Put-Call Ratio

(Derivatives Classroom- Series III)

Introduction

In this volatile market it is becoming extremely difficult for day traders and investors to predict the future market
movement. Trading in this choppy market is becoming complex day by day and one need to be equipped with new tools
and market indicators with which they can predict the market behavior and invest accordingly. Option market have
grown by leaps and bound in current market phase. Average turnover in Index option has almost doubled compared to
Index futures. Average Daily Volume in Index option has grown from INR 14800 CRS. (FY 2008-09) to INR 26000
CRS. (FY 2009 till date), whereas Average Daily Volume in Index futures have grown from INR 14200 CRS. (FY 2008-
09) to INR 16450 CRS. (FY 2009 till date). Thus it is necessary to study the activity on option in detail. Put - Call
Ratio is one of the important market indicator, others being implied volatility, VIX, etc. which we would covering at a
later date..

While most options traders are familiar with the leverage and flexibility that options offer, not everybody is aware of
their value as predictive tools. PCR volume is one of the reliable indicators of direction of future market. It is a
contrarian sentiment measure. By tracking the daily and weekly volume of puts and calls in the stock market, we
can gauge the feelings of traders. While too many put buyers usually signal that a market bottom is nearing, too
many call buyers typically indicates a market is in the process of making its top.

Chart I
Put-Call Ratio
(Derivatives Classroom- Series III)

The Put/Call Open Interest Ratio is simply the number of Put options Open Interest in a given day divided by the number
of Call options Open Interest in same day. A Put option gives the right to sell and a Call option gives the right to buy. If
Put Call ratio is high, there are more Put options trading in the market, it means that more people are buying a right to
sell i.e. more people want to sell in the future-an indicator of bearishness. If the put call ratio is lower then it indicates
bullishness, as more people want to buy in the future. In chart 1 we see that there is direct correlation between PCR OI
and Nifty. Whenever PCR OI moves Nifty rallies and vice versa. However there are instances where in sometimes this
relationship does not hold good.
Chart II

On other hand Put - Call Ratio Volume is contrarian strategy. There will be some lag effect as the Put Call Ratio is an
indicator of future trend while Nifty is the actual trend but then also PCR gives us some indication about the behavior of
the market in advance. When a broad trend line is plotted over the year till date, the trend of Nifty shows an opposite
direction to that of the Options.

It can also be easily made out that whenever PCR volume starts falling, Index moves up and vice versa. In the Chart II if
we look at the green highlighted circle we can see that as the PCR Volume fell from peak of 1.25 on 4th March 2009 to
0.63 on 5th May 2009 whereas Nifty gained 38 % from 2645 to 3662. Similarly blue highlighted circle shows that as the
PCR moved up Index came down. From 4th August 2009 to 19th August 2009, PCR moved from 0.81 to 1.00 whereas
Nifty came down from 4680 to 4395, clearly depicting inverse relationship.

In the end we can conclude that Put/Call ratio is yet another solid weapon within a speculator's arsenal to trade and give
clear picture many times that when to exit or when to enter the market but then also one cannot rely only on Put/call ratio
to survive in the market and earn money. This fact also cannot be ignored that it is a very powerful tool, which helps the
speculator a great extent to predict the market movement and invest accordingly.
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