Put Call Ratio Trading Strategy: Statistics, Facts And Historical Backtests!
The Put-Call ratio is a popular sentiment indicator. Extreme readings, mostly signaling panic and climax, are often used as contrarian signals to fade the market. For example, a high put reading might signal that traders and investors are panicking and are buying downside insurance (put options act as insurance) and that a market bottom is imminent. But does this hold up in a backtest? Can we make a profitable Put-Call strategy?
The Put-Call ratio divides the volume or open interest among both puts and calls for a certain instrument or asset class on a daily basis. The ratio can be used in different ways. Our own backtests reveal that there are better sentiment indicators out there, for example, the VIX-indicator.
What is the Put-Call ratio?
Put-Call Ratio (PCR) is the commonly used metric by traders and investors to gauge the stock and share market trends before it starts trading. An important indicator of the market’s recent ups and downs, PCR lets the investors and traders predict the direction the market is going towards on a particular trading day or session, to formulate their trading and investment plans.
It measures the ratio of the put open interest on a given day, as against the call option open interest on the same day.
- A put option allows the traders to sell an asset at a preset price
- A call option allows the traders to purchase an asset at a preset price
- Higher PCR indicates a bearish market sentiment
- Lower PCR indicates a bullish market sentiment
You have many types of Put-Call ratios. For example, you have Put-Call ratios on indices and you have on stocks (equities).
If you are using Tradestation you have access to a load of different put-call ratios and it might be difficult to understand what is what.
What are puts and calls?
In order to understand the put-call ratio, you need to have a basic understanding of what a call and a put are. We have briefly discussed it in our articles about selling puts and covered calls, but we briefly repeat it:
What are call options?
If you own a call you have the right to buy x shares of a stock at a predetermined price within a certain time frame. For example, if you have 10 calls in MSFT with a strike at 100 and an expiry date 3 months from now, you have the right to buy 1 000 shares (1 call contract equals 100 shares) of MSFT at 100 before three months. After three months the calls expire and they are worthless. Obviously, if the price of MSFT is higher than 100, it makes sense to buy at 100. Opposite, if the price is below 100, it doesn’t make sense to exercise the options.
What are put options?
If you own puts you have the right to sell x shares of a stock at a predetermined price within a certain time frame. For example, if you have 10 puts in MSFT with a strike at 100 and an expiry date 3 months from now, you have the right to sell 1 000 shares (1 call contract equals 100 shares) of MSFT at 100 before three months. After three months the calls expire and they are worthless. Obviously, if the price of MSFT is higher than 100, it makes no sense to sell at 100. Opposite, if the price is below 100, it makes sense to exercise the options and sell at 100 according to the option contract.
Put options work just like insurance. You simply pay to have insurance against a drop in market prices.
What does the Put-Call ratio indicate?
The logic behind the put-call ratio is that traders and investors are buying puts for protection when uncertainty is high. Thus, the put-call ratio is a little bit like the VIX indicator and a contrarian signal because the stock market is highly susceptible to mean reversion.
We can summarize the logic behind the Put-Call ratio in a few bullet points:
- If traders are buying more calls than puts, that means traders are “complacent” and see few clouds on the horizon.
- However, if they are buying more put options than calls, that means traders are fearing future uncertainty. When uncertainty is high, put volume tends to increase.
- An extremely high Put-Call ratio indicates the market might be oversold and too fearful.
- On the other hand, an extremely low Put-Call ratio indicates the stock market might be too optimistic.
How to Calculate the Put-Call ratio?
An investor or trader can calculate the Put-Call ratio on their own through simple mathematical calculations. It can be calculated by dividing the number of traded put options by the number of traded call options.
However, the volume and open interest are always different.
Volume is what is traded within a certain time frame, while open interest is different.
Open interest is the total number of option contracts at the end of the trading day that are still open.
Options are derivatives and they are a 100% zero-sum game. If you buy an option contract, someone else is issuing or selling. The profits and gains are equaled out: your gains are someone else’s losses, or your losses are someone else’s gains.