How to Use the Put-Call Ratio

There are several indicators that I use that are truly unique and helpful. The put/call ratio is one of those indicators that, on certain days, can give you a wealth of information and some insight into the market. Though I seldom use the put/call ratio as a primary indicator, I often use it to give me an overall view of what the traders are buying and selling. This kind of information is invaluable in ascertaining the overall mood and trend of the market.

There are three flavors of the put/call ratio:

1. The equity P/C ratio: This particular ratio is not terribly useful because it generally reflects what the retail buyers are doing and it is us biased toward the long side.
2. The Index P/C ratio: This ratio generally reflects what the institutional buyers are doing, which is hedging activity. This ratio will often reflect a bias towards put buying.
3. The Combined equity/index P/C ratio: This ratio is a combination of the first two ratios and gives a very accurate reflection of put buying versus call buying and is the put/call ratio you want to keep your eye on.

The mechanics of P/C ratios are fairly simple. The ratio is simply the number of individuals or institutions buying puts divided by the number of individuals or institutions buying calls. In essence, you get a unique insight into how many people are betting the market is going long and how many people are betting the market is going short. What better information could you have?

Generally speaking, a P/C ratio higher than 1.0 reflects a high degree of bullishness in the market and is good reason to ignore any potential short trades. As trend traders, you should also notice that the price action on the market indices should be trending upward since there will be an overwhelming number of buyers in the market, as opposed to sellers.

Conversely, I put to call ratio at.6 or lower indicates the wrong bearishness in the market and is good reason to ignore any potential long trades. Again, as trend traders you should also notice the price action on the market indices should be trending downward since there will be an overwhelming number of souls in the market, as opposed to buyers.

I would like to quickly note that the put/call ratio spends a tremendous amount of time in neutral territory and should be used when determining the strength of a trend in a given situation as opposed to a primary trading indicator.

As I said earlier in this article, I don't necessarily use the put/call ratio as the primary indicator in my trading. More importantly, the put/call ratio is an excellent tool to confirm a protracted or strong move either long or short, depending upon the reading. In other words, if the market is rallying I would prefer to have the market rally confirmed by the proper put to call ratio, and conversely if the market is breaking down, I would like to have that breakdown confirmed by the put call ratio.

Again, one of the basic premises of my trading which is convergence and divergence comes into play here. And if the market is in a weak rally and the put to call ratio does not confirm this rally with the reading of 1.0, there is good reason to believe that the rally is weakening or might reaching the end of the cycle. Just the opposite is true when evaluating a market breakdown and put/call ratio doesn't confirm the strength of the breakdown.

The P/C ratio is especially helpful in day to day trading, as opposed to intraday trading. It is important to know and understand the overall trend of the market and provide a perspective that is not short-term in nature. In other words, we use three minute charts to trade and a three-minute chart rally is, at best, a transient event and not indicative of overall longer-term market move. It's important to understand the overall trend of the market from several different perspectives and the P/C ratio is an excellent tool to help a trader understand what the general trend in the market is over a two or three day period.

So what is the significance of the put/call ratio? As a trader who is deeply interested in how the trend in the market is behaving I want to use every available tool at my disposal to gain a deeper and more complete understanding of what is actually occurring in the market. The put/call ratio gives me that understanding from a different perspective than any shorter-term indicator. It is important to understand that trends exist in longer period times than just a day and that is the exact use of the put/call ratio. Try it and see if it doesn't help you in your trend determination and give you a better overall look at how the market is functioning.