A ratio that compares the trading volume in put options with the trading volume in call options. Technicians use the put-call ratio to forecast market turns. A high ratio with heavy trading in puts indicates strong bearish sentiment and the possibility of a market bottom. A relatively low put-call ratio with heavy trading volume in calls indicates very bullish sentiment and a probable market top. As with many other technical indicators, use of the put-call ratio assumes that most investors are wrong.
Case Study Like most technical indicators, the put-call ratio can prove very misleading when it is influenced by unusual factors. In February 1996, the ratio nearly reached five, meaning that put options were nearly five times as active as call options. This high ratio would usually be interpreted as reflecting very bearish investment sentiment, and it caused many investors to view the stock market with great caution. Contrarians, who believe the majority of investors are usually wrong, would consider the unusually high ratio to be very bullish. In fact, the ratio was artificially high and was providing false signals to both groups of investors. The heavy trading in put options was largely the result of the owners of puts selling existing holdings of these contracts and simultaneously purchasing different put contracts. For example, a holder of March put options would sell those contracts and replace them with April put options. Rolling the options forward caused a great deal of activity in put options even though a large portion of this activity represented the trade of existing holdings of puts for different puts.
Since investors buy put options when they expect the market to fall, and call options when they expect the market to rise, the relationship of puts to calls, called the put-call ratio, gives analysts a way to measure the relative optimism or pessimism of the marketplace.
The customary interpretation is that when puts predominate, and the mood is bearish, stock prices are headed for a tumble.
The reverse is assumed to be true when calls are more numerous. The contrarian investor, however, holds just the opposite view. For example, a contrarian believes that by the time investors are concentrating on puts, the worst is already over, and the market is poised to rebound.