The Put/Call Ratio is an indicator that shows put volume relative to call volume. Put options are used to hedge against market weakness or bet on a decline. Call options are used to hedge against market strength or bet on advance. The Put/Call Ratio is above 1 when put volume exceeds call volume and below 1 when call volume exceeds put volume. Typically, this indicator is used to gauge market sentiment. Sentiment is deemed excessively bearish when the Put/Call Ratio is trading at relatively high levels, and excessively bullish when at relatively low levels. Chartist can apply moving averages and other indicators to smooth the data and derive signals.
Interpretation
As with most sentiment indicators, the Put/Call Ratio is used as a contrarian indicator to gauge bullish and bearish extremes. Contrarians turn bearish when too many traders are bullish. Contrarians turn bullish when too many traders are bearish. Traders buy puts to insurance against a market decline or as a directional bet. While calls are not used so much for insurance purposes, they are bought as a directional bet on rising prices. Put volume increases when the expectations for a decline increase. Conversely, call volume increases when the expectations for an advance increase. Sentiment reaches extremes when the Put/Call Ratio moves to relatively high or low levels. These extremes are not fixed and can change over time. A Put/Call Ratio at its lower extremities would show excessive bullishness because call volume would be significantly higher than put volume. In contrarian terms, excessive bullishness would argue for caution and the possibility of a stock market decline. A Put/Call Ratio at its upper extremities would show excessive bearishness because put volume would be significantly higher than call volume. Excessive bearishness would argue for optimism and the possibility of a bullish reversal.
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