The put-call ratio is simply an indication of the number of puts being traded versus the number of calls being traded. There are several put-call ratios that may be watched or used by investors including the total number of puts and calls, the number of puts and calls on equity options only, and some that include options from a specific index such as the S&P 500.
The put-call ratio is designed to measure overall sentiment within a market. The more puts being bought relative to the number of calls being bought may indicate bearish sentiment. The more calls being bought relative to puts may indicate bullish sentiment.
The key to using the put-call ratio is understanding that it may be most useful as a contrarian indicator.
When the ratio is high and a lot of puts are being bought, you may want to be bullish.
When the ratio is low and a lot of calls are being bought, you may want to be bearish.
A swing trader, for example, may potentially find the put-call ratio useful for timing trade entries and exits. Here is a simple way to potentially use the ratio as a trade timing tool:
Look for potential short positions when the ratio reaches .6o or lower.
Look for potential long positions when the ratio reaches 1.00 or higher.
The put-call ratio may also be useful for exiting trades or positions. If you are long calls on the S&P 500, for example, and the put-call ratio reaches a level of .60, you may consider exiting your long position. Conversely, if you are long puts on the S&P 500 and the put-call ratio reaches 1.00, you may want to consider exiting your position.
When the put-call ratio reaches an extreme level on the upside or downside, it means that market participants are heavily tilted long or short. Eventually, however, when everyone is bearish, there is no one left to sell and the market may reverse. On the other hand, when everyone is bullish, there may be no one left to buy and the market may reverse.
The put-call ratio is a great indicator of overall sentiment and what the “crowd” is doing. When it comes to trading, however, the “crowd” is often wrong making the ratio a potentially valuable contrarian indicator. Extreme levels on the ratio may potentially be followed by significant market reversals and understanding this may potentially lead to better position entries and exits.
