In the Dumb Money Trader Facebook Group today, I posted this pic with the comment “I look at put/call ratios from time to time. In specific, $PCSP and $PCALL. Noticed that both bottomed today. Bottomed where they’ve been hitting bottom for quite some time. These charts sometimes coincide with what the market does – the same seesaw effect. Meaning, if PC hit bottom, the market may pullback soon.“
Somebody replied to it basically asking what I meant, and what is the PC ratio telling me. And his question was my inspiration for this blog post. So here we go!
First, the only 2 PC charts I use are 1) $PCSP (put/call ratio for the S&P 500) and 2) $PCALL (put/call ratio for the entire market). There are others, but I will not get in to them right now.
The P/C ratio chart (I call them PC’s) is the ratio between puts and calls. Remember from options 101 that puts are bearish, and calls are bullish. To know what the ratio is you simply divide all the puts by all the calls.
Let’s say there are 1000 puts and 500 calls. The put/call ratio would be 2 (1000 puts divided by 500 calls). Now let’s say there are 500 puts and 1000 calls. The put/call ratio would now be .5 (500 puts divided by 1000 calls). Lastly, let’s say there are 1000 puts, and 1000 calls. The put/call ratio would be 1 (1000 puts divided by 1000 calls).
So now that you know the basic math involved, let’s discuss the basic theory behind this ratio.
According to Investopedia, a ratio above .7 is considered bearish, and below .7 is considered bullish. That is, above .7 means there are more people buying puts than buying calls. Which can be a bearish sign. Why .7? Simple. Since people typically buy more calls than puts, using a ratio of 1 would not be “accurate” to determine market direction because that would imply a 1 to 1 split between puts and calls. So, the investing gods decided .7 was a good “middle” point. Honestly, past what I just told you, I don’t know any other reason for .7 being “neutral.”
Now, what can this ratio tell us? I use these charts from time to time, to help me determine which direction I think the market is going. If I open this chart and see a rising PC, I may go easy on my bullish bets. But if I open this chart and see a falling PC, I may increase my bullish bets. I have noticed that this ratio sometimes coincides well with market moves. Meaning, I have noticed that some very bearish days in the market was preceded by a rise in the PC ratio.
If people are getting bearish, they’re not going to buy calls, and vice versa if people are getting bullish. So, if the PC is rising, that can be a sign that people may be getting more bearish because they are buying more puts. If the PC is falling, that can be a sign that people are getting more bullish because they are buying more calls. As always, does this mean it’s guaranteed bearish or bullish sign? Absolutely NOT! But the more tools you utilize to make investing decisions, the better off you might be. No one particular “indicator” is going to be 100 % accurate.
Investing is like a puzzle – You have to put all the pieces together to see the bigger picture.