Put Call Ratio (PCR): Meaning, Formula and Limitations

Initially, I was unaware of the concept of "PCR ratio" or "put call ratio," but I often heard seasoned traders mentioning this while I was through with stock market trading. To be honest, it seems too difficult to compromise at first, but once I got it, the whole thing about the market sentiment became easier.

Let's understand in easy steps, just like I wish someone had explained to me when I started. 

What is Put-Call Ratio (PCR)?

In simple words, the put-call ratio is a figure that reflects the mood of the traders regarding the market. Are they scared or are they sure? The PCR gives you that answer.

The simple and plain definition is that the PCR is calculated by putting the number of put options and the number of call options traded in the market in a ratio. 

Why should you care as a trader or investor about this?

From my point of view, knowing the market sentiment is the first step towards victory. When you realize whether the majority of traders are betting on the market going up or down, you can then make your decisions more smartly. The put-call ratio NSE provides you with this very insight for Indian markets.

I have seen that beginners very often overlook sentiment indicators and only pay attention to price charts. This is a mistake I made as well. The PCR value allows you to know what the big players are thinking, and believe me, that information is priceless.

Understanding Put and Call Options

To begin with, let's take a look at the concept of puts and calls. That is, I am going to keep it extremely simple and quick.

What are call options?

To call option buyer, it is just an idea that the stock or index will rise. You could say, "I hope Nifty goes up, so I am buying the option to acquire it at today's price even if it escalates even more tomorrow." 

What are put options?

Put options are a reverse technique. Buying a put means you are betting that the market will drop. You are either safeguarding yourself or making a gain through a decline.

Often, traders buy puts when they suspect a market crash or correction. It is like having insurance against price drops.

Thus, when we are calculating the Nifty put-call ratio, we are looking at how many traders are buying protection (puts) compared to those who are betting on growth (calls). This comparison reflects the overall sentiment.

Put Call Ratio Formula and Calculation Methods

Let me show you how to calculate the PCR using both main methods.

Basic PCR Formula

The basic formula for PCR is quite simple:

PCR = Put Options Count / Call Options Count

Or in a more precise way:

PCR = Volume (or Open Interest) of Put Options / Volume (or Open Interest) of Call Options

Method 1:

Volume-Based PCR Calculation

While volume-based PCR looks at how many put and call contracts were actually traded during the day.

Let's say on a particular day

Total put options traded = 45,000 contracts.

Total call options traded = 30,000 contracts. The formula for PCR ratio would be = +0.5ut. PCR= 45,000 / 30,000 = 1.5.  

A PCR of 1.5 means more puts were traded than calls, and it indicates we have bearish sentiment, thereby indicating a bearish trend. PCUR Conversion circulate this process.

Method  2:

Open Interest-Based PCR Calculation (more noise works correctly for ALL CASES, we could not leverage this since open interest and put contracts, but also options and obligations on put contracts)

This method is truly what EVERY PCR-loaded shredder tries to get at since it shows the bigger picture. Open interest is the expression of all the contracts that have not been closed.

For example, the open interest on the put option has been: 

Put option open interest = 80,000 contracts

Call option open interest = 100,000 contracts. 

PCR = 80,000 ÷ 100,000 = 0.8. Suggesting we have bullish sentiment since we have greater open interest as med to closed options compared to the open and total. 

Step-By-Step Calculation Example

Let we’ll understand you through a real scenario. Say today you want to calculate the Nifty PCR ratio. 

• Go to the NSE website and find the option chain for Nifty. 

• Add up all the open interest we see on the put options, I mean going up the ear at hand with the corresponding strike prices and so forth.

• Add all the open interest for call options. 

• Then divide puts by calls.

Let's say our puts total 1,200,000 and calls total 1,000,000. 

Therefore, PCR 1.2. This couldn't be simpler

Types of Put-Call Ratios

PCR ratios do not all have the same characteristics. Market and instrument disparities result in different PCR values, and the knowledge of these differences in my trading strategies, hence, a better trader.

• Total/Market PCR: This examines the whole market, including all stocks and indices. It provides the widest perspective on market opinion. When I want to understand the general market sentiment, this is the first place I go.

• Equity PCR: Only individual stocks are considered in this case. If you are dealing with particular companies rather than indices, equity PCR is more proper. I have found it helpful when trading large-cap stocks that have active options markets.

• Index PCR (Nifty PCR, Bank Nifty PCR): The Nifty PCR and Bank Nifty PCR ratios are probably the most closely monitored in India. These indices keep the entire market; thus, their PCR values are very significant. In my case, checking the bank Nifty PCR today before trading has kept me away from numerous bad trades. Banking stocks have a powerful impact on the Indian market, and thus their sentiment is of great importance.

• Per-Strike PCR: This assesses the put-call ratio at designated strike prices. Professional traders make use of this to recognize support and resistance levels. Although it is more complicated than others, it provides you with the precise location of large money being placed.

How to Interpret Put-Call Ratio Values

This is where it starts to become delightful. The PCR value by itself is just a number, but what does it mean? I'll explain what I've learned through the years.

• PCR Under 1 (Bullish Sentiment): When the put-call ratio is less than 1, it means that calls are being traded more than puts. The traders are bullish and expect the market to rise. For example, if the PCR is 0.7, that indicates that people are very bullish. I have found that this usually is the case in strong uptrends, as traders observe everyone riding the upward market sentiment.

• PCR Of 1 (Neutral Sentiment): A PCR of 1 means that there is equal interest in puts and calls. The market is neutral, and traders are uncertain about the direction. In my experience, this often happens before major events like budget announcements or Federal Reserve Meetings. 

• PCR Over 1 (Bearish Sentiment): When PCR goes above 1, you are trading more puts than calls. This displays fear and expectation of a downward action. A nifty PCR ratio of 1.3 or 1.4 suggests traders have huge bearish sentiment. But here is where it gets tricky, and this is what confused me at first.

Extreme PCR Readings and Their Significance

When the PCR is extremely high (let’s say it gets to 1.5 or so), it might indicate a bottom is about to happen. Why? Because when everyone is extremely bearish, no one is left to sell, so the market usually changes direction.

Just like the extremely low PCR (say 0.5 or less) might indicate a top, as people are usually too optimistic before corrections.

I have learned this lesson the hard way before.  I had the PCR at 1.6 during one of the market crashes and thought, "It's going lower!" And then within a few days, the market sharply bounced.

Understanding Typical PCR Ranges (0.7-1.3 for Index)

For the Indian market, I have noticed that the Nifty put call ratio is typically between 0.7 and 1.3.  Anything outside this range warrants attention.

When I see the PCR stay above 1.25 for a few days in a row, I look for buying opportunities. Likewise, if the PCR is below 0.8 for an extended period of days or weeks, I look out for overheated market conditions.

Put Call Ratio as a Market Sentiment Indicator

Grasping the market psychological aspect is what really gives the PCR ratio live tracking its full strength. So, let me explain how I utilize it.

• How PCR Mirrors Market Psychology: In a way, every put or call option shows a person's bet. When thousands of traders do so, the sum of individual bets gives an insight into the overall market's opinion.

  I have observed a pattern where retail traders, when we are scared about flooding the market with puts, whereas the opposite is true for the institutions that are holding the positions. This understanding has afforded me the advantage of making well-timed contrarian trades.

• PCR as a Contrarian Indicator: This is how I largely deal with the PCR. It is usually a superb moment to purchase when the market is down (high PCR). Conversely, when the market is up (low PCR), it is time to be watchful.

  Most people find it hard to do this because it is the opposite of the natural inclination to go along with the crowd. However, in my experience, the crowd is usually wrong at the extremes.

• PCR as a Momentum Indicator: Another way of using the PCR is as a tool for confirming the existing trends. In a scenario where the market is experiencing a rise and the PCR is slowly declining, it is a confirmation of the bullish momentum. Similarly, if the market is falling and the PCR is rising, then that is a confirmation of bearish momentum.

The Extremes of Sentiment that Signal the Reversals

The main point that I want to focus on is that extreme sentiment is not going to last long. Just like that, when the Bank Nifty PCR ratio gets to extreme levels, start looking for signals in price action that indicate a reversal.

If you are fond of learning about market indicators and analysis tools like this, Dhanarthi.com is a great resource for you, as it provides the necessary market fundamentals and sentiment analysis, which goes well with the PCR readings.

Real-World Examples of PCR Analysis

The theoretical concept is good; however, I will present you with some practical examples which will make everything clear (before you even realize it).

Example 1: Computation of PCR using Open Interest

Assume that you look at the data of the NSE PCR ratio Nifty on some random trading day:

Put Option Open Interest = 1,50,00,000

Call Option Open Interest = 1,25,00,000

Example:

      PCR = 1,50,00,000 ÷ 1,25,00,000 = 1.2

Example Interpretation

This represents a slightly bearish trend. More puts are put in a position, and this will show that there is more expectation of downside or that traders are insuring themselves.

Example 2: Calculation of PCR using trading volume

There is a day of trading: 

Traded volume of put options = 25, 000 contracts.

The number of call options that were traded = 35,000 contracts.

Example:

    Volume PCR = 25,000 ÷ 35,000 = 0.71

Example Interpretation

This shows a positive mood for that specific trading session/ work day. Traders are not discouraged from buying more calls; it means that traders are of the opinion that the underlying will see an increase.

Example 3: The interpretation of the Nifty PCR to the Market Direction

Once, I recall it was in early 2024. Nifty P/C ratio had increased to 1.55 after experiencing a huge fall in the market. Everyone was afraid, everyone was scared in the atmosphere, and news channels were discussing the market crashes and others.

I can safely say that I could stare at that extreme PCR and say to myself, everybody is already bearish and sold, who is left to sell, or short the market? It did no,t but a week or so later that the market bottomed and started a powerful recovery rally. 

This is why it is important to learn how to view PCR, not the quantity, but more precisely, what it depicts with regard to the behavior of the crowd.

How to Trade Using the Put-Call Ratio

So now we can move on to the question that you are actually interested in: how do you make money with this indicator?

1. Trading strategy Step-by-Step PCR Trading Strategy

Here is my working strategy to overcome for PCR ratio formula : 

First, I verify pcr ratio NSE in the morning prior to the opening of the market. This provides me with the base feeling. Then I keep an eye on its shift throughout the day.

When the PCR reaches approximately 1.1 to 1.3 with strength in the price charts, I seek to buy. At a PCR below 0.7 and weak prices, I will be defensive.

2. Contraindicative Trading Strategy

This style is effective in extremes. At the point where pcr value exceeds 1.4, I begin to gather long positions in stages. Having fallen below 0.6, I begin to sell off some position or even go short.

The key is patience. Do not rush in when PCR is at extreme levels. Wait for price confirmation.

3. Momentum Trading Approach

In the case of momentum trading, I would rely on PCR to affirm the trend as opposed to identifying reversals. In case the market is on an upward trend and PCR remains below, I remain long. If the market is moving in the downward direction and PCR remains above 1, I remain wary or short.

4. Integrating PCR and Other Technical Indicators

I never use PCR alone. It would be comparable to driving one eye closed. I use it together with moving averages, RSI, and support-resistance levels.

An example of a high-probability long setup will be when Nifty is at a very strong level of support, and the Nifty put-call ratio is at 1.5. However, in case PCR is 1.5, and I have no support around, I will wait.

In evaluating the wider market factors and PCR, I have discovered that the knowledge of the basic analysis, such as the screener offered by Dhanarthi, makes me realize whether the extreme sentiment is warranted by the actual company performance, or it is just a passing market mood. 

Key fundamental ratios like PE ratio, price to book ratio, and debt to equity ratio help validate whether the market's fear or greed reflected in PCR aligns with actual business health

5. Risk Management during PCR use

The majority find this very difficult, and that is why I need to be clear on this: PCR is a sentiment indicator and not a crystal ball. Always use stop losses.

I will normally take a risk of 1-2 percent of my capital on a single trade, even when PCR signals are ideal. It can take markets longer than it takes you to remain afloat.

Significance and Benefits of Put-Call Ratio

I would like to explain why it is almost every trading day that I check the PCR ratio live.

• Effectively Gauging Market Sentiment: PCR is a perfect tool for eliminating all the noise. Even though news stations might be reporting opposite stories, PCR will tell you what the traders are really doing with their funds. The actions that the front line takes are what matter, and the PCR tracks those actions.

• Spott-ing Possible Market Reversals: With my experience, I can tell that PCR has assisted me in catching several major reversals. When the combination of extreme sentiment and the presence of price action reversal patterns is noticed, the chance that a turning point will occur becomes very high.

• Choosing When to Buy and Sell: I do not depend on PCR exclusively when it comes to timing, yet it certainly hones my time. Trading when PCR is at its peak and the market sentiment is going against me has given me some of my most profitable trades.

• Reading Institutional vs Retail Behavior: Something unfamiliar that I've come across is the tendency of retail traders to panic and buy puts at the bottoms, while the institutions are the ones selling puts to retail and reaping profits. 

  By monitoring PCR, you can sometimes spot this interaction and reap the benefits by placing yourself on the winning side.

Limitations of the Put-Call Ratio

Honestly speaking, PCR isn’t the gold standard, and I am going to share with you the limitations I have found out, based on my personal experience.

• Does Not Guarantee Market Direction: PCR is showing sentiment, not certainty. I have encountered instances where the PCR was very bearish, but the market continued to drop. The sentiment can be extreme longer than you expect.

• Can Give False Signals: At times, the PCR falsely notifies when it sticks due to hedgers rather than traders. For example, to reduce the risk of losing with long portfolios, institutions buy put options, which raises the PCR but does not mean they are bearish.

• Does Not Account for Hedging Activities: This is one of the most important factors. Portfolio managers with large funds constantly hedge their holdings. Their hedging activity influences the PCR but does not mirror their market opinion. Most investors do not understand this when they check today's bank Nifty PCR.

• Limited Applicability: PCR applies only to stocks and indices that have active options markets. Many mid-cap and small-cap stocks do not have liquid options; thus, you cannot apply PCR to them.

• Needs Confirmation from Other Indicators: I learnt that the hard way: trading based on PCR alone is never a good idea. Always wait for confirmation through price action, volume, or other technical indicators.

• Time Lag in Market Reaction: There are times when the market takes extreme PCR readings to be a sign of the trend for several days or even weeks. If you can’t hold on, you might liquidate your position too early and lose the actual move.

• Influenced by Option Expiry Cycles: The behavior of PCR alters drastically as the monthly and weekly expiry dates come closer. In the weeks of expiration, PCR may be skewed and not very trustworthy. I have learned that it is best to be more vigilant with signals from the PCR during such times.

Where to Track Put-Call Ratio Data

You're likely curious about the sources for this PCR data. Let me tell you my trusted sources.

• NSE India Website for Indian Markets: The NSE site provides the most reliable and official source for PCR data. The site releases the open interest statistics of Nifty and Bank Nifty options daily. I visit the site every morning, even though the interface is not the most user-friendly. You will have to go to the derivatives section to find the option chain data.

• CBOE for US Markets: The financial data for the US markets is published by the Chicago Board Options Exchange (CBOE), which contains the most detailed PCR data for the US markets. Additionally, they can track specific PCR indices at your request.

• Trading Platforms and Tools: The newest and most popular trading platforms, like Zerodha, Upstox, and Angel On, are showing PCR data in their option chain sections. Some of them are even displaying historical PCR charts, which I personally find very helpful.

  For those looking for deeper market analysis beyond just PCR, sites like Dhanarthi are offering tools for analyzing financial statements and conducting fundamental screenings that will allow you to see if the market sentiment is consistent with the actual business performance.

• How Often to Monitor PCR: I look at the Nifty PCR ratio every day in the morning before the market opens. I monitor it once or twice during the trading day, especially when there is a significant price movement.

  I check it weekly for positions that I plan to hold for a longer period to see how the market is feeling. Daily ups and downs can be confusing, but weekly direction is clearer and more significant.

Best Practices for Using PCR in Trading

Having utilized PCR for many years, I would like to share the practices that have turned out the best for me.

• Merging with Technical Analysis: This is of extreme importance. Employ PCR in conjunction with your technical analysis, not as a substitute. If PCR indicates a market reversal while there is no support level nearby, then wait for a better setup.

• Utilization of Moving Averages for the Smoothing of PCR Data: Daily PCR can give misleading and rough data. A 5-day or 10-day moving average of PCR is my common practice to smooth the noise and observe the true trend in sentiment.

  I will keep an eye on long opportunities when the 5-day PCR average crosses above 1.3. On the other hand, if it drops below 0.7, I will be more cautious about my long positions.

• Always Factor in Market Context: PCR is not different from the market. During important events like elections, budget announcements, or global crises, the PCR might remain in an extreme state for long periods.

  I recall the time of the 2020 COVID crash when the PCR was very high for weeks. Those who used only the PCR indicator to catch the falling knife got hurt. Thus, context is important.

• Do Not Rely Solely on PCR: Understanding intrinsic value of stocks helps me determine if the sentiment-driven price movements present genuine opportunities or temporary noise."

  When you’re aiming for a holistic trading strategy, the merging of sentiment indicators like PCR with fundamental research is immensely beneficial. I, for instance, utilize platforms like Dhanarthi when I want to validate whether the extreme sentiment around a particular stock or sector is really supported by fundamentals, or it’s just a passing market mood.

Conclusion

The put-call ratio (PCR) is an easy yet effective measure to gauge market sentiment. It is obtained by dividing the number of put options by the number of call options; therefore, PCR = puts ÷ calls. 

Normally, a PCR value of less than one indicates bullishness since the number of calls bought is greater than the number of puts sold. On the contrary, a PCR value of more than one signifies bearishness, as traders are predominantly buying puts either to hedge or to speculate on a drop.

Extremely high or low PCR levels could occasionally signal that the trend is about to change, but they should always be combined with price action, other indicators, and risk management, and not used by themselves.

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