The Put/Call Ratio Charts

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.

WHAT IS A CALL OPTION?

There are many vehicles to trade in the markets: stocks, etf’s, futures, currency, and some others. My personal favorite equity to trade is options.

A call option is a contract. Yep, that’s right! A contract that gives the owner the right, but not the obligation, to purchase a set number of shares at a set price. That same contract gives the seller the obligation to sell a set number of shares to you at a set price.

For every one option contract you purchase, you are controlling 100 shares of the underlying. The underlying being any company (stock). I should mention that some futures contracts also can be underlying’s for options… but that is for a different post. We will keep it simple for this one.

So… If you were to purchase one call option contract for company ABC (hypothetical company), you would be controlling 100 shares of company ABC, without having to actually own 100 shares. Now, let’s say that option contract is selling for $1; to purchase the single contract you would have to pay $100 ($1 X 100 shares = $100). The price is just a quote price, it is up to you to determine the full amount. But it’s easy! It’s simply the option price multiplied by 100 shares. If you are buying two option contracts, then it would be the option price multiplied by 200 shares… so on and so forth.

So how do you make money with an option? Well, let’s say company ABC is selling at $10 per share in the open market, and you believe company ABC has a lot of potential and will rise to $12 soon. Instead of having to pay $1000 to own 100 shares of company ABC, you decide to purchase one call option for just $100 (using the $1 option price I discussed above). SWEET! Look at all that capital you freed up in your account to make other investment decisions.

A week later company ABC is selling for $12 in the open market. Awesome! Your analysis was correct and you decide you want to sell your call option to profit. But now, instead of that call option being worth only $1, it is now worth $2.50 (just an example). So you hit that sell button and notice that your profit on the trade was $150. You bought the option for $1 which means you spent $100 for it ($1 X 100 shares), and you sold the option for $2.50 and made $250 profit ($2.50 X 100 shares). Sure, you didn’t make $200 like you could have if you had just bought the shares outright… but consider your percent gain with the option compared to buying the shares outright. Not to mention, consider the amount of money you DIDN’T spend when you bought the option, which allowed you to make other investments.

That’s the basics of a call option. Pretty simple! I should note, however, that options carry with them unique risks, and can be VERY dangerous from a financial standpoint if you do not know what you’re doing. It would benefit you greatly to learn as much as possible about them, before you make your first option play.