For those not familiar with options, a call is the right, but not the obligation, to purchase a currency in the future at a predetermined price while a put is the right, but not the obligation, to sell a currency in the future at a predetermined price. Investors buy calls when they believe a currency is getting stronger and puts when they believe a currency is getting weaker. They often don’t have the money to buy the underlying contract itself and so an option is their next best alternative to speculate. What is interesting is that options traders are generally wrong, as 70-80% of options expire worthless, and this poor hit rate is welcome news for the contrarian strategist.
To calculate the put/call ratio, one divides the total amount of open interest in puts by the amount of open interest in calls. Ok then, what is open interest? Open interest is the number open put or call contracts on a particular currency. More open interest in puts means the market sentiment is bearish and the majority thinks the currency is going to be weaker in the future. More open interest in calls means the market sentiment is bullish and thinks the currency is going to be stronger in the future.
Let us bring in an example. If there are 40,000 open put options on Euro FX and 20,000 open call options, the put/call ratio is 2. This is indicative of a bearish market as there is more open interest in puts (options to sell) than calls (options to buy). A ratio over 1 is indicative of a bearish market and a ratio under 1 is indicative of a bullish market.
Confirmation Strategy (Ratio = Normal):
One can determine the general trend of the currency pair from using a 50 or 200 period daily moving average; if price is below the moving average it is in a downtrend and if above it is in a uptrend. If the put/call ratio is close to 1, then it can act as a confirmation of the current trend, up or down. Since market sentiment has not reached any extremes, the current trend can move along at a steadier pace. For instance, if you see that the EUR/USD has been moving below the 50-day moving average and thus in a downtrend, and you also see that the put/call of Euro FX is 1, then the market mood is calm enough to plan for a short trade to take advantage of the confirmed downtrend.
Contrarian Strategy (Ratio = Extreme):
Since most option players are usually less capitalized and uninformed, and usually wrong, one can profitably trade the direction opposite of any ratio extreme.
1) Hint of Trend Reversal.
Most commonly the put/call ratio is used in combination with past data to give hints on reversals. For example, if the downtrend market reversed at a ratio of 3 (3 times the number of put options to call options) in the past, many traders expect a bottom at this value in the future. Conversely, when the put/call ratio reaches a low value of 0.5 on an uptrend (2 times the number of calls to puts), the expectation is that the uptrend might falter, giving way to a correction or a reversal.
2) Hint of Trend Continuation.
Less commonly the put/call ratio is used to give strong hints of trend continuation. For example, if the put/call ratio reaches a low value (more calls to puts) in a downtrend market, it is an indication that the uniformed traders are hoping the market bounces from a suspected bottom when instead it is ripe time to keep on selling. Conversely when the put/call ratio reaches a high value in an uptrend, it is an indication that the uninformed traders are hoping that the market falls back from a suspected top when instead it is ripe to keep on buying.
In short, one can decide that a put/call ratio of 2 indicates that the herd sentiment is very bearish and thus one can plan for a long trade in anticipation of a bullish continuation (if uptrend) or bullish correction (if downtrend). Conversely, one can decide that a put/call ratio of 0.5 indicates the herd sentiment is very bullish and thus one can plan for a short trade in anticipation of a bearish continuation (if downtrend) or correction (if uptrend).
Remember: there is no magic number that indicates that the market has created a bottom or top, but traders will look for spikes in the ratio or when the ratio reaches levels beyond the normal range.
The indicator can also be used to gauge your leverage and take profit. You can use more aggressive leverage and larger take profits when the put/call ratio is low and the general trend is falling. This means that the uniformed options traders are anticipating a correction from the low and they will be probably wrong. They are trying to catch the falling knife and they will be cut down. You just need to hop on that knife. The trend is your friend and the herd is mostly wrong. You can also be more aggressive short trader at a suspected market reversal when the ratio has hit an extreme high and the market is also high. The informed options traders will panic at market bottoms, putting in more puts (larger ratio value), or become greedy at market tops, putting in more calls (smaller ratio value). The more extreme or spiky the ratio value the more likely there is bound to be a larger reversal or correction.
Spot forex does not have options, though thankfully its close cousin, the futures currencies, does. The spot and futures prices of a currency (not currency pair) tend to move in tandem. For instance, if the put/call ratio is over 3 on Euro FX options, then it represents that the market sentiment of both Euro FX and EUR/USD is extremely bearish and both markets are ripe for a bullish correction. There are two ways to source out this put/call ratio information.
Go to http://www.cmegroup.com/market-data/volume-open-interest/ to look up the volume and open interest for any given currency futures options. You will see on that page a report entitled Daily Volume and Open Interest Report.
Please note: The Daily Volume and Open Interest Report along with the Bulletin reports released at the end of each trading day (4:15 PM EST) are preliminary reports only. Final reports containing official data are released the following morning.
Each pdf report is a bulky 52 pages packed with volume and open interest stats. You will need to type in “Euro FX Options” in the Find button of your browser or pdf viewer in order to find the specific information related to the currency options. After skipping the European options, you will see a section that looks something like the one below (Jan 6, 2012), though with more currencies listed than what I have selected to copy.
To get the put/call ratio, you have to look at the open interest information on the right side.
put open interest / call open interest.
In the above example, you have 38,424 open puts / 33,270 open calls = 1.154.
A put/call ratio of 1.154 means that the sentiment is now bearish, though so close to 1 as to suggest that one can still use a continuation strategy of the dominant trend, which is down.
Cons of the Report:
- It is time consuming to look up the information
- You have to conduct the put/call ratio calculation yourself
- There is no historical reference of previous days put/call ratios that you can consult to give yourself context.