Last Updated on June 22, 2022 by Quantified Trading
The Put-Call ratio is a popular sentiment indicator. Extreme readings, mostly signaling panic and climax, are often used as contrarian signals to fade the market. For example, a high put reading might signal that traders and investors are panicking and are buying downside insurance (put options act as insurance) and that a market bottom is imminent. But does this hold up in a backtest?
The Put-Call ratio divides the volume or open interest among both puts and calls for a certain instrument or asset class on a daily basis. The ratio can be used in different ways. Our own backtests reveal that there are better sentiment indicators out there, for example, the VIX-indicator.
What is the Put-Call ratio?
Put-Call Ratio (PCR) is the commonly used metric by traders and investors to gauge the stock and share market trends before it starts trading. An important indicator of the market’s recent ups and downs, PCR lets the investors and traders predict the direction the market is going towards on a particular trading day or session, to formulate their trading and investment plans.
It measures the ratio of the put open interest on a given day, as against the call option open interest on the same day.
- A put option allows the traders to sell an asset at a preset price
- A call option allows the traders to purchase an asset at a preset price
- Higher PCR indicates a bearish market sentiment
- Lower PCR indicates a bullish market sentiment
You have many types of Put-Call ratios. For example, you have Put-Call ratios on indices and you have on stocks (equities).
If you are using Tradestation you have access to a load of different put-call ratios and it might be difficult to understand what is what.
What are puts and calls?
In order to understand the put-call ratio, you need to have a basic understanding of what a call and a put are. We have briefly discussed it in our articles about selling puts and covered calls, but we repeat here:
What are call options?
If you own a call you have the right to buy x shares of a stock at a predetermined price within a certain time frame. For example, if you have 10 calls in MSFT with a strike at 100 and an expiry date 3 months from now, you have the right to buy 1 000 shares (1 call contract equals 100 shares) of MSFT at 100 before three months. After three months the calls expire and they are worthless. Obviously, if the price of MSFT is higher than 100, it makes sense to buy at 100. Opposite, if the price is below 100, it doesn’t make sense to exercise the options.
What are put options?
If you own puts you have the right to sell x shares of a stock at a predetermined price within a certain time frame. For example, if you have 10 puts in MSFT with a strike at 100 and an expiry date 3 months from now, you have the right to sell 1 000 shares (1 call contract equals 100 shares) of MSFT at 100 before three months. After three months the calls expire and they are worthless. Obviously, if the price of MSFT is higher than 100, it makes no sense to sell at 100. Opposite, if the price is below 100, it makes sense to exercise the options and sell at 100 according to the option contract.
Put options work just like insurance. You simply pay to have insurance against a drop in market prices.
What does the Put-Call ratio indicate?
The logic behind the put-call ratio is that traders and investors are buying puts for protection when uncertainty is high. Thus, the put-call ratio is a little bit like the VIX indicator and a contrarian signal because the stock market is highly susceptible to mean reversion.
We can summarize the logic behind the Put-Call ratio in a few bullet points:
- If traders are buying more calls than puts, that means traders are “complacent” and see few clouds on the horizon.
- However, if they are buying more put options than calls, that means traders are fearing future uncertainty. When uncertainty is high, put volume tends to increase.
- An extremely high Put-Call ratio indicates the market might be oversold and too fearful.
- On the other hand, an extremely low Put-Call ratio indicates the stock market might be too optimistic.
How to Calculate the Put-Call ratio?
An investor or trader can calculate the Put-Call ratio on their own through simple mathematical calculations. It can be calculated by dividing the number of traded put options by the number of traded call options.
However, the volume and open interest are always different.
Volume is what is traded within a certain time frame, while open interest is different.
Open interest is the total number of option contracts at the end of the trading day that are still open.
Options are derivatives and they are a 100% zero-sum game. If you buy an option contract, someone else is issuing or selling. The profits and gains are equaled out: your gains are someone else’s losses, or your losses are someone else’s gains.
What is a good Put-Call ratio?
As mentioned, there are several types of put-call ratios. Due to the different types of markets, there are no universal rules as to what is a good or bad Put-Call ratio. All markets are different. But generally speaking, high readings signal fear, and low readings signal complacency. You need to look at the relative readings for each Put-Call indicator.
If you are serious about trading, we recommend to backtest and measure everything you do and don’t trust anything you read on the internet or social media.
We have never used the Put-Call ratio for our trading strategies.
The reason for that is simple: we have better tools in our toolkit. We believe our conclusions are confirmed by looking at some backtests on the internet, and most of them confirm that the Put-Call ratio is not among the best sentiment indicators.
That said, any indicator can be used in a zillion different ways and you might have reached different conclusions.
Where do I find the Put-Call ratio? Where can I download it?
The Put-Call ratio is given on almost every trading and investing website or mobile app. You can also find the daily ratio of official exchanges. Moreover, with the help of puts and calls data given on the trading platforms, you can calculate the Put-Call ratio yourself.
Unfortunately, it’s not easy to find sources where you can download the Put-Call ratio for free.
A visual view of the Put-Call ratio
Before we go on to the backtest section of this article, start by showing how the Put-Call ratio fluctuates from day to day:
The above chart is the Put-Call ratio on the S&P 500. There are extreme readings on both ends.
Put-Call ratio backtest
Let’s use the data from our index Put-Call ratio to do one backtest.
In the first backtest we test the following:
- After an extreme reading (over 3), what is the average gain in the next N-days?
We use Amibroker’s strategy optimization feature and we get the following table:
The first column shows the number of days until we exit. For example, after 115 days the average gain per trade is 6.36% (not including dividends).
The trading performance metrics in the table are, in our opinion, not very impressive. The backtest confirms backtests we have done over the years that the Put-Call ratio is not among the best trading indicators.
Put-Call ratio strategies
There are infinite ways to use the Put-Call ratio, only your imagination puts a stop to your possibilities. Below we list a few methods that can be employed:
- In 1993 the famous technician John Bollinger, the inventor of Bollinger Bands, suggested the following buy signal: when the daily put volume was twice the ten-day moving average. We have not backtested this strategy after 1993, but Bollinger presented some nice backtests in the magazine, and the results are later confirmed in 1998 in Gary Smith’s Trading For A Living.
- Readings above and below its moving average.
- Consecutive readings above certain levels.
Put-Call ratio – ending remarks
The Put-Call ratio is popular, but we have found it to be inferior to many somewhat similar sentiment indicators and strategies, like the VIX that we use to make VIX strategies. We believe our Put-Call ratio backtest in this article “proves” that.