In trading, there are various indicators you can use to gauge the market sentiment and the likely trend that helps the traders make the right decision for trading. And trading in options you need to be very cautious to get the right indication of the market to enter into the right trading strategy.

As much as the trading activities in call and put increases or decreases, the option premium prices also get affected. Hence you can use the trading activities in the call and put to get an indication of the market or identify the trend in particular underlying security. However, to use this as an indicator in trading you have to understand the put-call ratio.

What is Put Call Ratio?

The put-call ratio (PCR) is simply the ratio of the volume of puts over the calls for a specific time. And here volume means the volume of open interest in the call option and put option. The put-call ratio is measured against the value 1, if the PCR is more than 1 it means the put volume is higher than the call volume, while if the PCR is less than 1 it indicates the call volume is higher than the put volume.

What is Put put-call ratio in Options?

In options, the volume of trade is considered through the open interest that is built up in the market index or in specific underlying security trading in the options.When traders buy, more call options compared to the put option the PCR remains below 1.

Also Read: How to Use Open Interest for Intraday Trading or Trading

On the other hand, when traders buy more put options compared to call options, the PCR will remain above 1. And if PCR is equal to 1, it means the open interest in the call and put option is the same. The PCR ratio gives a certain indication of the market or the underlying security. Based on the indication you can make the right trade decision in options trading.

What Does Put Call Ratio Indicate?

The PCR shows the trading volume or open interest in the call and put, and the value of the PCR indicates the types of trends or sentiments of the traders towards the market or the underlying security. When PCR is above 1, it indicates there is bearish sentiment in the market, while a PCR with a value below 1 gives the indication of a bullish trend in the market.

Also Read: How to Identify Trend in Stock Market: 10 Points to Find Trend

And when the PCR is equal to 1, it means the market trend is neutral or there is no clear trend or sentiment visible in the market. An extremely low or high put-call ratio meansmarket participants are getting overly bullish or too bearish. Interpreting and analysing the PCR precisely will help you to make the best use of this indicator in option trading.

Also Read: Best Technical Indicators for Option Trading in TradingView

How to Interpret PCR Ratio?

To interpret the PCR ratio you need to understand more about call put and open interest that isgenerated during the trades. The PCR is calculated by dividing the number of traded put options by the number of traded call options. The traded quantity here refers to a number of contracts that shows the total open interest in the traded contracts.

The put-call ratio provides insights into the market sentiment with the potential for future price movement of the market or the underlying security. When PCR is less than 1, it means the open call contracts are more than put contracts which shows the market sentiment is bullish means the underlying security is likely to rise in the near future.

On the other hand, when PCR is more than 1, it indicates the open put contracts are more than the call contract. This means that the market sentiment is bearish, which means that the market index or price of the underlying security is likely to fall in the near future.

However, when the PCR is equal to 1, it means the open interest contract in call and put are almost the same and the market sentiment is balanced. Here the market trend is unclear or you can neither its bullish nor bearish with undefined movement. Overall, you can interpret the PCR ratio to know the sentiment of the traders in the options market.

How to Analyse PCR Ratio?

When put call ratio increases but the minor dips getting bought during the uptrend market, it gives the bullish indication. This is the indication that put sellers are aggressively selling at dips expecting the continuation of an uptrend in the market.

On the other hand, put put-call ratio decreases at the market is resisting at the resistance level which gives a bearish indication. It also shows that call sellers are creating new positions in the market with the expectation of correction or limited upside in the market.

Also Read: Support and Resistance: How to Find Support & Resistance

However, if the put call ratio decreases when the market is down-trending, it's also an indication of bearish sentiment. This shows the option sellers are aggressively selling the call option strikes and expecting an upside in the market trend.

What is a Good Put Call Ratio?

The put call ratio greater than or lower than 1 shows the bearish or bullish sentiment of the market. But the question right there is how much put call ratio is good. The PCR is not fixed and can vary as per the market trend with the change in the sentiment of the traders.

However, as per the market experts, the PCR value of 0.7 is considered a good put-call ratio. While the PCR value higher than 0.7 or more than 1, suggests a bearish sentiment is generating in the market. When the PCR value goes below 0.7 and falls close to 0.5, it means the buying activity in the calls is higher than the puts, indicating the bullish sentiment in the market.

How to Use Put Call Ratio in Options Trading?

One of the main motives for using and analysing any indicator or technical tool in the stock market is how to make the best use of such indicators in trading. The PCR can be calculated from the data gathered in the option market, while the result of the ratio can be used for trading in the cash market or in the future and option market to trade with the right trading strategy.

To use the PCR in trading or in option trading you have to interpret and analyse the PCR data in coordination with market movement. When you get an idea of market sentiment and the expected movement of the market, you can enter into the right trade position.

Using the put-call ratio, you can use this indicator to identify the sentiments with the potential of overbought and oversold status of the market. When PCR reaches the peak levels, and combination of another signal while analysing the price action, enters and exits into the trade positions. Similarly, there are various conditions you can use PCR for trading strategies.

Also Read: Top 10 Different Types of Trading Strategies in Stock Market

Put Call Ratio Trading Strategy

Using the put-call ratio as a trading strategy, when PCR rises, it gives the bearish signal and when it exceeds 1, it indicates the traders are buying more puts than calls. It suggests the bearish sentiment generated in the market giving the signal to go for short selling. However, when PCR equals 1, it indicates the same level of buying in calls and puts.

Also Read: Best Option Strategy for Bearish Market: 7 Option Strategies

Similarly, when PCR decreases, the decreasing ratio shows the indication of traders buying more calls than puts. And this gives the indication of bullish sentiment generating in the market providing the buying opportunity for the traders to go long in trade. Similarly, there are various trading opportunities given below you can get using the PCR ratios.

Also Read: Best Option Strategy for Bull Market: 7 Bullish Strategies

1.Identifying the Overbought or Oversold Conditions

You can use the PCR to measure the sentiment of the market and identify the oversold or overbought conditions. PCR above 1 gives a bearish sentiment and PCR below 1 gives a bullish sentiment. And when the market declines, the PCR rises as more puts are traded. While PCR moving above 1.5 or 2.0 shows the market is in the oversold zone.

And when the market moves, the PCR will fall as more calls are traded. On the other hand, a lower PCR maybe around 0.5 shows the market trading in the overbought zone. The traders who over bullish in the market give the signal of the top, so you can use the extreme PCR levels to enter into counter-trend trade or book the profits in the same direction.

2. Recognizing the Trend Reversals  

As a part of the trading strategy, you can also use the PCR as the trend reversal in which PCR moving above 1.5 after the downtrend shows a sign of submission with the possibility of a bullish trend reversal. And if PCR goes down below 1.0 you can consider it as a confirmed upside momentum in the market giving the opportunity to enter into a long position.

Also Read: Which Candlestick Pattern is Most Reliable for Trend Reversal

Similarly, PCR below 0.5 after the uptrend is likely to end and there is a bearish reversal ahead, and when PCR moves back above 1.0, you can confirm this indication as a downside momentum. However, traders in anticipation enter into trend reversal when PCR touches extreme levels and then starts inching towards the opposite direction.

Also Read: What are the Best and most Accurate Trend Reversal Indicators

3.Comparing with Price Action

You can use the PCR to get the signal of analysing the price action in coordination with other technical indicators. A PCR with a high value gives the signal that an oversold market situation will be more expressive if it coincides with the market bouncing off the support levels.

Also Read: Five Best Support and Resistance Indicators in TradingView

Similarly, a low PCR shows the market condition of overbought that you can validate when the price resisting the crucial key resistance levels and other important indicators like RSI show the divergence. Using the PCR with reference from price and volume data will help you to get a more precise timing of entering or exiting from any trade position.

Also Read: How to Use RSI Indicator for Intraday Trading or Day Trading

4. Modify Parameters for PCR

To make the best use of PCR you also need to adjust the inputs or parameters especially while trading in different option expirations. A normal PCR can be used for all options but the PCR weighted to near-term options may give you an early signal of change in the sentiment.

Hence, few traders tweak the formula of PCR to compare the PCR on the basis of volume based on the traded value involved in the trades rather than the volume of trade. This kind of adjustment can give a more precise picture of how much traders are bullish or bearish.

Also Read: Bullish Trend Reversal Candlestick Patterns

5. Limitations of PCR in Trading

PCR can be used best for major reversals in trends and to identify extreme situations in the market. Sometimes it gives too early a signal, so it could be risky to use this individually as an indicator for analysis, instead of with a combination of other indicators.

Also Read: How to Manage or Do Risk Management in Options Trading

Although during the very bullish or bearish market, PCR can stay at its highest or lowest levels respectively. Hence, you should utilize the indicator to measure the sentiment of the market only as an individual indicator to make trade decisions based on it.

Summing-up

Put-call ratio or PCR is simply the ratio of the total volume of trades in put against the total volume of trades in calls. A PCR value above 1 is considered a bearish sentiment in the market, while a PCR below 1 is measured as a bullish sentiment in the market. And PCR at 1 indicates there is no clear sentiment, which means the market is neither bullish nor bearish.

Also Read: Why Choose Algorithmic Software for Options Trading: 10 Reasons

But don’t use the PCR as an individual indicator to generate the trade signal. IT can give an idea about the current sentiment in the market or towards a particular underlying security. PCR can be also used as a contrarian indicator for trading in extreme market conditions. And it could be much safer to rely on when PCR reaches an extreme.

Also Read: How to Choose the Right Option Strategy in Algo Trading

However, in the case of the option index, the PCR above 1.3 can be considered extreme, while PCR below 1.3 for an individual underlying security may not be extreme. Hence, while taking the trade decision in option trading don’t rely on PCR individually, rather use it in combination with other most popular technical indicators used for intraday or option trading.

Also Read: Top 5 Best Technical Indicators for Intraday or Day Trading