Forex put call ratio

What is the put-call ratio and why should I pay attention to it?

The put-call ratio is a popular tool specifically designed to help individual investors gauge the overall sentiment (mood) of the market. The ratio is calculated by dividing the number of traded put options by the number of traded call options. As this ratio increases, it can be interpreted to mean that investors are putting their money into put options rather than call options. An increase in traded put options signals that investors are either starting to speculate that the market will move lower, or starting to hedge their portfolios in case of a sell-off.

Why should you pay attention to this? An increasing ratio is a clear indication that investors are starting to move toward instruments that gain when prices decline rather than when they rise. Since the number of call options is found in the denominator of the ratio, a reduction in the number of traded calls will result in an increase in the value of the ratio. This is significant because the market is indicating that it is starting to dampen its bullish outlook.

The put-call ratio is primarily used by traders as a contrarian indicator when the values reach relatively extreme levels. This means that many traders will consider a large ratio a sign of a buying opportunity because they believe that the market holds an unjustly bearish outlook and that it will soon adjust, when those with short positions start looking for places to cover. There is no magic number that indicates that the market has created a bottom or a top, but generally traders will anticipate this by looking for spikes in the ratio or for when the ratio reaches levels that are outside of the normal trading range.

This indicator can be created within a spreadsheet with relative ease. The data used for the calculation is available through various sources, but most traders will use the information found on the Chicago Board Options Exchange (CBOE) website.

Forecasting Market Direction With Put/Call Ratios.

While most options traders are familiar with the leverage and flexibility that options offer, not everybody is aware of their value as predictive tools. Yet one of the most reliable indicators of future market direction is a contrarian-sentiment measure known as the put/call options volume ratio. By tracking the daily and weekly volume of puts and calls in the U. S. stock market, we can gauge the feelings of traders. While a volume of too many put buyers usually signals that a market bottom is nearby, too many call buyers typically indicates a market top is in the making. The bear market of 2002, however, has changed the critical threshold values for this indicator. In this article, I will explain the basic put/call ratio method and include new threshold values for the equity-only daily put/call ratio. (Find out how to play the middle ground in Hedging With Puts And Calls .)

Betting Against the "Crowd"

I can remember late 1999 and early into the new millennium, when option buyers were in a frenzy, buying up truckloads of call options on tech stocks and other momentum plays. As the put/call ratio pushed below the traditional bearish level, it seemed like these frenzied option buyers were like sheep being led to the slaughter. And sure enough, with call-relative-to-put buying volume at extreme highs, the market rolled over and began its ugly descent.

As often happens when the market gets too bullish or too bearish, conditions become ripe for a reversal. Unfortunately, the crowd is too caught up in the feeding frenzy to notice. When most of the potential buyers are "in" the market, we typically have a situation where the potential for new buyers hits a limit; meanwhile, we have lots of potential sellers ready to step up and take profit or simply exit the market because their views have changed. The put/call ratio is one of the best measures we have when we are in these oversold (too bearish) or overbought (too bullish) zones.

CBOE Put/Call Ratio Data.

The equity put/call ratio on this particular day was 0.64, the index options put/call ratio was 1.19 and the total options put/call ratio was 0.72. As you will see below, we need to know past values of these ratios in order to determine our sentiment extremes. We will also smooth the data into moving averages for easy interpretation.

Chicago Board Options Exchange (CBOE) Options Volume.

Total Weekly Put/Call Ratio Historical Series.

Figure 2: Created using Metastock Professional. Data Source: Pinnacle IDX.

Figure 2 reveals that the ratio's four-week exponential moving average (top plot) gave excellent warning signals when market reversals were nearby. While never exact and often a bit early, the levels should nevertheless be a signal of a change in the market's intermediate term trend. It is always good to get a price confirmation before concluding that a market bottom or top has been registered.

These threshold levels have remained relatively range-bound over the past 20 years, as can be seen from figure 2, but there is some noticeable drifting (trend) to the series, first downward during mid-1990s bull market and then upward beginning with the 2000 bear market.

Despite the trend, the smoothed put/call ratio is still useful; however, it is always best to use the previous 52-week highs and lows of the series as critical thresholds. My experience has been that put/call ratios are best used in combination with other sentiment indicators and perhaps a price-based (i. e., momentum) indicator. More elaborate mathematical massaging of the data (i. e., de-trending by differencing the series) can also help.

Equity-Only Daily Put/Call Ratio.

As with any indicators, they work best when you get to know them and track them yourself. While I don't like to use them for mechanical trading signals, put/call ratios do outline zones of oversold and overbought market conditions quite reliably. They should thus be included in any market technician's analytical toolbox. (After years of debate, options have changed. Find out what you need to know in Understanding The 2010 Options Symbology .)

Put call ratio data. CBOE Equity Put/Call Ratio historical data, charts, stats and more. CBOE Equity Put/Call Ratio is at a current level of , up from the previous market day and down from one year ago. This is a change of % from the previous market day and % from one year ago.

Does the Put/Call Ratio Predict Market Behavior.

Put call ratio data. When speculation in calls gets too excessive, the put/call ratio will be low. When investors are bearish and speculation in puts gets excessive, the put/call ratio will be high. Figure 1 presents daily options volume for May 17, , from the Chicago Board Options Exchange (CBOE). The chart shows the data for the put and.

Put options are used to hedge against market weakness or bet on a decline. Call options are used to hedge against market strength or bet on an advance. Typically, this indicator is used to gauge market sentiment. Chartists can apply moving averages and other indicators to smooth the data and derive signals. The CBOE indicators break down the options into three groups: Contrarians turn bearish when too many traders are bullish.

Contrarians turn bullish when too many traders are bearish. Traders buy puts as insurance against a market decline or as a directional bet. While calls are not used so much for insurance purposes, they are bought as a directional bet on rising prices. Put volume increases when the expectations for a decline increase. Conversely, call volume increases when the expectations for an advance increase. These extremes are not fixed and can change over time.

In contrarian terms, excessive bullishness would argue for caution and the possibility of a stock market decline. Excessive bearishness would argue for optimism and the possibility of a bullish reversal. When using the CBOE based indicators, chartists must choose between equity, index or total option volume.

In general, index options are associated with professional traders and equity options are associated with non-professional traders.

Even though professionals use index options for hedging or directional bets, puts garner a significant portion of total volume for hedging purposes. Notice that this ratio is consistently above 1 and the day SMA is at 1. This bias is because index options puts are used to hedge against a market decline. Notice that the day moving average is at. Non-professional traders are more bullish oriented and this keeps call volume relatively high.

The put bias in index options is offset by the call bias in equity options. The day moving average is still below 1.

However, the indicator does fluctuate above and below 1, which shows a shifting bias from put volume to call volume. Not because it is necessarily better, but because it represents a good aggregate. Chartists should look at all three to compare the varying degrees of bullishness and bearishness.

A spike extreme occurs when the indicator spikes above or below a certain threshold. The chart below shows the indicator with horizontal lines at 1. A spike above 1. As a contrarian indicator, excessive bearishness is viewed as bullish. Too many traders are bearish. Extremes in May and June resulted in shallow bounces or flat trading before the market continued lower.

The indicator then spiked above 1. Calls are bought when participants expect the market to rise. Excessive call volume signals excessive bullishness that can foreshadow a bearish stock market reversal.

The October signal worked out well, the December signal was too early and the April signal worked out well. The chart below shows the indicator as a day SMA pink.

See the SharpCharts section below for ways to make a plot invisible. There are a few takeaways from this chart. First, notice that the indicator is much smoother with less volatility. Second, the day SMA can actually trend in one direction for a few weeks. Third, the spike thresholds are set lower because of less volatility. Fourth, the day SMA slows the indicator to produce a lag in the signals. A bullish signal occurs when the indicator moves above the bearish extreme.

A bearish signal occurs when the indicator moves below the bullish extreme. Because this moving average can trend for extended periods, it is important to wait for confirmation with a move back above or below the threshold. Waiting for this confirmation would have prevented a long position when the indicator moved above. Notice how the indicator kept on moving higher and remained at relatively high levels for an extended period of time.

A blue horizontal line is set at 1. This coincided with a flat market in the first half of and then an extended decline. The relatively elevated levels indicate a bias towards put volume downside protection or direction bet. The moving averages stayed in this range until April and then both shot above 1. Call volume increases as a rally takes hold, while put volume increases during an extended decline. These contrarian signals can sometimes pick tops and bottoms, but sometimes they will be too early or simply wrong.

Indicators are not perfect. It is important to identify the extremes and wait for an extreme to be reached. Waiting for a little confirmation can often filter out bad signals. This will expand the price scale to fit with the smoothed version day SMA.

These chart settings are shown below the chart. Click here for a live example. Larry McMillan is virtually synonymous with options. Now, in a revised and Second Edition, this indispensable guide to the world of options addresses a myriad of new techniques and methods needed for profiting consistently in today's fast-paced investment arena. Log In Sign Up Help. The calculation is straightforward and simple.

Predicting Market Extremes Using the Put/Call Ratio.

Options have long been popular with forex traders for hedging, for directional bets, maximizing profit or for more complex forex strategies that are out of the scope of this article, but over the years, the record of options trading for buyers has not been stellar exactly. Predicting market direction in a specific time frame is always a difficult endeavor, and when the options trader must make those predictions in strict adherence to the terms of the options contract, the chances of success plummet. About 90 percent of option buyers eventually lose money, in sad testimonial to the difficulty of market timing.

Option writers have been increasing the types of available contracts to satisfy the hunger of the crowd for these instruments, and if not for the recent economic crisis, the volume and diversification in this market would certainly have continued to accelerate. In spite of all that, the basic puts and calls remain the most popular tools for the trader who desires to try his luck in this field, and there’s always a great deal of demand for the ever increasing supply coming from option brokers.

The attractiveness of various types of options to the trader mostly arises from the limited nature of the risk. For instance, a stock trader who shorts the firm X will face unlimited losses if the firm’s price moves in the other direction, but if he simply buys a sell-option on the firm’s stock, the maximum amount he could lose will be limited by the value of the contract (in the same case, the option writer’s risk is unlimited, in theory). But that aside, there’s no reason to think that on a basic level options trading is any different from spot trading, and the similar nature of the spot forex market to the options market will be the basis of our market predictions.

Definition of put and call options.

Before examining the nature of the put/call ratio, and its significance for forex, let us remember that a put option is a contract that allows the buyer to sell an underlying asset at a specified price, and a call option is the kind which allows the buyer to buy the underlying asset. Thus, a buyer of the call option is expressing a view that the price will be higher at a specific point in the future, while the buyer of the put option believes that the price of the underlying asset will fall.

What happens when a bubble is created?

Now, what happens when euphoria (or panic) overtakes a market, and a bubble is created, as spot traders of any asset flock to grab a share of some security or futures contract on which options are available? How will the options trader’s reaction to the bubble be? Of course, the option trader is no different from the spot trader, and the bubble in the spot market has its mirror image in the options market as well. In other words, it is possible to identify extreme values in the spot market by looking at how ebullient option traders are, and the put/call ratio is utilized in a contrarian fashion to identify and exploit these extreme values for profit.

The put/call ratio.

As most of us know, a contrarian strategy focuses on finding undervalued or overvalued assets in a market, and betting against the market in those assets to exploit the correction that will inevitably occur. It is always possible to define oversold or overbought values on the raw price data, and to make counter-trend wagers on that basis, but the highly volatile nature of the forex market makes this a relatively risky effort. That is why the trader always attempts to confirm his positioning with reference to more than one type of data, and with the volume data gained through the usage of the COT report, and the put/call ratio options market extremes can help traders identify opportunities in the spot market. We calculate the put/call ratio by dividing the total amount of puts by the amount of calls and on that basis get a value that reflects the bias of the market. For example, if there are 24,000 put options on EUR/USD, and 60,000 call options, the put/call ratio would be 0.4 implying a bullish market. The put/call ratio will rise as sellers drive the trend, and it will fall as the buyers are more numerous. As positioning reaches extreme values, so will the put/call ratio, until a point is reached where the drivers of the bubble are exhausted, which is usually followed by a violent collapse. We can identify the values registered during past collapses, and by comparing the value of the put/call ratio with past data, we can gain an idea on the market direction in the near future.

Trading the put/call ratio depends on identifying the put/call values registered during past price extremes, and comparing that with today’s values, as we mentioned before. If a breakout or spike is not confirmed by an equivalent change in positioning in the options market, we will be reluctant to act in the direction of the trend. Such a situation would signify that options traders are not convinced by the action in the spot, and do not believe that it will lead to a sustainable price action. Since many speculative deals in the spot market are hedged in the options market, lack of a confirming movement could suggest that the price action is driven by less-informed, smaller players. For contrarian trades, we will take note of extreme values in options positioning, and will enter counter-trend orders in anticipation of the collapse. This method is really straightforward, allowing the trader ease of mind and clarity of analysis.

Two difficulties with this method.

Let us also remember two of the difficulties which this method poses for the trader.

1. Needless to say, the definition of extreme value is arbitrary, and there’s no way of knowing which of the previous peaks will hold, or if a new peak in the put/call ratio will be registered as a result of market action. This means that the trader should be cautious about using options market data for the exact timing of market reversals. There’s no magical quality to the put/call ratio, since quite often option traders also trade the spot market in forex, for the reasons mentioned at the top of this article.

2. Options traders are just traders, and there’s no reason to expect to be any smarter than spot dealers. Indeed, studies show that, if anything, they are more likely to suffer losses as a result of directional bets.

We conclude this section by noting that the data on put/call ratios, and trader positioning can be obtained from the CBOT website.

Risk Statement: Trading Foreign Exchange on margin carries a high level of risk and may not be suitable for all investors. The possibility exists that you could lose more than your initial deposit. The high degree of leverage can work against you as well as for you.