Put-Call Ratio
Put-call ratios are useful, sentiment-based, indicators. The put-call ratio is simply the volume of all puts that are traded on any given day divided by the volume of calls that are traded on that day. The ratio can be calculated for an individual stock, index, or futures underlying contract, or can be aggregated. For example, we often refer to the equity-only put-call ratio, which is the sum of all equity put options divided by all equity call options on any given day.How to forecast Market Direction With Put/Call RatiosWhile most options traders are familiar with the leverage and flexibility that options offer, not everybody is aware of their value as predictive tools. Yet one of the most reliable indicators of future market direction is a contrarian-sentiment measure known as the put/call ratio. By tracking the daily and weekly volume of puts and calls in the stock market, we can gauge the feelings of traders. While too many put buyers (high put/call ratio) usually signals that a market bottom is nearby, too many call buyers (low put/call ratio) typically indicates a market top is in the making.How to bet against the crowd using the Put/Call RatioIt is widely known that options traders, especially option buyers, are not the most successful traders. On balance, option buyers lose about 90% of the time. Although there are certainly some traders who do well, would it not make sense to trade against the postions of option traders since most of them have such an abysmal record? The contrarian sentiment put/call ratio demonstrates that it does pay to go against the options trading "crowd." After all, the options crowd is usually wrong.Looking inside the market can give us clues about its future direction. Put/call ratios provide us with an excellent window into what investors are doing. When speculation in calls gets too excessive, the put/call ratio will be low. This indicates that a market top is in the making.When investors are bearish and speculation in puts gets excessive, the put/call ratio will be high. This indicates that a market bottom is in the making.The next time you hear talk about the put/call ratio in the media, trade against the general crowd. After all over 90% of derivative traders lose money.
