- Wealth PMS (50L+)
The Put-Call Ratio is often quoted as a statistic that could, perhaps, influence market behaviour. Let’s take a deeper look
Take the ratio of the total traded volume of put options traded and the volume of call options, on any given day. That’s the put-call ratio. Here’s how it’s looked for the overall market in the last few months.
As you can see there is very little real correlation with the index. The first shaded area has a high put call ratio (PCR) and the index drops from 6,000 to 5,400.
In the second shaded area above, you see the PCR cross 1.1 levels but the market actually went up. So there is no simple correlation between the PCR and the stock market.
If we looked at the PCR on an “open interest” basis (that is, the total open interest in the puts versus the calls), would we have a useful ratio?
Let’s also focus on the Nifty alone, which is the single largest trading instrument in the market.
A High PCROI Value (Above 1.5) seems to predict a short-term down move.
However, what we’re seeing now is a massive outlier – the PCROI for the Nifty is at a huge low, of 0.8!
To understand what this means we’ll have to go back to the distant past. Let’s plot this indicator over many years:
Nearly every single time that we have seen the Nifty PCROI indicator go down to 0.8 has been on a downturn. This kinda makes sense. As markets fall, people offload their put options and sit tight on their call options, making the put to call ratio fall substantially below 1.
Today is different. We have a big event coming up and people have loaded up far more on calls than they have on put options. The open interest ratio is 0.8 now.
The last elections was after a massive downturn so people were scared. There was so much interest in put options that put open interest was 2x the call OI, so you saw the PCROI go to 2.
What then is the meaning of 0.8, in an uptrend?
I will be wary of coming to conclusions. But let’s look at the past few years of instances when markets showed the Nifty PCROI to be very low. Here’s the top few, along with:
Here’s the results:
On every occasion save in November 2008, we had seen a low PCROI corresponding to a short-term fall. From as low as -1.4% in December 2011, to as high as a -12% fall in October 2008, the index had been falling in the five days prior to the point when the PCROI hit a low.
In each of these instances the trend changed, including in that one instance when the Nifty had risen in the 5 days prior.
Could this be a starting indicator of a trend change? The point in the other occasions is that people are getting out of the put contracts and keeping their calls. Today, it’s that people aren’t buying puts and buying lots of calls instead.
The call-buying is now a consensus trade, today. The market has to go up, because Modi will come. But too often, the “consensus trade” is exactly wrong. The PCROI being at an extreme is a warning sign: the time to jump off the long trade may just be around the corner.
In general, using the PCR to make short term bets – and most option bets are short-term – is useless.
The PCROI though does tend to provide some indication of where the market is headed. This is not flawless, but in general it happens when the market’s falling and signifies a potential change of trend.
And at 0.8, we are an inflexion point today. Remember, though, that there is no data on when such an event occurs if the market’s on an uptrend, so take this with appropriate pinches of salt.
Nothing in this newsletter is financial advice and should not be construed as such. Please do not take trading decisions based solely on the matter above; if you do, it is entirely at your own risk without any liability to Capital Mind. This is educational or informational matter only, and is provided as an opinion.
Disclosure: The authors at Capital Mind have positions in the market and some of them may support or contradict the material given above, or may involve a direction derived from independent analysis.