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Tuesday, January 26, 2010

What can small investors learn from the Put-Call Ratio (PCR)?

Before launching into a discussion about the Put-Call ratio, I need to make a disclosure. I strongly feel that small investors should stay far away from Futures and Options (F&O) trading. Most options contracts expire worthless and investors lose the premium amount that they had paid.

(I had made this point very clear in 'Chapter 3: What are your Future Options?' of my eBook. Haven't got your copy yet? Get your FREE eBook today!)

A put option owner has the option, but not an obligation, to sell the underlying security (a stock or an index) at a pre-determined price within a specified time. Likewise, a call option owner has the option, but not an obligation, to buy the underlying security at a pre-determined price within a specified time.

The Put-Call ratio (PCR) is calculated by dividing the total number of put options traded by the total number of all options traded. A ratio of more than 1 means more put options were traded than call options (i.e. more investors were feeling bearish). A ratio 1 or less means more call options were traded than put options (i.e. more investors were feeling bullish).

If small investors are supposed to stay away from F&O trading, why should they be interested to learn about the Put-Call ratio? The short answer is: the PCR is a short-term contrarian sentiment indicator.

As stock market indices drop near a bottom during a bear market, investors turn extremely pessimistic in panic and fear and expect to see further downsides. Many more put option contracts are traded than call options, and the PCR ratio keeps going higher.

How high is high? There are no fixed benchmarks. But a ratio of 1.5 or more means that bearishness is becoming excessive. As option traders are generally incorrect in their market sentiment assessment, a high PCR is taken as a contrarian 'buy' signal.

When stock market indices rise to a top during a bull market, investors become excessively greedy and euphoric and expect to see newer highs. More call options are traded than put options, and the Put-Call ratio drops below 1. This is used as a contrarian 'sell' signal.

Most business channels and pink papers make a big noise about the PCR. Just keep your eyes and ears open. Whenever the PCR gets to 1 or less, a correction may be close at hand. When the PCR gets near 1.5 or higher, it may be a good time to enter.

Like all technical analysis indicators, the usefulness of the Put-Call ratio (PCR) should be taken with a pinch of salt. It is not infallible. So never take buy/sell decisions based only on the PCR indicator. It should be used in conjunction with other indicators.

5 comments:

googol said...

Dear Subhankarji,

The PCR is misleading most of the times.If one sees Jan figures,it was highest on 14th (1.38 for nifty) which means one should be buying but the index dropped by more than 250 points since then.

Just some musing

Thanks and regards,

Subhankar said...

That is exactly why the concluding paragraph was written!

scorpio said...

Which options should we look for the PCR - in the money or at the money options. Also lets say if i fixed the PCR for 5000 - and at the money PCR was 1.5. Market falls to 4900, should i look at the 4900 PCR then?

The Visitor said...

Dear Subhankar,

Well written post.

A ratio of more than 1 means more put options were traded than call options (i.e. more investors were feeling bearish). A ratio 1 or less means more call options were traded than put options (i.e. more investors were feeling bullish).

An observation about the above statement:

In the cash market, both buyer and seller are (usually) investors, whereas in a trade of an option contract, the seller of the contract is (usually) assumed to be more sophisticated and knowledgeable than the buyer, so while a high PCR reflects the bearish sentiment of the average investor, it also reflects the neutral or bullish sentiment of a more sophisticated type of investor.

This probably explains why a contrarian view often works out.

All said and done, I agree that all the indicators need to be taken with a pinch of salt. :)

My namaskaram to Googol Annachi. :)

Subhankar said...

@scorpio: Since I stay away from F&O, that question is better directed at some one who does not!

To keep things simple, I just look at the market-wide PCR.

@TV: Interesting point, and makes a lot of sense.