Put-Call Ratio: 3 Things to Know About PCR in Options Trading

Options trading involves a lot more analysis than stock trading. If you want to trade in the options market, you need to understand how to use various crucial metrics related to these unique derivative instruments. Among these is the put-call ratio (PCR). With the right analytical tools like the Samco trading app, which brings live, up-to-date options market data to your fingertips, you can easily access the data required to compute this ratio and use it in your trading decisions. 

This is because unlike many other analytical metrics like options Greeks, open interest and volume, the PCR in options trading is not readily available to traders. You need to calculate this ratio before you evaluate and assess it. 

So, in this article, we delve into the meaning of the put-call ratio indicator, understand how to calculate it and discuss three key aspects of this crucial ratio. 

What is the Put-Call Ratio (PCR)?

The PCR in options trading is the ratio of the put options traded to the call options traded in the market. The puts and calls have the same underlying asset. The put-call ratio indicator can be calculated using the open interest or the trading volume of the puts and calls for the asset you are tracking. 

It is important to know the PCR in options trading because you can use this data to gauge the market sentiment, potential price direction and overall market mood. These insights can be foundational for your next trade. Without understanding whether the buying pressure dominates the selling pressure (or vice versa), you may miscalculate the market direction and enter into trades that could lead to significant losses. 

How to Calculate the Put-Call Ratio?

To find the PCR in options trading, you need to compare the total put options traded with the total call options traded. You can do this in two ways — using the trading volume or the open interest (OI). Let us take a closer look at these two methods of finding the put-call ratio indicator.

• PCR Using Trading Volume

To find the PCR in options trading, you can use the trading volume of the call and put options on any given trading day. For instance, to find the PCR today, you can use this formula, which is based on the trading volume:

Put-Call Ratio = Total Trading Volume of Put Options ÷ Total Trading Volume of Call Options

For example, say the total volume of puts for a stock is 10,000 and the total volume of calls for the same stock is 8,000. The put-call ratio indicator will be 1.25 (i.e. 10,000 ÷ 8,000). 

• PCR Using Open Interest

Another way to compute the put-call ratio indicator is by using the open interest data. OI represents the total number of open or outstanding option contracts. The formula for the PCR using this data is as follows:

Put-Call Ratio = Open Interest of Puts ÷ Open Interest of Calls

For example, if the total OI for puts of a stock is 7,000 and the total OI for calls of the same stock is 9,500, the PCR will be 0.74 (i.e.7,000 ÷ 9,500). 

3 Important Things to Know About PCR in Options Trading

Knowing the put-call ratio indicator is one thing, but understanding and interpreting it correctly is another. In this regard, here are three crucial aspects of this ratio that you should know about.

1. Market Mood Indicator

The PCR in options trading is best used as an indicator of market sentiment. If the ratio is less than 1, it is a sign that the market mood is predominantly bullish. However, if the ratio is greater than 1, it means that bearish sentiment dominates the market. This can be pivotal in deciding appropriate options trading strategies for your next trade. You can also track changes in the PCR to understand how the market sentiment changes, so you can capitalise on such developments at the right time.

2. Support and Resistance Analysis

Support and resistance levels are both important in technical analysis — which is vital for options trading. However, it may be challenging to know which type of price limit to look for if you do not know the overarching market trend. The put-call ratio indicator makes this easier because it tells you whether the market is bullish, bearish or neutral. In a bullish market, the resistance level gains significance, while in a bearish market, the support level matters. With the PCR in mind, you can track these critical price levels easily. 

3. Contrarian Indicator 

Contrarian indicators help you identify extreme levels of pessimism or optimism in the market. The PCR is one such indicator because extreme levels of this ratio may indicate potential market reversals. For instance, if the PCR today is extremely low, it may be a sign of intense bullish optimism — which could precede a bearish reversal. Similarly, an extremely high PCR may be a sign of overwhelming bearish sentiment, which may occur before the market reverses upward. 

Conclusion

The bottom line is that the put-call ratio indicator is an essential metric for options traders. If you are eager to become a better options trader, ensure that you factor in this ratio and initiate your traders based on how the market is expected to move based on the prevailing sentiment. This will help you formulate a more informed opinion of the market direction. With this information, you can use Options B.R.O. from Samco Securities to find the best options trading strategy for your specific market outlook.