An indicator that compares put volume to call volume is called the put/call ratio.
- To protect against market weakness or place a wager on a decline, traders employ put options.
- To protect against market strength or place an early wager, call options are used.
- When put volume surpasses call volume and when call volume exceeds put volume, the put/call ratio is above one and below one, respectively. This indicator is typically used to determine market mood.
- When the Put/Call Ratio is trading at comparatively high levels or at relatively low levels, the emotion is judged to be unduly bullish or negative, respectively.
- Moving averages and other indicators can be used by chartists to smooth the data and provide signals.
How is Put/Call Ratio Interpreted?
- The Put/Call Ratio is employed as a contrarian indicator to assess bullish and bearish extremes, as is the case with other emotion indicators.
- When too many traders are bullish, contrarians start to turn pessimistic. When too many traders are negative, contrarians start to become bullish. Puts are purchased by traders as directional bets or insurance against a market decline. Calls are typically purchased as a directional wager on rising prices, rather than for insurance purposes.
- When there is a greater likelihood of a drop, put volume rises. On the other hand, call volume rises as advance expectations rise. When the Put/Call Ratio fluctuates between relatively high and low levels, sentiment reaches its extremes. These extremes might shift over time and are not constant.
- Because call volume would be much larger than put volume, a Put/Call Ratio at its lower extremities would indicate excessive bullishness. Excessive bullishness, in other words, would call for prudence and the risk of a stock market fall.
- The extremes of the put/call ratio would indicate overbought bearishness since the put volume would be much higher than the call volume. Extreme pessimism would support hope and the potential for a positive reversal.
What is a desirable put to call ratio?
- The put/call ratio fluctuates according to the state of the market and is not constant. Market participants use the ratio value of 0.7 as a compass, nevertheless.
- Put/call ratios higher than 0.7 or higher than one indicate the market is developing a negative trend. Similarly, a bullish trend is building when the put/call ratio number drops below 0.7 and approaches 0.5, which indicates that traders are purchasing more calls than puts.
- The put/call ratio shows how the market feels about the most recent income occurrences. While analysing the put/call ratio, it is critical to pay attention to the put (numerator) and call (denominator) values (call).
Less exchanges of call options would raise the value of the put/call ratio without significantly changing the number of put options, which could lead to an erroneous perception of market mood.
Conclusion
Even though a newbie could find all these details scary, stock trading isn't a challenging activity. It is always preferable for beginners to receive assistance and direction from specialists. The goal of Nifty Trading Academy is to close the knowledge and application gaps in trading. To learn more about technicalities like put-call, contact us.