Daily Put/Call Ratio
The P/C Ratio is derived by dividing the total number (volume) of option put contracts purchased by the number of option calls, for a given trading day. For those unfamiliar with options trading, options are contracts that give the purchaser the right, but not the obligation, to buy or sell a security at a specified and guaranteed price, called the "strike price." Options to buy are called "Calls," while options to sell are called "Puts." The option buyer can exercise their option so long as the underlying stock or index has achieved or bested the strike price no later than the day of expiration. Calls, therefore, imply the buyer is optimistic (bullish), whereas Puts imply the buyer is fearful of, or anticipates, a decline (bearish).
The P/C Ratio thus measures the degree of bullishness or bearishness in the market, based on the ratio of Puts purchased to Calls purchased (i.e. Daily Put Volume/Daily Call Volume = P/C Ratio). The Chicago Board of Options Exchange (CBOE) calculates the P/C Ratio for all equity and index options traded in their Daily Market Statistics. Traditionally, a P/C Ratio of .80 or greater is considered bearish. Readings above 1.00 over a number of trading days are considered strong signs of a market bottom. Below 1.0, the readings are considered neutral in the .40-.50 range, and extremely bullish at readings below .30. The lower readings are considered strong signs of a topping market nearing a reversal. Note that technicians regard extreme high or low readings as contrarian signals. The value of the Put/Call ratio is thus in determining when sentiment extremes have been reached, as such extremes tend to give way to their opposite.
It's also possible to apply the same principle to individual indices, sectors and stocks to get a read on trader sentiment.
How to Use our Put/Call Charts
Market Harmonics offers four daily Put/Call Ratio charts, free to users, for measuring short to near-term market sentiment:
1) Total Volume Put/Call Ratio: While the traditional method of measuring sentiment via the Put/Call ratio is useful, the whipsaw in the daily readings makes it less reliable for studying the underlying sentiment trend. We therefore apply a 13-day moving average. We also add a Rate-of-Change chart, which is particularly useful in helping determine directional bias when the market is in a trading range, as well as in signaling the potential of a reversal in the ratio (and subsequently, the market) since momentum tends to slow when extremes are being reached.
Along with the daily volume P/C, individual charts of the Put/Call Ratios for Equities-only, Index, and LEAPS are provided. LEAPS are long-term option contracts with expirations of up to 3 years, and can provide a read on the forward-looking expectations of investors. For example, when the LEAPS ratio is falling, but the Equity and/or Total ratios are rising, it implies that investors are less fearful about the long-term than they are near-term. When they are trending in the same direction, then it suggests both the short and longer term are likely to continue the market trend in process.
Lastly, Index options are generally used by portfolio managers to hedge their long stock exposures, as it is easier to use a basket of many stocks rather than hedge each exposure individually. The Put/Call Ratio for Index options may thus rise along with the market, as portfolio managers purchase puts to protect long positions against an unexpected market drop. It may also drop as the put options are exercised in a falling market.
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