Since there are generally more call options traded than put options, the ratio is usually below 1.
Example:
On February 15, 2001: the total number of Calls and Puts traded were:
Number of Calls (contracts): 7723
Number of Puts (contracts): 1693
Put-Call Ratio = Puts / Calls
= 7723 / 1693
= .22 (Rounded off to 2 decimals)
This is an important CONTRARIAN indicator of investor sentiment.
Put/Call ratios are commonly used as a measurement of market sentiment. It is widely believed that the “PUBLIC” is typically wrong on the market and thus should be used as contra-market indicators. In other words, when “PUBLIC” are overwhelmingly buying calls, it is bearish as they are probably wrong in their bet. Conversely, when put volume is at extreme levels, you should turn bullish as the put buyers are probably wrong.
The Ratio is drawn as a line chart.
When the ratio gets too low, it indicates that call volume is high relative to put volume and the market may be overly bullish or complacent. When the ratio gets too high, it indicates that put volume is high relative to call volume and the market may be overly bearish or in panic. Traders look to sell when the ratio gets too low and the market is extremely bullish. They look to buy when the ratio is too high and the market is extremely bearish.
In short term trading, bullish conditions often become more bullish, and bearish conditions lead to more bearishness. Therefore, use of this indicator is more difficult for short-term traders.
Given below are the S&P Nifty and the Put-Call ratio charts. Note that high ratios indicate market bottoms, while a low ratio indicated the beginning of a reaction.
Like most other overbought / oversold indicators, the Put-Call ratio should be used with care.
