Puts are generally purchased to bet on a downside move in a stock or index, while call buyers are speculators betting on an upside move. Thus when the prevalent market psychology is overly bearish or pessimistic toward the stock market, most investors will buy put options for downside protection, and vise versa when the public is optimistic or bullish on the market, that bias is reflected in a higher level of call activity.
The put-to-call ratio is computed as the total number of puts traded each day divided by the total numbers of calls. It is one of the best measures of market sentiment and it helps to determine whether option buyers are predominantly bullish or bearish and whether that relative bias is intensifying or diminishing. It can be applied to an individual stock, an index, or exchange. A rising ratio suggests a bearish attitude; a falling ratio indicates a bullish attitude. The greatest value of a put-to-call ratio is at extremes, similar to an overbought/oversold oscillator. It is then used as a contrary indicator.
High put-to-call ratio signals a market bottom and low number signals a top. If the ratio falls lower than 0.3, this implies a sense of market euphoria; however, a ratio over 0.7 means that the market is now pessimistic.
The put/call ratio works well in conjunction with overbought/oversold indicators such as the Arms Index and McClellan Oscillator. When you begin to see consistently extreme readings across several different measures, it is a good sign that a market reversal may be on the horizon. Traders should recognize these signals and incorporate them into their trading tool kit. Using the put/call ratio as a contrarian tool can help you avoid getting swept up in the prevailing sentiment, which often leads to buying when the market is high and selling when it is low.
The independent research team in association with our analysts will continue to publish their research on this topic over time.
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