As you may know, options are among the most popular forex derivative products. There are two basic kinds of option; put options (or puts) and call options (calls). A put option gives the owner the right, but not the obligation, to sell an asset, which could be a currency pair, equity, or commodity, at a particular ‘strike’ price. A call option gives the owner the right, but not the obligation, to buy an asset at its strike price.
At any given time, many thousands of option contracts will be outstanding in the market, both calls and puts, in a balance which shifts based on general market sentiment and participants’ views on future prices.
Options form an important part of the financial system, and their volumes are closely monitored by traders looking to gain an edge over their competitors. One of the best tools for looking at option activity in a particular market is the put call ratio.
What is the put call ratio?
The put call ratio (PCR) is simply the number of put options traded in a particular period divided by the number of call options traded. This provides a snapshot of market sentiment – the shared mood of the various traders active in a market, a concept critical to technical analysis.
When traders use the put call ratio they are looking for a change in market sentiment, which will lead to a future shift in price. This means the PCR is a forward-looking indicator, and its users believe it offers guidance on future price movements.
Market sentiment
The core trading concept behind the put call ratio is market sentiment. In the fx market, you will sometimes hear this referred to as ‘forex sentiment’.
When a significant number of traders hold the same view on an asset’s price movements, they create a directional trend in its price. This sentiment or mood spreads through other participants who join in with similar trades, pushing the price higher or lower.
Reversals
These trends, which can either be bullish (price increases) or bearish (price decreases) will continue until they start to run out of energy, as more and more traders either take profit or reassess their views of likely price direction. At that point, the trend will slow, then undergo a reversal.
These patterns reappear in similar ways on different timescales – thus a series of smaller trends seen on a minute-by-minute trend could all be part of one larger trend on a daily price moves chart.
What the put call ratio can highlight, along with other technical indicators such as the Money Flow Index, are signs that a trend is about to reverse. This means the PCR is an indicator most used by contrarian traders looking for mean reversions. How to interpret the PCR depends on a few factors, not least your view on the collective wisdom of options traders.
What kind of levels are normal?
This varies from market to market. In equities, a typical put call ratio would be around 0.7. A ratio of 1, indicating an equal number of puts and calls being sold, would indicate bearish sentiment on equities, as it is normal for call options to be more popular than puts.
A PCR of 1 means a market perfectly balanced between put and call interest – this should not be confused with the term ‘put call parity’, which has to do with European option pricing. PCR can be used for both American and European options contracts, which differ in the dates on which they can be exercised.
Conversely, a ratio significantly below 0.7, and particularly below 0.5, is a bullish signal, indicating positive market sentiment amongst participants. Such a low ratio could be a sign of excessive positive sentiment, indicating an imminent reversal.
An important consideration is the history of the PCR in the market you are looking at. Unlike indicators such as relative strength, it is not always possible to mark a particular reading as ‘overbought’ or ‘oversold’, and nuance is required in the interpretation. Check for historic highs or lows rather than relying on specific ratios, and always use other methods to verify a trend reversal.
The PCR seems elevated – what does this mean?
If having reviewed historical levels, the PCR still looks very high, it may be a sign that bearish sentiments are dominating the market, and a reversal is imminent. Particular points to look out for are a weakening of the PCR while prices continue to fall. This divergence could be the first sign of an upward correction.
You should always investigate other causes though – sometimes the ratio will be elevated because traders are expecting an adverse economic announcement, such as an interest rate change or weak employment numbers. Be careful that your PCR strategy isn’t actually a strategy of ‘guessing the news’.
Contrarian strategies using the PCR
Years of market data have confirmed one stable fact: The vast majority of options expire worthless. Estimates of the exact percentage range from 70 – 90% but the trend is clear. Some forex traders have used this information to develop a contrarian strategy, where a low ratio is automatically a sign that the market is overvalued, and high values (indicating increased put activity), that it is undervalued.
This can work, but it is important to be cautious. One thing that gets overlooked in the 90% figure is that many professional investors use options as hedges. A trader with a large long position in AUD/NZD might seek to hedge his exposure by buying AUD/NZD puts. Assuming his initial trade goes well, the hedge will expire worthless. This is a very different trading style to a retail speculator buying put options for profit, but the PCR does not distinguish between them.
It is normally safer to wait to see signs of divergence before entering into a trade, but if you do see a low put call ratio, it is perhaps a good time to look for other signs of a coming correction.
Tips to remember
- Use the put call ratio alongside other indicators
- Check for historical highs and lows, rather than absolute levels
- Check for upcoming economic data
The last point is very important: Always remember to think about why a particular reading might come up on the PCR. Is it possible economic news or announcements are driving put or call interest? As with all indicators, the put call ratio should be used in combination with other technical and fundamental analyses.
Trading the ratio with forex
The put call ratio can be used without major modifications in both forex and equities markets. Remember to understand which way round the currency pair is quoted, as this will impact how the bullish or bearish view is expressed.
For example, significant call interest in AUD/USD would indicate a bullish view on AUD, not on the USD. This is a simple point but it’s surprising how easy it is to get confused. Always double check.
There are several factors which can push up or down the forex PCR. In the equities market, index puts are frequently purchased by fund managers to hedge market risks in their portfolios. In forex options, this is less of a factor, although professional investors may still use puts to hedge particular currency exposures.
Who publishes the PCR, and how do I check it?
The CME group, which contains the Chicago Board of Trade (CBOT), is the largest marketplace for listed options worldwide. The CBOT and CME websites have live PCR data for all traded options on their platforms.
Additionally, many charting services include the PCR as a field in their interactive charts. If not, it is normally quite simple to find an up-to-date PCR reading by searching for the name of the currency pair and PCR.
How Rakuten can help
Options can be a confusing topic for new investors, but the PCR is a simple measure that can be used by all traders as part of your technical analysis toolkit.
If you’re keen to start using PCR alongside your other technical analysis tools, why not test your skills by signing up for a free demo account today and placing trades without risking any of your capital?