What It Is:
The Put/Call ratio is a popular sentiment indicator. These types of indicators attempt to gauge the prevailing level of bullishness or bearishness in the market. Typically, sentiment indicators are used as contrarian tools. In other words, when market participants are most bullish, the likelihood of a downside reversal is greatest. And when investors become overly bearish, a market rally may be on the horizon.

How It Works:
There are several Put/Call ratios in use. The one that many investors rely on is based on data collected by the Chicago Board Options Exchange (CBOE). Each day, the CBOE adds together all of the call and put options that are traded on all individual equities, as well as indices like the OEX, or S&P 100. Purchasing a call option, you'll remember, simply amounts to a bet that a particular a stock or index will rise in value. By contrast, a put buyer is anticipating that an underlying stock or index is poised to fall. 

Each day the CBOE calculates the ratio below:

Volume of put option contracts / Volume of call option contracts

On days when the major averages perform strongly, the number of calls bought typically far outweighs the number of puts. On these days, greed prevails and the put/call ratio may be very low -- perhaps in the neighborhood of 0.70. On days of deep market weakness, however, fear prevails and the number of puts purchased is generally far greater than calls -- possibly reaching 1.10. While 1.0 might seem to be a neutral reading, there are more calls than puts bought on an "average" day. As such, a reading of around 0.80 is about "normal" on this indicator. 

The daily put/call line, when plotted on a graph, is very erratic. To make the graph easier to read, most charting packages allow you to plot a moving average to smooth out the raw data. Common moving average periods are 10 and 21 days.

Why It Matters:
The put/call ratio works well in conjunction with overbought/oversold indicators such as the Arms Index and McClellan Oscillator. When you begin to see consistently extreme readings across several different measures, it is a good sign that a market reversal may be on the horizon. Traders should recognize these signals and incorporate them into their trading tool kit. Using the Put/Call ratio as a contrary tool can help you avoid getting swept up in the prevailing sentiment, which often leads to buying when the market is high and selling when it is low.

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