The put-call ratio gives the ratio of the total trading volume of put options, divided by the total trading volume of call options. Let’s say that the total trading volume of put options was four, and the total trading volume of call options was two. The put-call ratios, in this case, would be two.
Trading & Put-Call Ratio
A put-call ratio can be used as a supporting market sentiment indicator to assess the market’s current mood on security or index. We can look at it this way: a higher put-call ratio also indicates a high relative volume of puts to calls. This means that traders want to profit from a downward signal in the price of a security.
Still, options can be used as a type of insurance, meaning a high put-call ratio could indicate that many traders have taken a long position in the underlying security, purchasing relatively inexpensive out of the money put options to safeguard against unforeseen and substantial downward price movements.
The ratio is an indicator of market sentiment but still remains ambiguous. The put-call ratio is just one of many market sentiment indicators.
Putting it all together:
The put-call ratio is a practical market sentiment indicator. When the put-call ratio is further from parity, it has a higher likelihood of perceiving some significant price event in the security’s future.
Day traders are continually on the hunt for securities that have a high potential for sudden sharp price movements. That’s why the put-call ratio is such a useful tool for identifying and sorting likely profitable trades.
Because the put-call ratio is such an imprecise measure and so ambiguous, it’s most reliable to be used as part of a broad basket of market sentiment indicators. Moreover, in general, market sentiment is too deficient in identifying profitable trades, so additional analysis of each potential trade is required.