The put/call ratio is a valuable tool in assessing how other traders view a stock in terms of expected future performance. Put and call options are investments that potentially make money as the price of a stock drops or rises respectively. By tracking and comparing the fluctuations of the put/call ratio, it is possible to assess the overall bullishness or bearishness of traders and also spot potentially high-probability trading opportunities.
Calculation
The put/call ratio is calculated by dividing the number of puts options traded by the volume of calls options traded. For instance, if 7,500 puts and 10,000 calls of a specific contract are traded in a session, the ratio for that day would be 7,500 divided by 10,000, yielding a ratio of 0.75. The volume of puts and calls traded is available from the Chicago Board Options Exchange (CBOE), the world's largest options exchange.
Recording Data
Put and call volume should be recorded daily for a stock of interest so fluctuations can be monitored over time. Recording data chronologically in a spreadsheet is an easy way to accomplish this. Create one column for the date the data is recorded, a column for put volume and a column for call volume. Finally, create a fourth column that calculates the put/call ratio for each date.
Chart the Data
Visually seeing the put/call data will make interpreting the fluctuations in the ratio easier. To create a chart, highlight the dates and corresponding ratios recorded in the spreadsheet, then insert a line chart into the spreadsheet (do not include put and call volume in the chart). The dates should represent the x-axis and the put/call ratios the y-axis values. This will show how the values change over time as investors become more bullish or bearish. Some websites also provide put/call ratio charts and historical options data.
Applying the Indicator
The put/call ratio is considered a contrarian indicator; a very high reading is likely to result in the stock price rising, and a very low reading is likely to lead to the stock price falling. Each individual stock will develop its own range of typical ratio values that it will fluctuate between. By monitoring the put/call ratio, it is possible to see when spikes outside of the typical range of values in put or calling buying occur. These spikes usually create an extreme and are followed shortly by a reversal in the stock price.
