While the put call ratio is a popular market indicator, it’s often misunderstood. Below is a list of pros and cons of using this indicator. The pros first.
Probably the most obvious advantage of using the Put Call Ratio is that it reports something that is often considered one of the primary market drivers, i.e. market sentiment.
Secondly, any investor with access to the internet can access the data needed to calculate several variations of the ratio.
Thirdly, most major charting packages and some trading platforms offer that ability to plot the put call ratio on many timeframes.
The fourth point in support of the put call ratio is that it is an easy concept to grasp for even the beginner trader or investor.
And last (although not necessarily least) the fifth point in support is that it’s a contrarian indicator and can help investors anticipate market moves ahead of the crowd. Other indicators rely on data that will cause investors to “follow” the herd.
And now, for balance, the cons.
One of the major cons of using the p/c ratio is its simplicity. The simple calculation doesn’t always reflect a such a complex dynamic as investor psychology.
The second point in contra is that most people calculate the ratio using options volume, which doesn’t take into account that most investors make decisions on the dollar amounts investors and not quantity of contracts. A dollar-weighted ratio can resolve this issue.
Thirdly, the p/c ratio is not a stand-alone indicator and, to be useful, must be applied with other indicators of market sentiment.
Fourthly, to calculate the p/c ratio for an individual stock, there must be options offered on the issue. So, the ratio cannot be calculated for smaller stocks.
And the 5th and final consideration against using the ratio is that, even if a stock has options available, there must be enough volume activity for the ratio to be meaningful.
So, those are some of the advantages of using the put call ratio.
So, should you incorporate the put call ratio into your analysis?
The p/c ratio is a worthy indicator in most investors toolbox. However, it should always be applied with understanding of the ratio’s constraints.
There are many online resources available to help investors study Market Sentiment. Take your time to study such topics as contrarian indicators, technical analysis and sentiment indicators.