Markets do not move based on facts, but on interpretations of those facts. Diverse opinions on the same set of facts lead some traders to take long positions and some to take short positions. It is no different with sentiment indicators. This week, we discuss one such sentiment indicator -- put-call ratio.

Bullish or bearish?

Put option is the right to sell an underlying; but not an obligation to sell. Call option is the right to buy an underlying; however, not an obligation to buy. There is a simple observation based on this definition.

When open interest in puts is greater than that of calls, it ought to mean more traders are interested in selling the underlying than buying it. The reverse is true; more traders are interested in buying the underlying when open interest in calls is greater than that of puts.

When you divide the open interest of puts by the open interest of calls, you get the put-call ratio. Based on the above argument, when put-call ratio is greater than one, the underlying is considered bearish. When put-call ratio is less than one, the underlying is considered bullish.

But the above interpretation considers the long side of the contract: long calls and long puts. What about the short side, which is more important?

This is because typically professional traders and institutions take short positions in the market. And these participants ought to know more about the market than retail traders do. There is yet another reason to seriously consider the short side.

Traders can set up a short call position against a long stock or a long futures position or even a long lower strike call. In such cases, the short call is not a bearish outlook. It is just a means to squeeze more gains from a given outlook on the underlying.

For instance, if you were to short an immediate out-of-the-money (OTM) call against long futures, you may be able to capture the difference between the futures price and the strike plus the call premium as your gains. Short put positions are a different story. If you want to cover your short put, you must short futures or go long on another strike put.

Take note
If professional traders and institutions are the ones going short, then put-call ratio should be used as a contrarian signal

The risk is greater compared to a short call combination strategy discussed above. Yet, if traders are willing to short puts and build-up open interest, what does it tell you about their conviction? It is not difficult to argue that their views could be neutral or, perhaps, even bullish on the underlying. So, does a high put-call ratio indicate a bullish or bearish view on the underlying?

Optional reading

If professional traders and institutions are the ones going short, then put-call ratio should be used as a contrarian signal. That is, an increase in put-call ratio ought to be seen as bullish. It is, therefore, best to observe the relationship between put-call ratio and the underlying returns before you use the ratio.

The author offers training programmes for individuals to manage their personal investments

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