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Knowledge Corner

Futures & Options [F&O] – Put & Call

How does PCR (PUT-CALL RATIO) Capture Market Sentiment…?
What is PC Ratio?
This ratio is also known as the put-call volume ratio. It is widely used to understand the sentiments prevailing in the cash market. The put-call ratio is calculated by dividing the daily or weekly traded volume of put options by the daily or weekly traded volume of call options. This ratio is not only easy to calculate but also simple to interpret. Higher the number of call options traded higher is the chances of the market turning bullish in future. If put options are more popular, bears could dominate the market. An increasing ratio over a period of time means investors are putting more money in put options, implying the broad market outlook is bearish. Thus, the market can be expected to move south or witness a sell-off. This could also be the case of investors trying to hedge their portfolios. On the other hand, a declining put-call ratio indicates investors are showing more interest in buying call options and the market is likely to move up in the near future.
How does PCR capture market sentiment?
Markets are sentiment-driven and a put/call ratio (PC ratio) is simply a popular sentiment indicator. Bullishness is greed driven and bearishness is fear driven. The one bullish on the market buys a call option and the one bearish on the market buys a put option. PC ratio is the number of put options divided by number of call options. This ratio tells us about the level of bullishness or bearishness in the market. PC ratio can be used in two ways, either the direct way or the contrarian way. For the direct way, you simply follow the ratio and flow with the tide, and for the contrarian way when bullishness is high then downside risk is also high so you take a contrarian view and sell or vice versa. It can act as a preventive measure against sentiments which often lead to buying when the market is high and selling when it is low.
PC ratio goes well with overbought and over sold indicators. A low PC ratio, generally below one, reflects a bullish sentiment and vice versa. It can be based either on open interest or volumes. PC ratio on volumes indicates the sentiment on that particular day while PC ratio on open interest (PCR-OI) gives a carry forward view. Open interest is the total number of options and/or futures contracts that have not yet been exercised, expired or fulfilled by delivery on a particular day. PCR-OI is mainly used to gauge the sentiment for the coming trading sessions. Theoretically, if one buys a put option then he is bearish on the underlying and one who buys a call option is bullish on the same. This theory works very well in matured markets where options turnover as well as open interest is significantly high. So there, one can form a conclusion that if PCR-OI is high then market participants are expecting underlying to correct and vice-versa. However, PCR-OI is not seen in isolation, it is seen with price movement. For example, if underlying after moving up has become range-bound and then you see that PCR-OI of that underlying is increasing then one may say that participants are expecting correction and vice-versa.
Finding ‘Overbought’ and ‘Oversold’ Situations using PC Ratios:
PC ratio is known as Put Call-ratio; is a common tool used in derivative analysis. It is calculated by adding all strikes (Call options and put options) open interest of a stock or index and dividing the put options number with call options number. If the ratio is above 1.2 it sends a message that majority of the market participants are bearish and one should buy calls. On the other hand if the ratio is below 0.2 it means majority is long in Call and we should buy put options.
Another way of finding the PC ratio is adding the total traded volume of Put options and divides with the total traded volume of Call options number. As the Indian markets scaling to a new high the PC ratio analysis remains complicated now. In the recent times the PC ratio, if Nifty remains above 1.2 and sometimes even it had moved above 2.25. It is very interesting to study the PC ratio behavior specifically to the Indian context. Analysis of PC ratio of stocks and Nifty should be interpreted differently.
In the initial stages of a Bull-run in a stock, the PC ratio decreases, for example from 0.8 to 0.4. After reaching the stock a certain level the PC ratio will further declines to 0.2 or even below. Here caution should be taken that the stock has reached in the overbought territory and at any time corrections can sets in. So we should avoid buying Calls. Once the correction has started the PC ratio will raise from 0.2 to 0.8 or even to 1.2.
Sometimes the ratio will further move up to 1.5 or 1.8 (in the case of stocks). It sends us a message that the stock has already reached the oversold territory; upward price movements can be expected. So we should take long call positions. In the case of Nifty the situations is slightly different. As the Nifty is scaling to a new high many of the hedger’s starts accumulate the Nifty Puts for portfolio hedging. Due to this situation the PC ratio of the Nifty will move above 1.2 and it can even move towards 1.8 or even above 2. If the PC ratio rises we should assume that the market is heavily getting overbought. And corrections are expected. Once the correction starts the PC ratio will decline. This is the common strategy adopted by the common man. The recent trend in the PC ratio reveals something more. If the PC ratio of Nifty is on raising mode and the market is also scaling to a new high means, bullish outlook for the Nifty. But if the market fall in tandem with fall in PC ratio suggests weak market outlook.
PC ratio analysis ahead of expiry has high degree of importance that that of early days of a contract in predicting the market outlook. PC ratio analysis will differ from stock PC ratio and Nifty PC ratio on different situations. However, PCR as an indicator has its own flaws. PCR levels in a highly volatile market can be misleading as typically, during such times; traders tend to sell puts instead of buying calls. So, while on an overall basis, put call ratio can be used as a market indicator, it could prove costly you if time markets solely based on put-call ratio.
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