Learn How the Put/Call Ratio Gauges Stock Market Sentiment

To follow or bet against the crowd? Some say it depends on how you’re reading it.

One way to gauge short-term investor sentiment in the stock market is the put/call (P/C) ratio. It’s an indicator that measures the amount of put activity relative to call activity in the options market.

Investor sentiment tends to matter more when certain indicators are hitting extremes. Those readings typically don’t last long, but when they do happen, price reversals can occur (see figure 1).

When everyone seems upbeat, optimistic, and bullish, they can’t all possibly be right. Right? Contrarians—those who typically buy or sell against prevailing trends, the bears in this case—would say that when everyone’s already buying equities, who’s left to buy? At that point, it might make sense to adjust your own long portfolio strategy by hedging your positions, reducing equity exposure, or moving to the sidelines, as the probability increases that a market reversal might be near. On the other hand, when pessimism, negativity, and bearishness dominate investor sentiment, perhaps it’s time to consider bottom-fishing or increasing your equity exposure.

So, the question is: when to act?

Unfortunately, the art of contrarian thinking isn’t easy. Objective information is needed to gauge whether sentiment is bullish or bearish. The P/C ratio—an indicator that measures total put options volume relative to call options volume—is one such tool, and you don’t have to be an option trader to potentially benefit from its insights.

Getting P/C

Let’s review. A put contract gives the holder the right to sell a specified amount of the underlying security at a specified price and by a specified date. A call is the right to buy the underlying security. P/C ratios can be computed for any market or instrument that has listed options. The math is simple: puts divided by calls. For example, the Options Clearing Corporation (OCC), which is the central clearing house for all U.S. options, computes a P/C ratio for all options trading across various exchanges.

Let’s say that on a certain day the OCC reported that 8.82 million puts and 7.47 million calls traded, meaning the P/C ratio was 1.18 (or 8.82/7.47). According to some analysts, a P/C ratio below 0.75 signals high levels of bullish sentiment, so it’s considered bearish from a contrarian viewpoint. Between 0.75 and 1.00 is neutral. Above 1.00 indicates high levels of bearishness and is considered bullish by contrarians.

As an investor, you might look at a number like 1.18 and the high level of bearish sentiment it potentially signals and plan your trading accordingly. In some instances, the historical data has shown a very high P/C ratio before market rallies. Extreme bearishness and a spike in the put/call ratio may warn that negativity is extreme, perhaps signaling that the market might be running out of sellers.

It can also work the opposite way. When the market is going up, consider checking the P/C ratio for very low numbers below 0.75. This could be a signal that the market might be getting overbought and headed for a move the other way. Again, it’s important to consider other factors as well, including fundamentals like earnings and economic data. That said, this can potentially be another tool in your box, or just something to keep on your radar as you assess market direction.

P/C ratios can be applied to individual stocks and sectors as well (see figure 2). If you want to gauge sentiment toward semiconductor stocks, for example, look at the P/C ratio on any of the large chipmaker stocks.

Do you think bearishness is too extreme in the bank and brokerage stocks? See how many puts and calls are trading on a financial sector exchange-traded fund (ETF). Want a potential read on broader-market sentiment? Check the P/C ratio on the S&P 500 Index. And so on.

Learning to Read Ratios

P/C ratios may be useful, and they can be applied to different markets. But keep a few things in mind:

1. Focus on actively traded markets.

   If options on a stock trade only a few hundred contracts per day, the ratio can produce misleading signals. For example, an investor might sell 400 puts on a stock one day and make a bullish bet—yet, the ratio spikes, indicating bearishness.

2. Consider the market action.

   If a stock is rallying to new highs and the P/C ratio spikes, it’s probably not a sign of bearishness. Extreme bearishness typically surfaces after a period of falling prices.

3. Look at trends over time.

   Some markets see more hedging activity (i.e., put-buying) and will have higher P/C ratios. It’s important to establish a norm, or average reading, for each market.

4. No indicator is an island.

   P/C ratios are indicators, not stand-alone tools or tickets to riches. The P/C ratio is typically best used with other sentiment data, as well as a fundamental analysis of the market or technical studies of chart trends.