Put Call Ratio (PCR)-Definition, Formula and Importance

If you are a frequent trader in options, you must be aware about the term Put Call Ratio (PCR). Investors use this PCR to access the market whether it is bullish or bearish.  It is an instrument through which one can determine mood of the options market. 

But before we begin with the topic it is important to understand few concepts mentioned below

As we mentioned Put Call Ratio is used by Options Traders So What are Options?

An Option is a contract which allows an investor to buy or sell an underlying instrument like a stock or even index at a predetermined price over a certain period of time for which premium is paid by the buyer to the seller.   Options contracts expire on the last Thursday of the month. 

For example: 

Mr. Sham wants to buy share of the company A which is currently trading at Rs 600. Mr. Sham feels that the share price would rise in future and would go up to Rs 700. Here Mr. Aman holds shares of Company A and he wants to sell the shares as he feels the price might further go down. So here Mr. Sham enters in to the contract with Mr. Aman specifying a strike price of Rs 700. He pays a premium amount of Rs 50 to Mr. Aman. Here we have to understand that Mr. Sham will execute the contract only if the share price goes above Rs 600.

Which means Mr. Sham has the choice to exercise the contract and there is no obligation or compulsion that he should execute the contract. If suppose the share price falls below Rs 600, Mr. Sham will not execute the contract and will incur loss for the premium amount paid and if the share price goes up to Rs 800 Mr. Sham will execute the contract and buy the share from the seller at Rs 700 and sell in the market at Rs 800 and earn profit.

So now that we know what is Options lets understand it Types i.e. Put Option and Call Option

Put Option

Put Option gives the buyer the right but not the obligation to sell an asset. A Put Option buyer believes the stock prices will fall. Put Option seller maximum loss is strike price minus premium amount. For example let’s say Mr. Aman believed that his share price would fall down further to Rs 600. So in case of Put option Mr. Aman will decides a strike price of Rs 550. And if the prices fall below Rs 550 to Rs 400 Mr. Aman will execute the contract at Rs 550 and earn profit.

Call Option

Call Option gives the buyer the right but not the obligation to buy an asset. A call option buyer believes that the prices will rise. For a call option buyer the loss is limited to the premium paid. For example Mr. Sham in the above example believed that Share price would go up from Rs 600 to Rs 700. So in this scenario he will execute the option contract and earn profit of Rs 100. But if the prices fall down from Rs 600 he will not exercise the contract. The logic here is very simple. If the share price are falling below it is better to buy the share market rather than purchasing it from the seller.

In both the cases we should remember that the contract has expiry Date and the share prices should rise or fall before the expiry date. The contracts would then expire worthlessly or there may be additional charges levied for the same. So don’t forget to square off your options contract before expiry!

Now that we are clear with our basic terms Let us understand  our topic

What is Put Call Ratio?

Put Call Ratio is a popular derivative indicator or measurement of the volume of Puts to the Volume of Calls within a specified period of time. Here the objective is to determine the mood of the market or predicting the future price action. A High Put Call ratio indicates that the markets are currently bearish whereas lower Put Call Ratio indicates the market is bullish. 

Put Call Ratio Calculation

The Put/Call Ratio has two formulas

1. PCR= Put Volume / Call Volume, where Put volume and Call volume are the number of Put and Call options traded over a specific day.

Example:

On a particular Day total number of Puts traded is 1500 and Total Number Call option traded is 2000 then the

PCR ratio = 1500/2000

                  = 0.75

Points to be noted:

• A PCR value below 1 is indicative of the fact that more Call options are being purchased relative to the Put options which signals that investors are anticipating a bullish outlook for the markets ahead.
• Similarly, a PCR value above 1 indicates that more Put options are being purchased relative to the Call options which signals that investors are anticipating a bearish outlook for the markets ahead.
• A PCR value equal to or close to 1 implies the number of purchased Call options and Put options to be roughly the same and is indicative of there being a neutral trend in the markets.

1. PCR = Total Put Open Interest / Total Call Open Interest, where the numerator and denominator are the Put Open Interest and Call Open Interest on a specific day.

Example :

Assume that the open interest of puts the Nifty 10,700 strike is 38, 00,000 contracts and the open interest of calls for the same contract and expiry is 49, 00,000 contracts. In that case,

PCR (OI) = 38, 00,000 / 49, 00,000

                  = 0.78

Points to be noted:

• Open Interest means number of active contracts. These are the contracts that have been traded but not liquidated by offsetting the contract.
• Open interest also gives you key information regarding the liquidity of an option. When options have a significant open interest, it means there are a large number of buyers and sellers out there.

Put Call Ratio as Contrarian Indicator

• Put  Call Ratio differs for each investor depending upon their investment methodology. Contrarian investing is defined as a strategy which focuses on going against the prevailing market segment.
• Traders usually use the Put call ratio as a contrarian indicator when the values touch extremely high levels.
• When the ratio touches extreme levels, it is usually indicative of the fact that the market is currently characterized by overly bullish or overly bearish sentiment.
• In short the utility of the Put Call Ratio as a contrarian indicator, an extremely high Put-Call Ratio suggests that the market is extremely bearish, which to a contrarian a bullish signal is implying that the market is in the oversold zone and up for a turnaround, which may be a good buying opportunity.
• Similarly, extremely low values of the Put-Call Ratio would imply the exact opposite and indicate to the contrarian that the market is in the overbought zone and too bullish, thereby implying that the market is due for a sell-off and it may be a good selling opportunity.

 How to analyse PCR (Put Call Ratio)?

Let’s see how PCR analysis can be interpreted taking option sellers into consideration who are the major players in the market as compared to the retail public who are usually on the buying side of the trade.

As there are two sides of a same coin, Put Call Ratio has its importance as well as Certain Limitations . Let us understand what they are

 Importance

• Put Call Ratio helps to determine the market direction and its mood at given period of time
• It guides the traders when to place their best bets on the stocks
• As it is a contrarian tool , it helps traders to analyze whether a recent fall or recent rise in the market is extreme or if the time has come to take the contrarian call.

 Limitations

• Most of the investors are unaware about the PCR. Even a small shift in the market serves as an essential indicator.
• Investors must use other factors also before betting on current market sentiments , rather than just depending on PCR.

Conclusion

Investors must remember that any ratios will not give you a complete picture of the market sentiments. It just gives us a fair idea that market is at top or bottom and helps to anticipate the market. But rather than just sticking to one single ratio investors must consider other factors as well before placing their positions in the market.