Put-Call Ratio as an Indicator of Market Sentiment

The put-call ratio (P/C ratio) is a very useful number to monitor. It measures the feeling of market participants and can be used as a leading indicator of where the market may be headed. Let’s look at it:

The P/C ratio is defined as the number of traded put options divided by the number of traded call options. So what? Why should I care?

When speculation in the markets is high, people feel good and tend to buy more calls. Conversely, when the market drops a lot, people become scared and defensive and tend to buy more puts. When speculation in calls gets too excessive, the P/C ratio will be low. When investors are bearish and speculation in puts gets excessive, the P/C ratio will be high. Because of this we have a very useful tool. A high P/C ratio indicates extreme bearishness and suggests a market turn to the upside is ahead. A low P/C ratio indicates a high degree of bullishness, and suggests a market downturn may be forthcoming.

How can we use this indicator: When it is low, call prices on average will be high and put prices will be low. And the converse is true as well. Thus, we may monitor the P/C ratio to help determine the best time to sell options. Of course, it can be used to time the entry and exit of stocks and ETFs too.

As with any indicator, the put-call ratio works best when you get to know it by tracking it yourself. Fortunately, this ratio can be gotten online or in the news from a variety of sources. Investors Business Daily, a market newspaper that I like very much, tracks this sentiment indicator and several others on a daily basis.




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