How Investors Can Forecast Trend Strength Using the Put-Call Ratio
Forecasting the strength of the trend is important as it can give you valuable hints on when to open larger positions or when to sell your shares. One popular tool investors can employ in forecasting the strength of the trend is the Put-Call Ratio. This ratio can help investors understand the mood of the market and possibly forecast whether a trend is gaining or losing strength.
Let’s dive into what this ratio is, why it’s important, and how investors use it. Along the way, we’ll explain some of the key terms, like derivatives and options, in simple terms.
What Are Derivatives and Options?
Before we can understand the Put-Call Ratio, we need to know what derivatives and options are.
A derivative is a financial contract whose value depends on another asset. Imagine you and a friend betting on the future price of a stock. The bet itself isn’t the stock, but it gains or loses value based on what the stock does. That’s what a derivative is. Derivatives are popular in financial markets because they let investors make predictions on the value of an asset without actually owning it.
Options are a type of derivative. They give investors the option, but not the obligation, to buy or sell an asset (like a stock) at a specific price within a set time frame. There are two main types of options:
- Call Option. This gives the holder the right to buy an asset at a certain price. Investors buy call options if they think the asset’s price will go up. Investors benefit when the price rises because they can buy the asset at a lower price and sell it at a higher market price.
- Put Option. This gives the holder the right to sell an asset at a certain price. Investors buy put options if they think the asset’s price will go down. An investor benefits if the price goes down because they can sell at a higher price even if the market price has dropped.
What Is the Put-Call Ratio?
The Put-Call Ratio is a tool that compares the volume (or number) of put options traded to the volume of call options traded.
The formula is:
Put-Call Ratio = Number of Put Options Traded / Number of Call Options Traded
This ratio provides a quick view of how many people expect the market to go down (by buying puts) versus how many people expect it to go up (by buying calls).
- Put-Call Ratio above 1. More puts are traded than calls, suggesting that investors expect the market to decline.
- Put-Call Ratio below 1. More calls are traded than puts, suggesting that investors expect the market to rise.
Lets see an example on how to apply this ration for an individual stock. You can use the Financial Modeling Prep Institutional Stock Ownership API endpoint to see the Put-Call Ratio for your selected stock. Simply input your custom API key, which you obtain after registering with FMP, and replace the stock ticker in the endpoint with your desired ticker. For example, your endpoint will look like this:
https://financialmodelingprep.com/api/v4/institutional-ownership/symbol-ownership?symbol=NVDA&includeCurrentQuarter=false&apikey="your custom API key”
In the example above, input your custom API key and replace the stock ticker. In my example, I use the NVDA stock ticker, and as of June 30th, 2024, I get 1.1615, as shown in the picture below which basically means that people were buying more put options, expecting NVDA to go lower.
And indeed, NVDA shares lost more than 15% from the end of June. Later, they went up again after touching a local minimum. But trader expectations were right; pessimism was higher, and it was reflected in the Put-Call Ratio.
How to Use the Put-Call Ratio in a Simple Strategy
Here’s a simple way investors use the Put-Call Ratio:
- Identify Extremes. Look for a Put-Call Ratio significantly above or below 1. High numbers (above 1.5) suggest bearish sentiment, while very low numbers (below 0.7) suggest bullish sentiment.
- Wait for Confirmation. Investors don’t just jump into the market based solely on this ratio. They use it alongside other indicators to confirm their predictions.
- Don’t Use It in Isolation. The Put-Call Ratio can be a helpful piece of the puzzle, but it’s not a crystal ball. Investors use it as part of a larger toolkit to get a fuller picture of the market.
The Put-Call Ratio offers a peek into investor sentiment. By understanding whether more investors are buying puts or calls, traders can get a sense of market expectations — and sometimes spot when a trend is about to strengthen or reverse.
