Implied volatility usually shoots up prior to the outcome of a key event, such as an election result. Investors use options to bet on the direction of volatility. As liquidity in options increases, the put-call ratio starts indicating prevalent market sentiment. PCR, alias put-call ratio, is the ratio of trading volume of put options to call options. A higher PCR, with put volumes being higher, signals bearish sentiment. An increase in call options can be an indicator of a buildup in bullish sentiment.
In 2008, the volume-based put-call ratio for Nifty options had fallen from over 1.5 in early January to under 0.7 by mid-week. However, the markets turned in the deep correction mode only by mid-January ? when greed ruled high as captured by relatively low PCR. More recently, PCR has negative correlation with Nifty.
Markets in the shorter term are driven more by emotions than fundamentals. Times of greed and fear are reflected by low or high PCR. For Indian markets, we can peg the optimal level at 1.2 to 1.4. Because puts are used more for hedging than speculation, only PCR above or below this level may be construed as an effective indicator of an overbought or oversold market.
?Arup Misra is an analyst at Elara Capital