What is a Put Call Ratio (PCR)? How to use PCR in Trading
The put-call ratio is a ratio of a number of contracts traded in the put options to the number of Contracts traded in calls. It is used generally to determine the sentiment of the option market on particular stock or index. The ratio is calculated either on the basis of options trading volumes or on the basis of options contracts on a given day or period.
One can calculate PCR by dividing the number of open Interest in a put contract by the number of open interest in call option at the same strikes price at the particular day and particular expiry. If you are you new to the option you can check the basic here.
It can also can be calculated by dividing put trading volume by call trading volume, in this case, it is known as PCR volume and the above is known as PCR OI or simply PCR.
PCR (Volume) = Put trading volume on particular day/call trading volume.
We can also calculate PCR for wide market by taking the total number of OI for all open Call options and for all open Put options in a given series.
PCR (OI) = Put open interest on a particular series/Call open interest on the same series
Importance of PCR
It is a contrarian indicator that gives insights about the option build ups, that helps traders to understand whether a top or bottom has been formed so they can take contrarian bet.
On the flip side, if the ratio is higher than 1, it suggests traders are buying more Put options than Call options. However, one needs to keep in mind that puts are also bought for hedging purposes against any decline in the market.
For example, someone has invested in a stock hugely, and he wanted to reduce his risk, he also can buy put for saving his investment if any sudden decline comes in the market.
The market sentiment will be highly bearish when the PCR is at a relatively high level. But for a contrarian, it suggests that the market may soon bottom out. And if the ratio falls relatively low, it suggests extremely bullish, but for contrarians, it conveys top is in the making.
The PCR can be calculated for an index or for an individual stock.
A PCR ratio below 1 suggests that traders are interested in buying more Calls than Put options. It signals that most market participants are betting on a likely bullish trend in upcoming days.
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Here, we have Open Interest positions for nifty on different strikes. If we want to calculate PCR for 11200, we can do it this way,
PCR for strike 11200 = 7.79/5.34 = 1.45.
Trading Option With PCR
If on the basis of PCR, you have made a bullish view on a stock, you can buy a call option of that stocks and if the price moves up, your premium will be moved up as well. You also can sell a put if your view is bullish. However, you should keep in mind the option buyer has limited risk but option sellers have unlimited. However, option buyers have unlimited profit whereas options have limited profit
On other hands, if your view is bearish, you can buy a put or sell a call. Option buying needs precise selection of strike price.
If the ratio is high in a falling market, it reflects how bearish the sentiment could be. But a rise in the ratio in a rising market is considered to be bullish if you are not a contrarian.
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