An Explanation of Put/Call Ratios
It’s pretty exciting when you make the decision that you’re ready to start investing in the stock market. It can be a viable investment strategy to earn more money for both new and veteran investors. Especially when you’re relatively new to investing, you may want to learn more about market indicators, which can give you a clue as to how the market, a fund, or an individual security is trending and help guide your investment decisions.
One of the greatest ways to measure how an overall market or specific security is doing is by looking at its associated put/call ratio. The ratio remains a reliable indicator of how the market is trending, and many investors use it to figure out what their best option is for buying and selling stocks. Learn more about the put/call ratio, including what it indicates, different ways to interpret it, and details on buying puts and calls.
What Is a Put/Call Ratio?
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A put/call ratio is a security’s volume of put options relative to its call options, usually over a period of time like a day or a week. It is used by investors to measure how well (or not so well) the stock market is doing. It’s made up of two parts, and you can probably guess what they are:
- A put, also called a “put option,” is a stock owner’s right to sell their securities at a certain predetermined price. Traders who hold a put are expecting that the price of the security will decrease in cost because they make money when the price falls below the target (strike) price before the expiration date. More puts than calls in the market indicate that the market is bearish, meaning the prices of stocks will probably be in a decline, sometimes even more than 20%.
- The call, also called a “call option,” is the opposite. It’s the right for a buyer to purchase assets at a predetermined price. Traders who hold a call option are expecting that the price of the security will increase in cost. When traders are buying more calls than puts, it indicates that the market is bullish and therefore, stock values are rising overall.
When there are more put options than call options, the ratio is above one. When there are more call options than put options, the ratio is below one.
The calculation of the put/call ratio is: Put/Call Ratio = Put Volume / Call Volume
What Does a Put/Call Ratio Indicate?
Think about how each security can increase or decrease in value all on its own. There are so many companies represented in the stock market that you can’t always expect every single one’s value to go up or down at the same time and by the same percentage. So, each security can have its own put/call ratio that can determine how it is performing.
However, even with this being the case, in any economic upswing or downswing you may notice a trend of most stocks’ put/call ratio moving in the same direction. Some technical traders and stock market analysts use an overall put/call ratio to get a better sense of how the sentiment of the market is doing as a whole, with many of them looking toward the popular S&P 500 to begin with.
Understanding the Put/Call Ratio
To the person new to investing, you may want to make it as simple as possible for yourself. It’s usually best practice to sell when the p/c ratio is higher and buy when the p/c ratio is lower. The reason for this is when the ratio is higher, it indicates that most investors are expecting a future decline and therefore, protecting against that decline in the price of the stock.
Keep in mind that not all put/call ratios have to be high or low — they can also stay close to its current value. A ratio between 0.70 and 1.0 generally indicates a more horizontal trend in the stock, without much movement up or down to indicate either a bearish or bullish market.
To go just a little further, let’s examine how some more experienced traders interpret the put/call ratio. These traders know that, beyond the indication of how the market is doing, the put/call ratio is also used as a bet, or insurance, that a stock will go one way or the other.
Contrarian traders will figure that most investors are placing some insurance on one side over the other (sell-side versus buy-side) because of a general consensus of how prices are moving. For example, if most investors are placing insurance on the sell-side, it typically means they’re concerned that the price will start dropping. On the other hand, more insurance placed on the buy-side means that the major expectation is that the price will start rising.
When contrarian traders see this happen, they’ll do the opposite by buying when the ratio is above one and selling when the ratio is below one. Their goal is to make money on an eventual correction.
As you can see, how you interpret the put/call ratio can be different from another investor’s approach. Everyone’s investment philosophy is unique, investors’ actions vary, and there isn’t a right or wrong way to view the ratio. What’s most important is to understand the put/call ratio enough to make an informed decision for your investment.
Buying a Put Option
Buying a put option isn’t complicated, and it can often be cheaper and give you more leverage than other trading options. Follow these steps to purchase a put option:
- Find a stock to buy. The goal is to invest in a security that you expect will decrease in value over a certain period of time. You can identify this asset by getting feedback from an experienced broker or investor, looking at the security’s trend, or paying attention to its put/call ratio.
- Select an expiration date. The expiration date is the amount of time you’re allowing yourself to decide on your purchase. It’s a good idea to give yourself a bit of extra time because the more time you have before expiration, the lower the stock is expected to go.
- Choose a strike price. The strike price is the amount a stock must meet before a put option can be exercised. For example, if you buy a put option with a strike price of $30, you are able to sell the option at $30, although you aren’t under any obligation to. Remember that the goal of put options is to buy low and sell high.
Buying a Call Option
If you’re a stock buyer who wants to purchase the option to buy stocks, consider first buying a call option. To buy a call option, follow these steps:
- Find a stock you want to buy. This should be a stock that you expect to increase in value. The idea is that you want to have the option to buy that stock before it rises too high.
- Buy the call option. The call option is your right, without being under any obligation, to buy a security (in groups of 100 shares) once the stock price reaches a predetermined amount before a predetermined expiration date.
- Choose whether to exercise your call option or to sell your call. Once you have a call option, you may choose to sell the option if the stock isn’t moving, only losing the premium you paid for the option. Or, if you see that a stock is increasing in value, you may want to exercise your call option and buy the stock at the agreed-upon price. You don’t have to wait until the expiration date to make a move.
A security’s put/call ratio really does tell a story, guiding you in your next investment move. The ratio allows you to make a more educated decision when it comes to your investments and choose the right time to buy or sell securities so you can reach a maximum profit.