PUTS / CALLS RATIO

Overview

Developed by Martin Zweig, the Puts/Calls Ratio ("P/C Ratio") is a market sentiment indicator that shows the relationship between the number of Puts to Calls traded on the Chicago Board Options Exchange (CBOE).

Traditionally, options are traded by unsophisticated, impatient investors who are lured by the potential for huge profits with a small capital outlay. Interestingly, the actions of these investors provide excellent signals for market tops and bottoms. When put volume becomes excessive in relation to call volume, it is an indication of excessive bearishness in the market, which is usually bullish.

To calculate the Put/Call Ratio simply divide the number of puts by the number of calls. The raw ration can then be smoothed into a moving average.

When more puts are traded than calls, the ratio will exceed 1. When the ratio gets too low, it indicates that call volume is high relative to put volume and the market may be overly bullish or complacent. When the ratio gets too high, it indicates that put volume is high relative to call volume and the market may be overly bearish or in panic.

(Click here to see a live example of the Put/Call Ratio)

Interpretation

A Call gives an investor the right to purchase 100 shares of stock at a pre-determined price. Investors who purchase Calls expect stock prices to rise in the coming months. Conversely, a Put gives an investor the right to sell 100 shares of stock at a pre-set price. Investors purchasing Puts expect stock prices to decline. (An exception to these general rules is that Puts and Calls can also be purchased to hedge other investments, even other options.)

Because investors who purchase Calls expect the market to rise and investors who purchase Puts expect the market to decline, the relationship between the number of Puts to Calls illustrates the bullish/bearish expectations of these traditionally ineffective investors.

The higher the level of the P/C Ratio, the more bearish these investors are on the market. Conversely, lower readings indicate high Call volume and thus bullish expectations.

The P/C Ratio is a contrarian indicator. When it reaches "excessive" levels, the market usually corrects by moving the opposite direction. The following table , general guidelines for interpreting the P/C Ratio. However, the market does not have to correct itself just because investors are excessive in their bullish/bearish beliefs! As with all technical analysis tools, you should use the P/C Ratio in conjunction with other market indicators.

	P/C Ratio 10-day Moving Average	P/C Ratio 4-week Moving Average
Excessively Bearish (buy)	greater than 80	greater than 70
Excessively Bullish (sell)	less than 45	less than 40

The following chart shows the S&P 500 and a 4-week moving average of the Puts/Calls Ratio.

The entry signal was "buy" (see the arrows) when investors were excessively pessimistic (greater than 70) and "sell" (see the arrows) when they were excessively optimistic (less than 40). The arrows certainly show that investors are buying Puts when they should be buying Calls, and vice versa.

Calculation

The Puts/Calls Ratio is calculated by dividing the volume of Puts by the volume of Calls.

Total CBOE Put Volume

Total CBOE Call Volume