Derivatives Trading Basics
by 5paisa Research Team Last Updated: 2022-06-16T01:07:47+05:30

Introduction

Derivatives traders use multiple indicators and tools to make sense of the market movement. While some analyse the open interest and volume, others check the put-call ratio, volatility index or VIX, and others. Of the many indicators and data checked by derivatives traders, the put-call ratio or PCR ratio is the most common. So, what is the put-call ratio, and why is it so important? The following sections contain the answer. Read on to know more.

What Is Put-Call Ratio?

The put-call ratio is a broad indicator of the sentiment of derivatives traders. PCR ratio is composed of two elements - put and call.

Investors buy calls when they believe that the price of the underlying asset, such as a stock, index, commodity, currency, etc., will increase before a specific date. In contrast, they buy put when they are certain that the underlying asset price will decrease before a specific date. When the number of put buyers equals the number of call buyers, the PCR ratio is 1. However, while analysing the numbers, you can rarely find the put-call ratio as 1.

Generally, if the put-call ratio of a stock or index, such as NIFTY or BANKNIFTY, is less than 1, it indicates that the bulls have control over the market, and investors expect the market to rise further. In contrast, if the PCR ratio is above 1, it indicates that the bears have control over the market.

The PCR ratio is calculated based on the Open Interest (OI). OI, not volume, is a more accurate indicator of investor sentiments in the derivatives market. The PCR ratio increases of the total put OI is higher than the call OI. Conversely, the PCR ratio decreases when the total call OI is higher than the put OI.

How to Interpret the Put-Call Ratio

While the PCR ratio is a decent indicator of the market sentiment, it can also misguide you into making incorrect decisions.

Although the put-call ratio displays the relationship between put OI and call OI, it does not show whether buyers or sellers have inflated the OI. This is the reason why some traders consider a PCR ratio above 1 a healthy indicator of a bullish market.

Sometimes, big institutional sellers sell put intentionally for two reasons - (i) when they are confident that the market will not go below the level on which they sold, and (ii) to beguile (read, misguide) retail traders. Since more selling will eventually increase the PCR ratio, retail investors may think that the market is poised for a downturn. This is why it is crucial to analyse the put-call ratio with other parameters like bid-ask spread, Implied Volatility or IV, technical parameters, and the like.

Analyse Put-Call Ratio Properly to Trade Efficiently

Some investors say that NIFTY and BANK NIFTY put-call ratio (PCR) is more of a sentimental indicator than a real indicator. However, if you can read the fine print and combine it with other parameters, the PCR ratio can give you good hints about the upcoming opportunities or dangers.

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