What is PCR Ratio? Meaning, Formula & Example
Imagine you’re standing at a bustling marketplace, surrounded by traders shouting out their offers and bids, trying to gauge the collective mood of the crowd. Now, imagine if there was a secret language, an indicator that could provide valuable insights about what other market participants are doing, wouldn’t that be great? One such tool is the Put-Call Ratio(PCR), a fascinating metric that captures the balance between bullish and bearish options trading activity.
In this blog, we will understand and analyze the importance of the Nifty Put-call ratio and how it is calculated.
What is the PCR Ratio?
The Put-Call Ratio is a technical instrument that demonstrates investor sentiment. The PCR Ratio Nifty is also known as the Put-Call Ratio. It is a widely used financial indicator that measures the relationship between the number of put options and call options traded in the stock market. Thus, put options refer to when a holder has the right to sell a share/asset at a predetermined time and place to the writer of the put. While the call options refer to the contract between the buyer and the seller that they set in exchange for the security.
An average put-call ratio of 0.7 for equities is considered a good basis for evaluating sentiment.
Investors and analysts can gauge market sentiment by analyzing the Market Mood Index(MMI) and Put-Call Ratio.
- Put Call Ratios with a high value indicate bearish sentiment. Since more traders are purchasing put options for profit or to protect themselves against price declines.
- In contrast, a low Put Call Ratio indicates a bullish sentiment. Since more traders are buying call options in order to speculate or protect against price increases.
How Can I Calculate the PCR Ratio?
To calculate the Put-Call Ratio (PCR), let’s first discuss its components.
For instance, the put option and the call option are one of its prime components. While the former provides the rights to traders to sell security at a specific price, time and place. The latter offers the right to purchase assets at the current market prices.
Hence, the PCR ratio Nifty calculation can be done in the following ways:
1. Based on Open Interest for a Specific Day: The PCR is determined by dividing the open interest of put contracts on a particular day by the open interest of call contracts on the same day. The PCR ratio formula is as follows:
PCR (OI) = Put Open Interest / Call Open Interest
2. Based on Options Trading Volume: In this approach, the PCR is calculated by dividing the trading volume of put options by the trading volume of call options on a specific day.
PCR (Volume) = Put Trading Volume / Call Trading Volume
In this context, the term ‘Put volume’ refers to the total number of put options initiated within a defined time period. Conversely, ‘Call volume’ represents the total number of call options initiated within a specific time frame.
It’s worth noting that the interpretation of the PCR may vary depending on the type of investor or trader involved.
Example of Bank Nifty Put Call Ratio
Let’s have a look at this put call ratio example to understand how Nifty PCR functions.
Let’s say you are analyzing options data for Company XYZ. You find that the total number of outstanding put options is 10,000, and the total number of outstanding call options is 15,000.
| Type of Option | Numbers Initiated |
|---|---|
| Puts Initiated | 10,000 |
| Call Initiated | 15,000 |
Now according to the PCR ratio formula
PCR Ratio = 10,000 / 15,000 = 0.67
In this example, the calculated PCR ratio is 0.67, indicating a higher number of outstanding call options compared to put options and suggesting a bullish sentiment in the market for Company XYZ. Simply put, this means investors are buying more call options when compared to put options.
How Can We Interpret the Nifty PCR Ratio?
Interpreting the Nifty PCR (Put-Call Ratio) can provide insights into market sentiment and potential trends for the Nifty 50 index. Nifty weightage plays a crucial role in determining the performance and direction of the Nifty 50 index. Here are the primary key points to consider when interpreting the Nifty PCR Ratio:
- Bullish and Bearish Signals: A PCR ratio below 1 suggests a higher number of outstanding call options compared to put options, indicating a bullish sentiment in the market. It implies that market participants are more optimistic and anticipate upward price movements in the Nifty 50 index.
- Market Sentiment: A PCR ratio above 1 signifies a higher number of outstanding put options relative to call options, indicating a bearish sentiment. It suggests that investors and traders have a negative outlook on the Nifty 50 index, anticipating potential price declines.
- Overbought and Oversold Conditions: An extremely high PCR ratio (above 1.5 or 2) could suggest an overbought market. However, an extremely low PCR ratio (below 0.5 or 0.3) may indicate an oversold market.
- Contrarian Indicator: Some investors and traders use the Nifty PCR ratio as a contrarian indicator. For example, a very high PCR ratio (bearish sentiment) could indicate a possible market bottom. In contrast, a very low PCR ratio (bullish sentiment) could suggest a market top.
Nonetheless, it must be noted that a PCR of 1 is not a reliable point to measure market sentiment. It is because more traders tend to buy call options than put options.
Why is PCR Ratio Important?
The Put Call Ratio indicator is important because it can help traders gauge the overall sentiment of the market.
- The PCR ratio provides insights into market sentiment and the prevailing mood among investors and traders.
- The Nifty PCR ratio is often used as a contrarian indicator, signalling potential turning points in the market.
- When the PCR ratio is out of balance, it can create opportunities for traders to take advantage of the market sentiment.
- The put call ratio helps traders understand the direction of price movements in underlying securities.
PCR – The Contrarian Indicator
Before delving into how the put call ratio is a contrarian indicator, let’s first understand what a contrarian indicator is first.
So basically, a contrarian indicator is a type of market indicator that hints to the trader that this might be the right time to do exactly the opposite of what other market participants are doing. This strategy is inspired by herding behaviour and is considered a little risky for a new trader to practice.
Now that we’ve covered what a contrarian indicator is, let’s move on to understand how the put call ratio NSE is a contrarian indicator.
A put call ratio is usually used by traders as a contrarian indicator when the value of an asset reaches an extremely high PCR value of Nifty. This signifies that traders may perceive a high Put Call ratio.
Let’s say 1.4, as a promising buying opportunity. Their belief stems from the notion that the market sentiment is excessively bearish and is likely to correct itself soon. They anticipate that those with short positions will reverse their positions to cover, resulting in a market downturn.
In general, the NIFTY put call ratio exhibits a pattern where it oscillates between 0.8 and 1.3. The lower band is at 0.8, while the upper band is at 1.3
However, there isn’t a specific threshold that indicates the market has hit a bottom or a top. Nifty Trader PCR typically anticipates this by observing spikes in the ratio or when the ratio goes beyond the usual range of trading levels.
What are the Limitations of PCR in the Stock Market?
The Put-Call Ratio (PCR) is undoubtedly a powerful tool for analyzing market sentiment and potential turning points. However, one of its biggest disadvantages is that it does not always present the intricate nuances of the stock market.
Let’s have a look at the others:
- Limited Time Horizon: The PCR is calculated based on options data from a specific time frame, such as a day or a week.
- Imbalance in Open Interest: The PCR ratio relies on the assumption that open interest in put options and call options reflects the sentiment of market participants despite the imbalances.
- Exclusion of Out-of-the-Money Options: The PCR focuses on in-the-money and at-the-money options but excludes out-of-the-money options.
- Market Manipulation: While rare, market manipulation can influence the PCR. Individuals or entities with substantial resources may attempt to distort the PCR ratio.
Well, despite these limitations, the Put-Call Ratio remains a valuable tool in a trader’s arsenal. It offers insights into market sentiment and can help identify potential turning points. However, other than these factors, investors must carefully consider other options to make informed decisions.
To Wrap It Up…
To conclude, as an astute trader, it is essential to recognize that trading encompasses more than solely relying on the PCR. Even when the put and call ratio reaches extreme levels, it is crucial to understand that these indicators are not set in stone and can fluctuate over an extended period of time.
FAQs
One of the most trustworthy financial market indicators present in the stock market is Put Call Ratio also known as the Nifty PCR ratio. A high/low PCR ratio indicates that there is more bearish/bullish sentiment in the market.
Put Call ratio is a derivative indicator. However, traders use this indicator during extreme market times to identify periods where reversals are likely to occur.
PCR ratio above 1 indicates that put volume has exceeded call volume. It indicates a rise in bearish sentiment. PCRs below 1 indicate that call volume exceeds put volume indicating bullish market sentiment ahead.
A high put call ratio indicates that small and medium investors are actively purchasing puts, while simultaneously signalling that more experienced traders are engaged in aggressive selling.
