The Put Call Ratio
The Put Call Ratio (PCR) is a straightforward calculation that helps us identify when the market is particularly bullish or bearish. Traders traditionally interpret this contrarian indicator to mean that if the PCR reading is very bearish, it implies the market will turn and become more positive, thus traders go long. The opposite applies as well: extreme bullishness signals for traders to act bearishly.
To determine PCR, simply divide the open interest of Puts by that of Calls. The figure typically ranges near one.
As on 10th May, the total OI of both Calls and Puts has been calculated. Dividing the Put OI by Call OI gives us the PCR ratio –
37016925 / 42874200 = 0.863385
The interpretation is as follows –
Clearly, plotting the daily PCR values for a period of 1-2 years can help identify extreme bearishness. For Nifty, it could be 1.3 while Infy may indicate a value as low as 1.2. Back testing also plays a role in providing clarity on this issue.
One may question why the PCR is seen as a contrary indicator. It is quite difficult to explain the reason behind this, however, the general belief is this; if traders have already taken their bullish/bearish stance, then most of the market participants have established their positions (causing a high/low PCR). Therefore, very few other traders are available to further push the stock/index in that direction. As a result, it will ultimately be levelled off and this leads to driving it in the opposite direction.
That’s PCR. There are variations to this technique – some choose to use total traded value instead of OI, and others opt for volumes. However, I don’t think it necessary to over-analyse PCR.