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The put call ratio is the only financial ratio that does not compare the current market price to any financial statement item. Rather it compares what investors plan to do with a given stock or an index at a later date. Put and call are derivative options. The put option gives the seller a right but not an obligation to sell, however the call option gives the buyer a right but not the obligation to buy. Analyzing the put call ratio can give the investors some insight about where the stock is headed for in the near future. This ratio is more relevant to short term price movements rather than long term ones and is hence more widely used by speculators who are looking to make a quick buck.
Put Call Ratio = Number of Put Options / Number of Call Options
This data is periodically published by the exchange. Hence investors can easily have a look at these numbers.
A high put call ratio signals a bearish trend in the future and indicates that short selling must be done to profit from this change. On the other hand, a low put call ratio indicates a bullish trend which speculators perceive as a signal to go long.
Many speculators believe that the put call ratio does not represent the true picture. This is why there are a few variations of the put call ratio that are used. Before making a call based on any put call ratio, investors must understand what variation is being used and therefore how to interpret it. Common variations are as follows:
Moving Average: Instead of using the put call data for a single day, speculators usually use data for an extended period of time. Usually the moving average used is that of 21 days. However, the number of days can be different.
Money Weighted: Some speculators feel that money weighted put call ratio is a better indicator since it informs about the possible number of options that will be exercised.
Billionaire investors like George Soros are known to have used the put call ratio to predict the market sentiment. It is said that investors who have a constant eye on the put call ratio can gauge changes in market sentiment faster than other investors and have a lead time in modifying their positions and thereby benefitting from the change.
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