or index prices. By looking for extremes in the put/call ratio, traders isolate periods where a reversal could occur. Therefore, this ratio is typically used as a contrarian indicator.
What Is the Put/Call Ratio?
Traders and hedge funds use options to make speculative bets, as well as hedge other positions. A call option is used if a trader expects an equity price to rise, or can be used to hedge a short stock position. A put option is used if a trader expects an equity price to rise, or can be used to hedge a long stock position.
Individual traders usually are more active in the options of individual stocks, while hedge funds (and the like) are more inclined to trade index options.
For this reason there are three dominant put/call ratios that are used, with data provided by the Chicago Board Options Exchange (CBOE).
All charts courtesy of StockCharts.com
- CBOE Equity Put/Call Ratio looks at puts relative to calls in individual stock options. Since most individual traders are looking to profit from rising prices, this ratio tends to hover below 1; more calls than puts.
- CBOE Index Put/Call Ratio looks at puts relative to calls in index options. Major funds and even individual traders will often use index options to hedge other equity positions. Given the long-term upward bias in the stock market, and the tendency for uptrends to last longer than downtrends, this ratio tends to hover just above 1; slightly more puts than calls, because puts are used as a hedge against long equity positions.
- CBOE Total Put/Call Ratio combines the above ratios into one. This helps eliminate the biases inherent in each ratio, and provides a broader picture of how all market participants feel about the stock market. Unless you are very experienced at reading put/call ratios, this is the ratio to focus on as it tends to hover closer to 1, and therefore extremes (deviations from 1) are easier to spot.
How Is the Put/Call Ratio Calculated?
The Equity Put/Call ratio is calculated by taking total put volume and dividing it by total call volume traded on equity options on the CBOE.
The Index Put/Call ratio is calculated by taking total put volume divided by total call volume traded on index options on the CBOE.
The Total Put/Call ratios is both equity and index put volume divided by equity and index call volume on the CBOE.
If the ratio rises, there are an increasing number of puts relative to calls. If the ratio falls there are fewer puts relative to calls.
Be sure to also see Everything You Need to Know About Market Breadth Indicators
What Is the Put/Call Ratio Used For?
The Put/Call Ratio is used as a contrarian indicator. An extremely high number of puts indicates that traders may be too bearish, and if all the “bears” have already taken positions then there is no one left to push prices lower. A very high Put/Call Ratio is therefore potentially short-term bullish for stocks/stock indexes.
An extremely low number of puts (high number of calls) indicates that traders may be too bullish, and if all the “bulls” have already taken positions then there is no one left to push prices higher. A very low Put/Call Ratio is therefore potentially short-term bearish for stocks/stock indexes.
Traders watch for extreme levels in the Put/Call Ratio to signal periods where stock and index prices could reverse. These levels will vary based on which ratio is used (discussed above), as well as market conditions. A long-term up or downtrend in the stock market may alter the exact levels used to indicate extreme bullishness or bearishness. Viewing the long-term Total Put/Call Ratio will show which levels are acting as extremes.
How to Interpret the Put/Call Ratio
Figure 3 shows the Total Put/Call Ratio over two and a half years. Below the ratio there is an S&P 500 chart showing the overall uptrend in the index over that time. Notice that as the price rises, the Put/Call ratio is actually trending lower, as more puts are accumulated to hedge against an eventual decline. This highlights how the levels the Ratio fluctuates between can change over time.
When the Total Put/Call Ratio moved above 130 it often signaled a short-term bottom and prices rose shortly after.
Due to the strong uptrend, sell/short signals, where the ratio dipped below 0.65, were not quite as timely, although prices did fall after two of the signals.
The Put/Call Ratio is extremely choppy and can result in a lot of trade signals that aren’t ideal, as shown above. Therefore, it’s possible to average out the Put/Call Ratio. This gives the indicator a smoother and easier to read appearance. It will also decrease the number of trade signals as the Put/Call ratio will only reach an extreme level if there is some persistence to the extreme bearishness or bullishness.
On StockCharts.com, apply a 10-period simple moving average to the Total Put/Call Ratio ($CPC), and change the chart type to “Invisible.” This means you’ll only see the moving average of the Put/Call Ratio, and not the crazy gyrations as shown in previous figures.
Figure 4 shows how this looks. The chart is much less choppy, although since an average is being used, the extreme levels need to be reduced. Over this period, when the Total Put/Call 10-period average exceeded 1.05, and then dropped back below it, it was a good buy signal.
There was also only one sell/short signal generated by this average over the entire 2.5 year period, which captured a decline in early 2014.
Extremes can last for some time; this is why traders typically wait for the average to drop back through the bearish extreme level (green horizontal line) before initiating a long, or waiting for the average to rally back above the bullish extreme level (red horizontal line) before initiating a short position.
Limitations of the Put/Call Ratio
A non-averaged Put/Call Ratio can be very volatile, providing lots of a false signals or ill-timed signals. Using an averaged Put/Call Ratio can help filter out some of these signals, the drawback to averaging though is that trade signals occur later in the move. In Figure 4 the buy signals occurred after the price had already begun to move higher, missing out on a large chunk of the move in some cases.
The extreme levels are never fixed either. Traders need to look at the Put/Call chart and pick out which extreme levels caused reversals in the past and then trust that that level will produce the same result in the future. It may or it may not.
Using the Total Put/Call Ratio will be simplest for many traders, but if using the Equity or Index Put/Call Ratio on their own, traders need to be aware of inherent biases and adjust their extreme levels accordingly.
The Bottom Line
The Put/Call Ratio can be used to assess bullishness or bearishness in stocks, indexes or both (Total). The Total Put/Call Ratio should satisfy most traders’ needs. The ratio can be choppy, but when it reaches a bullish or bearish extreme level, it can provide timely reversal signals. Applying an average to the Put/Call Ratio will reduce the choppiness and provide fewer signals, but those signals will occur later and thus possibly reduce profit potential. The Put/Call Ratio extremes are not fixed, and will require the trader to assess what levels have worked recently and form a strategy around those levels when they are approached again.
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