[Options ABC] How to spot investment opportunities by using the Put-Call Ratio (PCR)?

Hello everyone and welcome back to moomoo. I'm options explorer. In today's [Options ABC], we'll be taking a look at an important ratio when trading options: PCR.

Be it stock trading or option trading, the trading actions of other investors may indicate some potential signals of the market. Then, what indicators can effectively reflect the market's trading behavior? Today, we will introduce three valuable metrics: the trading volume PCR, open interest PCR, and trading value PCR.

Typically, a PCR greater than 0.7 or above 1 suggests that traders buy more put options than call options, indicating a bearish market sentiment. Conversely, a PCR less than 0.7, means that put options are less than call options, signaling a bullish market sentiment.

It's important to note that since PCR is a ratio, changes in put and call options have asymmetrical impacts on the PCR value. For example, if put options' volume doubles, the PCR value will increase by a factor of two; if call options' volume doubles, the PCR value only decreases by half.

First, a quick primer on “open interest” before we dive into open interest PCR. Open interest represents the number of options contracts that have not been settled – in other words, the number of contracts still held by investors.

When the market is doing well, sellers are more inclined to sell put options, increasing the number of puts and, consequently, the PCR. In a falling market, traders may shy away from selling puts and lean towards selling call options, increasing the calls and decreasing the PCR.

Moreover, Open Interest PCR can help indicate potential market turning points and confirm market trends. Extreme levels of PCR may indicate potential market reversals. If the PCR aligns with the market trend, it may suggest a healthy trend. Conversely, a PCR that contradicts the trend might signal a divergence, warranting further analysis. Remember, these forecasts should not be based solely on open interest status but combined with other indicators for a comprehensive analysis.

Trading Volume PCR refers to the ratio of put option volume to call option volume traded within a specific timeframe.

Generally, a higher Trading Volume PCR indicates a bearish sentiment, while a lower one suggests bullishness. However, it's not all that straightforward. A higher Trading Volume PCR means a higher proportion of put option trades. But remember, each put option trade can either be an investor buying (bearish outlook) or selling (not bearish) the option – these are opposite sentiments.

In this context, knowing whether buyers or sellers are more dominant in the market becomes crucial. In a market where most investors are buyers, a higher Trading Volume PCR implies pessimism. Conversely, in a seller-dominated market, a higher PCR suggests optimism.

Trading Value PCR is the ratio of the trading value of put options to that of call options within a certain time frame.

Typically, ATM options and slightly OTM options have the highest trading values. These are favored for hedging and speculative purposes. Extreme speculators, seeking to maximize gains with minimal investment, often prefer deep out-of-the-money options. Therefore, trading value is considered to better reflect the sentiment of major players than trading volume.

Furthermore, Trading Value PCR can help assess market liquidity. Generally, a higher Trading Value PCR indicates greater market sentiment fluctuation and potential for larger price volatility, whereas a lower PCR suggests a calmer market.

You might wonder, what's the difference between Trading Volume PCR and Open Interest PCR? The two PCRs have different characteristics.

With high time sensitivity, the ratio may show exceptionally high values in certain cases.

Trading Volume PCR may be appropriate for short-term trading and market trend forecasting. This indicator reflects the number of options traded within a specific period, showing market sentiment in a timely manner. However, it can be volatile and show abnormally high values when the volume of call options traded in a period is deficient.

With high stability, the ratio is less reflective of short-term sentiment fluctuations.

Open Interest PCR may be appropriate for analyzing long-term trends and large-scale investor behavior. It is calculated based on the total open interest at each point in time and is thus very stable, with little short-term fluctuation. It captures long-term trends well but is less effective at reflecting short-term sentiment shifts and style changes.

However, it's important to use both Trading Volume PCR and Open Interest PCR cautiously. They should not be the sole basis for investment decisions. Instead, they should be combined with other technical and fundamental analysis indicators for a comprehensive market understanding.

That wraps up today's Options ABC. If you have other ideas or thoughts, feel free to leave a comment and discuss.