Put-Call Ratio (PCR): Definition, Formula, and Importance

A trader who is about to open a demat account must learn the concept of the “put call ratio.” But, what are put and call options? A put option’s buyer has the right to sell an underlying asset at a predetermined price on or before a specific date. However, a call option’s buyer has the right to buy an underlying asset at a predetermined price on or before a specific date.

Both the buyer of a put option and that of a call option have a right, not an obligation, to fulfil the contract. However, the seller has an obligation to sell an underlying asset in the case of a call option and buy an underlying asset in the case of a put option. Let us understand what the put call ratio is. 

Meaning & Formula of the Put Call Ratio (PCR)

Put call ratio (PCR) is one of the most important indicators, which can help you understand the sentiment of investors towards a particular stock or the stock market in general. It is calculated by dividing the open interest in put options by the open interest in call options.

If the open interest in put options is more than that in call options, it means the number of traders who expect an asset’s price to fall is more than the number of traders who expect an asset’s price to rise. Hence, the overall sentiment towards that asset is bearish.

On the other hand, if the open interest in call options is more than that in put options, it shows that more traders expect an underlying asset’s price to increase than fall. Hence, the overall sentiment towards an underlying asset is bullish.

You can calculate the PCR by using the following formula:

Put Call Ratio (PCR) = Open Interest in Put Options / Open Interest in Call Options 

Importance of the Put Call Ratio (PCR)

PCR can help you understand the direction which the stock market is likely to take before it takes that direction. Hence, it can help you in intraday trading and also in trading for a longer term.

However, you need to know how to use it. So, instead of just considering the PCR, you should look at its numerator and denominator. For example, if the number of traded calls reduces, the value of PCR will move up. Does it mean that traders are turning bearish about an asset?

In this case, we cannot say that more traders are becoming bearish because the number of traded puts should increase for that to happen. However, here, the number of traded calls is decreasing.

Hence, if the value of PCR increases because the number of traded calls is decreasing, it does not mean that more traders expect the price of the underlying asset to fall. However, it means that fewer traders are buying the right to buy the asset.

It could be that those traders are waiting for an important event to happen. For example, they may be waiting for the company to announce its results and then they will decide whether to buy a call option or not.

Hence, the context is extremely important when using the put call ratio. Some traders also use the PCR as a contrarian indicator. If the value of PCR is very high, the sentiment is extremely bearish. Hence, contrarian traders think that the price of a stock is likely to go up.

However, when the PCR is very low, contrarian traders think that the price of a stock may go down. 

Conclusion

There is no denying that the put call ratio can help you whether you are in intraday trading or you buy and sell stocks for longer than a day. However, it is important to know how to use it well. And, there are no shortcuts to it.

You will learn how to use the PCR well only with experience. Besides, you should never use it alone. Instead, you must use it with other indicators to be on the safer side.