What is Put Call Ratio?

Nifty PCR : A Complete Guide to NIFTY Put Call Ratio

The Put Call Ratio is one metric that stands out among various indicators and ratios because it provides a clear understanding of market mood and future movements to F&O traders. This ratio offers investors a glimpse into their thoughts and significant information that might influence trading techniques and investing choices. Thus, when it comes to stock markets, traders and investors may use the NIFTY PCR and other index indicators to evaluate market activity.

In this article, we’ll look into the depth of what is put call ratio, how it is calculated along with its analysis and significance.

What is Put Call Ratio?

Put-call ratios are derivative indicators aimed to help traders make an informed decision about the state of the options market. It measures the activity of put options (which bet on a drop in the underlying asset’s value) to call options (which bet on a rise). A high ratio often reflects bearish sentiment, implying that investors foresee a decline, while a low ratio suggests positive sentiment, indicating an upward trend. Traders and analysts pay close attention to this ratio for indications about the market’s direction and potential changes.

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Understanding Put Call Ratio

Understanding the Put Call Ratio meaning in depth enables investors to make educated judgments in the ever-changing world of financial markets.

An increasing put-call ratio of more than 0.7 or greater than 1 indicates that stock traders are purchasing more puts than calls. It shows that a bearish mood is rising in the market. Investors either bet the market will fall or hedge their portfolios in anticipation of a sell-off.

A dropping put-call ratio, especially one less than 0.7 but nearing 0.5, is considered a bullish indication. It indicates that more calls are brought against puts.

What Is A Good Put Call Ratio?

A good put-call ratio implies that investors’ expectations are balanced between bullish and bearish. A ratio less than one usually indicates bullish sentiment since more calls (bullish bets) are exchanged than puts (bearish bets).

In contrast, a ratio greater than one indicates bearish emotion, suggesting that more puts are traded than calls. However, the perception of a “good” put-call ratio is dependent on the market backdrop and the specific stocks or indexes under consideration, but generally speaking, a PCR of less than 0.7 indicates a strong bullish sentiment whereas a PCR of more than 1 indicates a strong bearish sentiment.

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How To Calculate Nifty Put Call Ratio

Now that you know what is a good put call ratio, let’s look at how we can calculate the nifty pcr ratio. To compute the Put-Call Ratio (PCR), first let’s consider its elements.

One of its primary elements is the put option and the call option. While the put option grants traders the right to sell securities at a defined price, time, and place, the call option provides the right to acquire assets at current market pricing.

The calculation can be done in the following ways:

  • Considering open interests on a specific day
    The PCR is calculated by dividing the open interest in a put contract on a certain day by the open call interest on the same day.

Therefore, PCR (Open Interest) =

put open interest
———————————
call open interest

Let’s understand this with an example:

On a specific day, if the total quantity of puts traded is 3000 and the total quantity of call options sold is 4000,

the PCR ratio = 3000/4000 = 0.75

Here, as you can see, the PCR value is less than 1, which indicates that more call options are being bought than put options, indicating that investors expect a positive outlook for the markets in the future.

  • Considering the volume of options trading
    The PCR is calculated by dividing the put trading volume by the call trading volume on the specified day.

Therefore, PCR (Trading Volume) =

put trading volume
——————————————
call trading volume

Let’s understand this with an example:

Assume that on a particular trading day, the total volume of Nifty put options is 5,00,000 contracts, whereas the total volume of call options is 4,50,000 contracts.

Then, the NIFTY PCR ratio = 500,000 / 450,000 = 1.11

In this case, the estimated PCR ratio of 1.33 indicates a bearish market mood, implying a likely downward trend.

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How To Analyse PCR (Put Call Ratio)?

  • A declining Put-Call Ratio in a market moving downwards is a bearish indicator. It indicates that option traders are pushing the call option strikes aggressively.
  • When small dips are brought into an upward-going market, the put call ratio rises, indicating a bullish trend. This suggests that, put traders actively trade during dips, hoping the upswing will continue.
  • A declining put-call ratio is a bearish indicator when markets challenge resistance levels. It means that call traders are initiating new positions with the expectation of a restricted upside or a market correction.

Put Call Ratio As a Contrarian Indicator

It should be noted that an investor’s investing technique affects how they view the Put-Call Ratio. The put call ratio nse cis is also considered a contrarian indicator.

In simple words, a strategy that emphasises defying the mood of the market as a whole is known as contrarian investing. When significant events occur, such as earnings calls, it can be helpful to evaluate the Put-Call Ratio to understand how the market views predictions for the future. The ratio frequently demonstrates whether the market has been characterised by an excessively bullish or bearish attitude when it reaches extreme levels.

Why is PCR important?

Let’s analyse the significance of PCR Ratio Analysis in terms of traders managing their portfolios effectively:

  • Put call ratio analysis is used by contrary traders to gauge the emotion of the market.
    A high PCR indicates a prospective purchasing opportunity.
  • A low PCR value indicates a potential selling opportunity.
  • Hedge positions may be necessary for traders when the PCR value is high.
  • PCR value traders may detect possible market risks and implement suitable modifications to help manage risk.
  • In addition to the technical indication, NSE PCR ratio data analysis might help improve trading choices.
  • Put call ratio analysis makes it simple for traders to spot trends that are about to reverse.
  • Traders may encounter a bullish market in the low PCR market.
  • PCR Data Analysis facilitates the development of optimal options trading strategies by considering the current market involvement rate.
  • High PCR often offers information regarding the market’s liquidity and trading volume.
  • Many traders consider the PCR Ratio as one of the most crucial instruments for conducting a comprehensive market analysis.

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Limitations of PCR

NIFTY PCR is widely used and has numerous uses; however it’s important to recognise that using PCR alone for decision-making has its drawbacks. One of its main disadvantages is that PCR sometimes misses important subtleties in the market mood. Others include:

  • The primary limitation of PCR is its tendency to shift according to market mood instead of being exclusively determined by internal factors. Emotions like fear and greed may significantly impact PCR levels, which can cause the ratio to sometimes misinterpret the underlying fundamentals of supply and demand in the market.
  • PCR measurements can become twisted during high optimism or pessimism, which could mislead investors who depend only on this measure.
  • There are many company stocks without options. For the majority of stocks in the stock market, this makes it difficult to compute the PCR.
  • PCR is not very detailed when identifying the motives underlying put or call option trades. Although a high PCR value can suggest that investors are feeling pessimistic, it doesn’t explain whether these trades are speculating or hedging.
  • Interpreting PCR results might be difficult in the absence of additional information, which could result in incorrect interpretations and poor investment decisions.
  • The PCR does not include out-of-the-money options; it concentrates on in-the-money and at-the-money options.
  • Savvy market players hold the ability to manipulate PCR. Large traders or institutional investors may occasionally participate in strategic options trading to intentionally change PCR values, producing misleading signals to trick other market players. This modification can potentially erode confidence in PCR’s predictive power as an indication.

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Combining PCR with Implied Volatility (IV)

PCR may be wisely interpreted by combining it with IV. The implied volatility, or IV, in an option price, is a reflection of the market’s sense of risk. Investors can also evaluate the longevity and strength of market movements by combining the analysis of PCR and IV. Here are a few things to consider:

A big shift in the market or opportunity may be indicated when PCR and IV coincide. For example, an elevated IV and high PCR may indicate an impending recession with more volatility, leading to hedging or caution investing. On the other hand, a low PCR combined with a suppressed IV might suggest a positive outlook with minimal volatility, which could imply favourable conditions for bullish strategies.

Evaluating Investor Sentiment

When bulls in the market do not trade actively, it indicates that bears are flooding the market with trades. This doesn’t imply that the markets are bearish; rather, it might indicate that bullish traders and investors are waiting for some possible event—such as an election or the release of significant economic data that will cause the markets to start moving in a positive manner once more. It can only benefit traders and investors if they closely monitor the PCR to see how markets react to news or earnings releases.

When the ratio reaches extreme levels, it indicates either a very bullish or extremely negative emotion. This is why some investors believe that although the PCR is a useful indicator, it is also contrarian.

Conclusion

The Put-Call Ratio (PCR) is a useful metric analysts and traders use to determine how options traders feel about the Bank Nifty index. Put-call ratios are useful but they shouldn’t be the only ones used in making trading decisions. This is because it is very uncommon for any one ratio to be able to accurately identify when the market is going to peak or drop.

Thus, when making buy/sell/hold decisions, the PCR should be utilised by investors in conjunction with other market indicators rather than being used alone to obtain better results.

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Reference :
https://economictimes.indiatimes.com/
https://www.investopedia.com/ask/answers/06/putcallratio.asp

Author: All Content is verified by SMC Global Securities.

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