What is the put option ratio?
The put-to-call ratio is a widely used measure of overall market sentiment by investors.
A “put” or put option is the right to sell an asset at a predetermined price. A “call” or call option is the right to buy an asset at a predetermined price.
If traders buy more puts than calls, it is an indication of rising bearish sentiment. If they buy more calls than puts, they are seeing a bull market.
Understanding the Put Option Ratio
The put ratio is calculated by dividing the number of traded puts by the number of traded calls.
- A put option gives a trader the right to sell an asset at a preset price.
- A call option is the right to buy an asset at a preset price.
- If traders buy more puts than calls, it is an indication of rising bearish sentiment.
- Watch out for a future bull market if they buy more calls than puts.
A put ratio of 1 means that there are as many buyers of calls as there are buyers of puts. However, a ratio of 1 is not an accurate starting point for measuring market sentiment, as investors typically buy calls more often than puts. Therefore, a stock’s average put/call ratio of 0.7 is considered a good basis for assessing sentiment.
- The put option ratio rises, Or the ratio is greater than 0.7 or more than 1, meaning that stock traders are buying more puts than calls. This shows that the market is building bearish sentiment. Investors are either speculating the market is headed lower or are hedging their portfolios against a sell-off.
- A decline in the put ratio, or below 0.7 and close to 0.5, is seen as a bullish indicator. This means that more calls are being bought than puts.
The put option ratio can be used as an indicator of how the market views recent events or earnings. A ratio at either extreme indicates overly bearish or overly bullish sentiment.
The data used to calculate the put ratio is available from a variety of sources, but most traders use the information on the Chicago Board Options Exchange (CBOE) website.
special attention items
The put option ratio helps investors gauge market sentiment before the market turns. However, it is important to look at both the numerator (puts) and denominator (calls) demand.
The number of call options is found in the denominator of the ratio. This means that a reduction in the number of traded call options will increase the value of the ratio. This is important because fewer calls can push the ratio higher without increasing the number of put purchases. In other words, we don’t need to see buying a lot of put options to boost the ratio.
With bullish traders on the sidelines, the default outcome is that there are more bearish traders in the market. This doesn’t necessarily mean the market is bearish, but bullish traders are on the sidelines until an upcoming event, such as an election, a Fed meeting, or the release of economic data.
The average put/call ratio for a stock is considered a good basis for assessing sentiment.
Looking at the put option ratio can help to understand how the market views recent events or gains. When the ratio is at extreme levels, it can indicate overly bearish or overly bullish sentiment.
For this reason, some investors use the put option ratio as a contrarian indicator.
Contrarians use the put/call ratio to help them identify when market participants are overly bullish or overly bearish.
An extremely high put-to-call ratio means the market is extremely bearish. For contrarians, this could be a bullish sign that the market is overly bearish and that a turnaround is due. A high ratio could be a sign of a contrarian buying opportunity.
An extremely low ratio means the market is very bullish. Contrarian investors may conclude that the market is too bullish and should pull back.
There is no single ratio that can definitively indicate that the market is at a top or bottom. Even levels of put/call ratios that are considered extreme are not set in stone and change over time.
Typically, investors compare the current ratio level to the average over time to gauge whether there has been a recent change in sentiment. If the put ratio is trading in a tight range and suddenly rises, traders may see this as a sudden increase in bearish sentiment and act accordingly.