What is Put Call Ratio? A Simple Guide for Indian Traders

What is Put Call Ratio? A Simple Guide for Indian Traders

Almost every trader relies on indicators to analyse the behaviour of the market. In the options market, the sentiment indicator that is often used is the Put Call Ratio.

For those who understand the basics of stock markets and options, but are stuck on the concept of Put Call Ratios, this blog is just for you. We will simplify the concept that will enable you to make smarter market choices.

Introduction to Put Call Ratio

The Put Call Ratio is used for estimating the mood of the market based on how many put options as compared to call options are traded. Sounds more technical than it really is - it helps you gauge whether traders are keen on buying puts or calls and to what extent.

Put options are exercised by traders who anticipate a decline in the market whereas call options are made by traders who anticipate an increase in the market. The ratio of puts to calls, otherwise known as the Put Call Ratio, gives a rough estimate of whether the market is more bullish or bearish when averaged out.

How is Put Call Ratio Calculated?

Calculating the Put Call Ratio is quite straightforward:

Put Call Ratio = Total Put Open Interest / Total Call Open Interest

The open interest refers to the total number of contracts that are currently active in the market at any given time. While some traders prefer using trading volume instead of open interest, most seasoned traders opt for using open interest as it depicts a clearer portrayal of actual market activity.

Let's assume the total put open interest is 8 lakh while the total call open interest is 4 lakh. In this case, the Put Call Ratio or PCR will equal:

PCR = 8,00,000 / 4,00,000 = 2.0

Thus, putting on a bearish trade indicates that traders are indeed purchasing more puts than calls.

Put Call Ratio

Understanding the Put Call Ratio reveals important information that can help traders anticipate market actions. This is how it works:

A Put Call Ratio greater than 1 means that more puts than calls are being traded. It is likely that the market is going into a bearish trend, which is why many traders expect it to drop.

A Put Call Ratio less than 1 means that more calls than puts are being traded. This reflects a bullish attitude, which shows that traders expect the market to recover.

If the Put Call Ratio is approximately equal to 1, it indicates the existence of a roughly equal amount of bullish and bearish forces in the market. This makes the market sentiment neutral and the market is considered to have a neutral sentiment.

Nonetheless, many experienced traders tend to use the Put Call Ratio as a contrarian indicator. This implies that when too many traders are pessimistic and featuring a high PCR, it is time to take a long position on the market as chances are it will soon go up. While the opposite strategy will apply to a low PCR. The logic behind this theory is that people, in this case the majority, are wrong at crucial turning points.

Put Call Ratio Classification

In the Indian Stock market, there are primarily two classifications of the Put Call Ratio believed to exist:

1. Volume-Based Put Call Ratio

This is computed from the trading activities of the put and call options in a given period like a day. It gives a quick estimate of how much each type of option is actively traded.

2. Open Interest-Based Put Call Ratio

This is based on the total open interest of puts and calls. This version indicates the total number of outstanding contracts and is said to provide a better picture of the prevailing market trend.

Of the two, traders prefer open interest based PCR because it shows the positions that have been established but not yet liquidated.

Strategies with Put Call Ratio in Trading

While the primary focus of the Put Call Ratio is to help gauge the investor sentiment, it is also useful for determining the market entry or exit points.

1. Prior to Making a Trade

Before entering a position in the market, verifying the PCR can assist you in gauging the overall sentiment. A high PCR indicates bearish sentiment among traders, while a low PCR indicates bullish sentiment. This may help you determine whether you want to go with the trend or take the contrarian approach.

2. Identifying Market Reversals

Values that are extremely high or low in PCR may suggest a reversal. An extremely high PCR value may suggest that the market is oversold and a bounce may take place. An extremely low PCR value may suggest that the market is overbought and a correction may occur.

3. With Other Metrics

Avoid using PCR alone for your trades. Always combine it with other technical indicators such as RSI, MACD, moving averages, and also with the support-resistance zones to confirm your perspective.

Applications of the Put Call Ratio in Indian Markets

In India, the Put Call Ratio's value is well understood, especially among traders who work with index options like Nifty and Bank Nifty. Many traders monitor Nifty PCR to assess how the market is expected to trend.

Traders keenly observe the compulsory call ratio (PCR) of stocks with heavy trading volumes. Active option chains can be found for Reliance Industries, HDFC Bank, Infosys, and Tata Motors. Monitoring the stock-specific Put Call Ratio can be beneficial for short-term trading decisions.

Where can you find PCR data?

Put Call Ratio data can easily be found on:

The official NSE India website

Brokerage platforms such as Zerodha, Upstox, and Angel One

Market analysis websites like Sensibull, Moneycontrol, and Stock Edge

These websites usually show both volume-based and open-interest based PCR, some even showing historical trends and charts.

Benefits of using Put Call Ratio

The Put Call Ratio has many benefits for retail traders in India:

The Put Call Ratio is simple to understand and calculate

Provides quick insights into market movement

Can serve as an early signal for trend reversal

Easily accessible across platforms

Using PCR intelligently can reinforce confidence in trading strategies.

Drawbacks of Using Put Call Ratio

Even though the Put Call Ratio can be fairly helpful, it does have some drawbacks:

• It may not be precise in fast-moving or highly-publicised markets.

• It may provide clear and accurate insight when used alongside other indicators.

• Some unusual activity in the options market may distort the value.

• Approximately 50 percent of the options sellers and their counterparts interpret the ratio differently, based on the trader's view, impacting the trader's perception.

For this reason, it is best to pair the PCR with proper risk mitigation plans while having other tools at hand.

Final Remarks

The Put Call Ratio is a wonderful tool that offers insight into what most market participants do. For example, high values of PCR mean that there is bearish sentiment and low values indicate bullish, but it can also be observed that traders prefer counter positions during extremes.

That said, without additional technical and fundamental analysing pieces, PCR should not be regarded as the sole pointer for trading decisions.

Indian traders who intend to utilise this tool are advised to understand its mechanics first, as it poses additional advantages.

Begin tracking the daily PCR values, observe the subsequent market movements, and incrementally develop your strategy. Eventually, this will become an instrumental component of your trading practice.