PCR: How to use advanced market mood indicator?
The put-call ratio (PCR) is considered one of the best indicators to determine the market sentiment. It is also the best indicator to find out the swing highs & lows. It is an advanced derivative market mood or a sentiment indicator that gives clues well before other indicators. It provides clues to traders about the market tops before it turns.
How to find out PCR?
PCR measures the ratio of the put open interest on a given day to the call option open interest on the same day. In simple terms, it is the total open interest of puts divided by the total open interest of the calls. This is called open interest-based PCR. It is also calculated by trading volumes of the put divided by calls. However, generally, prefer to follow OI-based PCR because volume-based PCR indicates the past but not the future. Open interest means open positions in the market, which is valid to find out the traders' bias. For example, the current month i.e. May series total put OI stands at 4,18,236 (as of May 10), and the total call OI is at 2,60,830. This means that the PCR is 4,18,236/2,60,830 = 1.63
What does it mean?
We can find out this value for any series of the given index or the stock. What is this value indicating to us? We know many indicators, such as RSI overbought and oversold levels. Like that, PCR also has similar overbought/oversold conditions with more relevant implications. Generally, in a matured derivatives market, if the PCR value is above 1.3 /1.4, it means that overbought or swings high is in place. In the recent past, several times, Nifty PCR crossed over 1.5. Recently, on December 17, Nifty PCR was recorded at 1.92. Soon after this, Nifty fell by 444 points on December 21. Though they are in an overbought condition, no other indicator is given an early signal to sell or exit the existing position. Even on February 8, the PCR was at 1.71 when Nifty is trading at 15,126 levels. Because of this high PCR, Nifty declined to 14,521 by February 22. Similarly, we can find the bottoms using PCR. Whenever PCR reaches below 0.7 or 0.8, it’s a sign that the bottom has been made. We can see the same on January 27, February 22, and March 18 & 25 when Nifty PCR was below 0.8, followed by Nifty bounce.
The clue
As we are awarea about the historical high and low levels of PCR and its implications. With the latest history, a PCR value between 1.7 and 1.9 means that the market is at strong resistance or a swing high or in an extreme overbought condition. If the PCR value is 0.6 to 0.8, the market is at a strong support level or at a swing-low or oversold condition. In any case, the PCR value is at 0.80 to 1.2; it is a neutral zone with positive bias.
The strategy
When PCR is above 1.7 zone, apply bearish vertical spreads such as bear call/put spreads. When it is in the neutral zone, apply short straddles and strangles or even short guts. At the same time, if the PCR is below 0.8, apply bullish spreads and buy naked calls with optimal stop-loss.