How To Interpret Put-Call Ratios

| April 24, 2012 | 0 Comments

long callsIf you’re a new option trader, knowing the basic idea of how to read put-to-call ratios can be a valuable piece of information.

The ratio acts as an indicator by simply looking at the day’s put volume divided by call volume.  Since the ratio is calculated by dividing the number of puts by calls, the lower the number, the more calls are being purchased.

Here’s the good news about understanding this ratio…

Put-to-call option ratios can be applied to specific stocks, to sectors, or to the entire market.

You see, on a normal day, the ratio should be in the .75 to .95 range.  This is because the overall market is generally bullish.  In other words, most individual investors and mutual funds invest for the long term with the theory that the market will rise.

Let’s look at a quick example…

Last Friday the stock market finished the week relatively flat on the day.  The S&P was down fractionally about 1 point.  But on Thursday, Microsoft (MSFT) earnings provided some optimism in the market.

So, looking at Friday’s overall put-to-call ratio, we see it was .64.  Meaning, for every 10 option contracts purchased, between six and seven of them were calls.

This indicates that Friday was a relatively bullish day.

So, what about a ratio above .90?

On Monday April 16th, the overall market put-to-call ratio rose to an extreme level of 1.07.

That’s the highest level for 2012.  While the S&P was in the midst of falling over 22 points, 7.39 million puts traded with only 6.91 million calls.

For option traders, the interpretation was that the overall market was showing extreme signs of concern and fear.

But on the other hand, here’s the problem with strictly looking at put-to-call ratios…

The major concern is that it only considers volume, or the number of contracts traded.  It doesn’t take into consideration whether puts or calls are being bought or sold.

For example…

In one of my previous articles, I explained that it would be wrong to consider a large put sale as a bearish trade.  Option traders could simply be selling puts to collect large amounts of premium.   And thinking the stock would remain unchanged or even rise in value.

This will certainly skew put-to-call ratios.

So, what’s the bottom line to interpreting them?

The total put-to-call ratio is simply a tool for gauging investor sentiment.

But we must remember, one off day in the short-term, like the increase on Monday could throw you for a loop.

So remember, look at put-to-call ratios carefully.  Draw a general conclusion on sentiment and then decide whether there’s other influences driving activity, like a down day.  If not, use this ratio to help you invest.

 

Safe trading,

Marcus Haber

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Category: Put Call Ratio

About the Author (Author Profile)

Marcus Haber is the co-editor of Options Trading Research and boasts well over a decade of real-life options experience. Learning from some of the biggest names in the business, Marcus has served as an Options Strategist for a number of firms and was also appointed to the Options Advsiory Board with Pershing, a branch of the Bank of New York.

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