The put/call ratio is a popular gauge of market sentiment, and is a favorite of contrarian investors and traders looking to capitalize on the greed, fear, and over-reactions of others.
Put/Call Ratio Definition
So how is the put-call ratio calculated? It’s pretty straightforward actually:
Put/Call Ratio = Put Volume / Call Volume
Where it actually gets a little more interesting and complex is in determining which groups of options to include in your volume calculations. But ThinkOrSwim makes this pretty easy by segmenting option put and call volume into groups for the S&P 500, Dow Jones, Nasdaq, Russell, etc.
What the Put-Call Ratio Means
The put/call ratio basically tells you how big a portion of the traders out there are bearish on a market. Normally you would think that sentiment would indicate which direction the market will likely take. This is partly true: at moderate sentiment levels, the general sentiment is usually in line with the market direction. But the party doesn’t last forever. Eventually, sentiment can get to extreme levels. And when it does, the probability of an imminent reversal becomes very high. When everybody believes the market is going higher, that’s usually a good time to sell. And when everybody thinks the markets going lower, that’s usually a good time to buy.
How to Use the Put/Call Ratio
When the market’s put/call ratio gets extreme (either high or low), it’s time to start looking for trading opportunities in the opposite direction. You can look for price action based entries or use the PCR to time entries for other trading signals you use.
Using the put-call ratio might seem a little counter intuitive at first, though. When the ratio is showing a high reading, that’s when you want to consider taking long trades. It’s not an overbought indication, or an indication of enthusiasm in the market, it’s an indication of pessimism. The higher the reading, the more option puts have been bought, and thus the more traders are short in the market. Essentially a high reading means that the “dumb money” — or the novice traders out there — have all jumped on board the short selling train. And when there is no one left to sell, it’s time to buy, and thus the market usually starts to turn and go higher when the put/call ratio readings get elevated.
Likewise, when the option put-call ratio is showing a low reading, that’s when you want to consider short trades. Extremely low readings can mean that there is simply nobody left to buy the market higher: all the “dumb money” traders have bought in, and there are few short traders left to switch over to longs. When this happens, a market can’t really move any higher. That’s why low readings usually happen near market highs.
How the Put-Call Ratio Indicator Works
This indicator lets you choose to choose to display one of several market put/call ratios:
- $PCALL – OCC options
- $PCI – DJIA options
- $PCND – Nasdaq options
- $PCRL – Russell 2000 options
- $PCSP – S&P 500 options
The indicator plots the ratio as a line graph by default. You can choose to display a custom moving average along with it of any type you choose (simple, exponential, Wilders, etc.) and of any length you choose. You have many options for customization.
- Which index put/call ratio to use
- Type of moving average to use, if any
- Moving average length
- Optionally show only the MA and not the ratio itself, if desired
- Show/hide alerts
- Customize alert sound, message, behavior, etc.
- Extreme high reading level (choose value, show/hide, color, etc.)
- Extreme low reading level (choose value, show/hide, color, etc.)
- Scale max and min levels – squish crazy high or low readings down to normal levels so the chart is more readable
- Choose all colors, line styles, thicknesses, etc.
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