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Devangshu Datta: Put-Call Ratios indicating a quick recovery

Alternatively it could also be an indication that the worst is still to come with an absolute collapse of sentiment waiting around the corner

Devangshu Datta 

The put-call ratio (PCR) is a popular technical indicator. PCR divides puts by calls to assess sentiment in options . Some analysts use total volumes, while others divide by outstanding open interest (OI). The PCR will be between 0 and 0.99 when calls outnumber puts. It's above 1, when puts outnumber calls. (In the following, OI-based ratios are used)

There are two interpretations. One is straight forward: Sentiment is bullish if PCR is low; vice-versa, sentiment is bearish if PCR is high. There is also a contrarian interpretation and that is actually more popular.

Contrarians say the PCR is usually headed in the wrong direction. In an oversold market, puts will be high (everyone expects the market to fall more). Hence, the market is likely to rebound when PCR is high. Conversely, in an overbought market, the number of calls will be high and the market is therefore, likely to travel down more.

Contrarians will be bearish if PCR is low and bullish if PCR is high. This interpretation seems to work often, probably because hedgers use options. Traders with long stock and futures positions often take long puts and traders, with short futures positions often hold long calls.

It is important to set a “balanced” level when interpreting PCR. Once that is set, the trader must decide what he considers a significant variation in either direction. Both the balanced level and the significant swing factor will vary in different underlyings.

In general, the PCR will be low in stock options. People always buy more stock calls. Most Indian stock options are not liquid enough to allow for the use of PCR. Sometimes there is near-zero OI. Some traders use 0.7 PCR as a balanced level in stock options; others use 0.5 PCR.

Index options are more liquid. In the Nifty, a PCR of 1 (when calls and puts are equal) can be taken as a balanced level of "no signal". In practice, we could assume that the range of 0.95 to 1.05 (a five per cent spread around 1 PCR) is neutral in the Nifty. If the PCR is below 0.95, or above 1.05 in the Nifty, there will be a contrarian signal of overbought (hence bearish) and oversold (hence bullish) sentiment respectively.

The Bank Nifty develops a lot of futures volumes and some amount of option volume. It has consistently the second-highest OI in options. But the balanced levels in the Bank Nifty are low. The PCR rarely rises above 0.7 or 0.8 - if you are analysing the Bank Nifty, it is probably best to take 0.5 as the balanced level.

The past few sessions have seen the PCRs of both the Nifty and Bank Nifty travelling down in tandem, with the index price levels. In both indices, prices have hit successive 52-week lows in the last 5-7 sessions. However, even though the PCRs have declined, neither index has seen the PCR move into bearish territory.

It is difficult to interpret this. The Nifty has often hit levels of 0.9 PCR or lower during bearish periods. The Bank Nifty has also dropped below 0.4, when the financial index is down. In this case, although prices have fallen sharply, the PCRs have remained above 1 (Nifty) and above 0.5 (Bank Nifty).

This may be a positive divergence suggesting that sentiment is better than expected and we could expect a quick recovery. Alternatively it could also be an indication that the worst is still to come with an absolute collapse of sentiment waiting around the corner. It is worth filing away for future reference, since it is unusual behaviour in a trending market.

The author is a technical and equity analyst

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First Published: Tue, September 08 2015. 22:38 IST