The Put Call Ratio Calculation
The put call ratio simply measures the relationship between the number of puts being bought versus calls being bought. The call put ratio is calculated by taking the total count of puts and dividing it by the total number of calls.
If there are a large number of puts relative to calls, this is a sign that investors are bearish on the market. When there is a large number of puts being bought by traders, this indicates that the emotion of fear is present and if the market is to pessimistic, a contrary trading opportunity could be presenting itself. The opposite of course applies, when you see a very low put call ratio reading.
Using the Information for Bigger Profits
High put/call ratios in historical terms indicate excessive pessimism on the other hand, low put/call ratios indicate a point at which there optimism and greed are control of the market.
As with any strategy, you need to be mindful of certain factors when using the put/call ratio.
The extremes identified by this ratio are not a market timing indicator – they are simply to give you an idea of how overbought or oversold the market it is in historical terms.
In some cases, options positioning may not reflect Cash Forex market set up accurately as its such a small market which reduces the predictive value of the put/call ratio.
Three Ways to Use Put Call Ratio
The majority of option buyers tend to get wiped out by the market and it's a fact that of all option buyers 90% lose money The contrarian sentiment put/call ratio is useful for both option buyers, option sellers and spot FX traders:
If you are an option seller, you can use the ratio to sell option premium into greed and fear. While the option buyer losses 90% of the time, the option seller wins 90% of the time. Of course he only has a limited gain and unlimited risk so needs to be very careful in terms of the market he buys and sells but if he trades extremes in the put call ratio he increases his chances of success.
If a market is excessively bullish or bearish the option buyer needs to think about going opposite to the majority.
In terms of spot traders, the put call ratio gives him an idea of the sentiment of the market and warns of areas of over or under valuation.
The best trades in terms of risk reward, tend to be at market turning points and the put call ratio is an excellent tool for spotting contrary trading opportunities and works very well if combined with another two popular sentiment indicators – the CFTC Net Traders positions and Market Vanes % Bullish. If you are serious about making money in Forex check out the put call ratio and get a better understanding of market movement.