How to Measure Stock Market Sentiment With the Put/Call Ratio

Use the put/call ratio to gauge the market's next move.

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Gauging market sentiment over short-term time horizons can be a vexing endeavor for investors and requires more than just knowing how many days the market rose or fell in a given week. The put/call ratio -- the number of put contracts divided by call contracts on a certain security -- can help investors gauge sentiment over medium-term and longer-term time frames.

Contrarian Indicator

Properly using the put/call ratio means understanding it is a contrarian indicator. Puts are the options contracts that traders buy when they expect a stock to fall, and calls are the options used to establish bullish positions. However, a high put/call ratio is not necessarily a bearish sign. Usually a high put/call (more puts than calls) is looked at as a bullish sign. Conversely, a low put/call ratio (more calls than puts) is often viewed as a bearish sign.

Understanding Different Ratios

Multiple put/call ratios are worth monitoring, but the task is not as difficult as it sounds, as many trading platforms offer access to this data. The most important put/call ratio is the Chicago Board of Options Exchange, or CBOE, intraday volume on index options or those options pertaining to major indexes such as the S&P 500. With this contrarian indicator, a rising ratio is considered bullish and a falling ratio is considered bearish. Another put/call ratio investors should monitor is open interest in the OCC (formerly known as the Options Clearing Corporation) put/call ratio. Open interest data has been known to offer important clues about the market’s next move.

Remember Liquidity

To properly apply the put/call ratio to single stocks and to some indexes, consider typical options activity in a stock or index. An index or stock that sees a one-day, unusual spike in options trading may wind up with a put/call ratio that is deceiving to investors. For example, a trader buys 1,000 calls on ABC Inc. in what is a bullish bet, and that could skew the put/call ratio in favor of calls, but the ratio being tilted in favor of calls in this example would not be a bearish signal.

Other Considerations

Other things to consider when using the put/call ratio include recent market action. If the broader market has moved sharply higher in a short amount of time, falling put/call ratios could be a sign of a looming pullback. Investors should also study the long-term trends of previous put/call ratios on various indexes.