A put-call ratio is a method used by investors to make market predictions and watch the mood of the market. This a popular way to sense the growth or volatility of the market.
What is Put in Stock Market?
In the financial world, Put is the action of selling the assets to the original seller at a given price and within a determined time period. The act of put is not looked at in a positive light as it questions the future-value of the stock. People normally opt for put when the stock prices don’t seem promising and could have the tendency to go way below the purchase price.
What is Call in Stock Market?
A call option or call, as it is commonly referred to, is a financial contract between the buyer and the seller of the commodity. The buyer in this contract, can buy a said number of bonds within a certain period and at the set price. The seller should be willing to sell the bonds if the buyer wants to purchase, and the buyer in return will be paying a fee for the bond called the premium. The term came into existence because the buyer, in this case, has the power to call(take) the commodity away from the seller.
Why is Put-Call Ratio vital?
As mentioned earlier, this system is to determine the tone of the market. This tool helps the investors to draw financial conclusions of the market. This helps them decide where to put the money and tread accordingly. Being a strong indicator, this helps the traders not to get driven by trends and follow practical and measured movements. This ratio is calculated based on open interest and volume.
Indicators of Put and Call:
When the ratio in put and call exceeds .7, the market becomes bearish. It means that the stock prices will go down, and the traders will make more puts than calls.
When the ratio in the market goes beneath .7, and towards .5, the market is bullish. This implies that more calls are being purchased as opposed to puts.
Contrarian investing, as the name suggests, is the method of making investments contrary to the tone of the market. When the high put-call ratio makes the market extremely vulnerable and bearish, people make puts. But a contrarian investor will wait for the stock to hit rock-bottom prices and then expect a turnaround.
Similarly, a very low ratio makes it a golden opportunity for traders to make more calls. But this may disinterest the contrarian investor, and he/she will not dip his hands in the market as this is a lull period, according to him/her.
Finally, it is important to note that as strong as the put-call ratio indicator is, it can also have its flaws. This implies that no ratio can make a definitive indication of when the market will peak and when it will drop. It is a bankable device, but it can also have its drawbacks. Ratio levels vary over the years, and that should be kept in mind while applying it. The investors make conclusions only after observing the market sentiment for some time.