In this article we'll review some of the major advantages and disadvantages of using the put call ratio to help anticipate market turns and trends.
Let's start with the pros.
The principal point favoring the use of the put call ratio is that it allows investors to quantify and plot market sentiment, which many investors consider the primary market catalyst.
A second point in favor is that the options data used to calculate the ratio is easy to find and is available to anyone with an internet connection.
The third supporting point is that, because historical data is rather abundant, the ratio can be charted easily using most major trading platforms or charting packages.
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 wil cause investors to "follow" the herd.
And now, for balance, the cons.
The primary point against using the put call ratio is also one of the strengths outlined above – it's simple. Because the ratio is a simple calculation, it does not always describe important nuances of market sentiment.
The second point in contra is that most people calculate the ratio using options volume, which does not 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.
The third point in contra is that the ratio must be used in conjunction with other indicators and not as a stand-alone signal generator.
A fourth negative point is going to be that not all stock issues have options available. It's, therefore, impossible to calculate a Put Call Ratio for many 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 there you have it, the pros and cons of using the put call ratio to identify market opportunities.
Within a final analysis, is following the put call ratio a good idea or a bad idea?
Like so many market indicators, it's good to follow this ratio but with the caveat that it has its limitations and must be used in conjunction with other indicators.