April 17, 2011
Should You Use the PC Ratio?
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, the data used to calculate the put call ratio is widely available to all investors with access to the internet.
The third advantage of using the ratio is that almost every major charting package delivers the ability for market technicians to create and study historical trends.
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.
Here are the main disadvantages of using the put call ratio.
The primary point against using the put call ratio is also one of the strengths outlined above — it’s simplicity. Because the ratio is a simple calculation, it doesn’t always describe important nuances of market sentiment.
Secondly, the ratio is mostly commonly calculated using options volume. This approach treats all options as equal value, whereas, in reality, they are priced differently.
The third con of using the put call ratio is that it must be used alongside other indicators of market psychology to be of value.
A fourth negative point is that not all stock issues have options available. It’s, therefore, impossible to calculate a Put Call Ratio for many stocks.
The fifth con is that the options must have enough volume to reveal meaningful trends in investor sentiment.
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.
Take your time to study investor sentiment before determining if it is a good fit for you. Also, study other contrarian indicators and sentiment indicators.
Filed under Money by
