Probably the most widely used barometer utilized to evaluate trader mood is the Put Call Ratio. The Ratio uses exchange volume of options contracts as a measurement for trader mood. An options contract provides the owner the choice, but not the requirement, to purchase or sell a stipulated quantity of shares at a fixed price level and defined time frame.
An investor who is expecting a stock to slide may invest in put contracts (the legal right to sell at a later date) whilst a trader who is expecting the stock to go up may invest in call contracts (the legal right to buy at a later date).
The most popular way of computing the put call ratio employs the trading activity of calls and puts. It's determined by dividing the quantity of puts exchanged by the amount of calls. For example, if 30,000 puts had been exchanged throughout a trading session but just 15,000 calls, the put call ratio would be 2.
Whilst utilizing trading volume to determine the put call ratio is the most common technique, some investors choose to use the actual dollar amount traded or the quantity of "open interest" for a stock. Open Interest describes the total quantity of contracts that have not yet been closed or expired. The Open Interest Put Call Ratio divides the total quantity of put contracts outstanding by the total quantity of call contracts. For instance, if there were 150,000 puts in the marketplace and 200,000 calls, the Open Interest Put Call Ratio would equal 0.75.
The ratio is usually fairly volatile day-to-day, which makes it tough to identify general trends. Because of this, most investors will look at weekly data or compute a moving average in order to smooth out the variances, therefore exposing longer-term trends and extreme situations.
The put call ratio is frequently utilized as a contrarian signal. If the ratio is very high, i.e. there's a lot of investors expecting a drop in prices, contrarian investors will seek out an opportunity to buy the stock. On the other hand, whenever the ratio is very low and many investors are forecasting a rally, they'll consider selling the market.
It ought to be noted that the put call ratio is frequently utilized in conjunction with additional sentiment indicators rather than as a stand-alone method. Additional sentiment indicators include the Volatility Index (VIX) as well as the Advance Decline Ratio.
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