A Guide to The Put-Call Ratio Indicator as Used in Crypto Trading

Handy Tips / 29.04.2021

Making a trade, especially in stocks bourse and in cryptos, may come across various specialized trade terminologies. The put-call ratio indicator is one such terminology that’s relatively common in trading circles.

Investors use it to weigh the market’s mood, which in turn determines if an investor is going to buy or sell his/her digital assets. It may also use it to forecast the market direction when deeply assessed. The article shall bring to light what the put-call ratio indicator stands for and the various ways during crypto trading.

What is the Put/Call ratio?

The put-call ratio contains two trading options within it. These are the put option and the call option.

Put Option

A put option refers to one’s right to sell crypto at a certain price level in a simplified explanation. To elaborate further, the put option Is a trade contract where one has the right to but isn’t mandated to sell certain crypto security within a stated time frame and price level.

A strike price refers to the set price level at which the trader with the put option has the right to sell the crypto.

Call Option

On the other hand, a call option is the opposite, implying the right to buy crypto at a certain price level. The trader has the right but not the obligation to buy a certain crypto asset in a given time frame and at the set price level.

The strike price here refers to the trader’s set price level with the call option having selling rights for the crypto.

Interaction Between the Two Options 

The interaction between the two options is what is referred to as a pull-call ratio indicator. What traders buy of the two options reflects the general market mood.

For instance, if traders buy far more puts than calls, it reflects the fact that they are unwilling to commit to buying more crypto assets and would rather commit to selling. This is usually a reaction to the general price movements not providing incentives to invest further, hence a bearish market sentiment.

Groupings of the Put-Call Ratio Figures 

To begin with, the put-call ratio is arrived at by dividing the number of put options by those of call options. The resultant ratio coefficient is what determines the actual market mood. The coefficient, therefore, has a scale that is accepted as reflective of specific market sentiment.

A Ratio Greater Than 0.7 

This is known as the rising put-call ratio. A ratio above 0.7 implies that the market’s traders are buying more puts than calls, hence a bearish market.

Ideally, it should be a put-call ratio indicator of above 1, but this is not realistic in the trade market of cryptos. The average market has a usual setting of more investors buying calls than buying puts as the market is always adding new buyers. 

Sticking the ratio to 1 would therefore underestimate the level of bearish sentiment. So the ratio could be better stated as a put-call ratio greater than 0.7 or exceeding 1.

A Ratio Lower Than 0.7

A put-call ratio that is lower than 0.7, on the other hand, implies a bullish market sentiment. It is also referred to as a falling put-call ratio and reflects that traders are buying more calls than puts.

Thanks to the normal market condition of more traders who are willing to buy calls than puts, starting analysis from a ratio of one would overemphasize the level of bullish sentiment. The best definition for the ratio is a put-call that is lower than 0.7 and approaching 0.5.

Exceptions to the Two Groupings 

While the ratio does help investors determine the general market sentiment, there are, however, some key exceptions. Changes in either the numerator alone representing puts or the denominator alone representing calls may give a different sentiment to the ratio.

For instance, the puts number is represented by the numerator coefficient. If the number of put trade being bought reduces, the ratio will change and swing more towards a bullish sentiment. This may not be the case. 

The number of call trades being bought hasn’t increased to mark a bullish sentiment. Bullish traders will be less than their bearish counterparts as they are probably holding out on trade temporarily. Issues like an ongoing security breach being solved or an important crypto stakeholders meeting may cause the hold-up. 

The reverse where call trades being bought reduce, resulting in a ratio indicator change without put trades increasing, also applies.

Making Market Predictions

Once the ratio has been established, the put-call ratio is quite a good tool for making market predictions. The individual coefficient numbers must, however, be analyzed so as not to give a non-reflective sentiment. it can make predictions in the following instances;

Moderate Put-Call Ratio Indicator

When the Put-Call ratio has a relatively moderate indicator number, it can be predicted to stay as-is for the short term. A moderate figure is not too far from the 0.7 barriers. If the ratio ranges just above 0.7 to around 1.1, the market can be predicted to stay bearish for the short term. 

However, if it is hovering not too far below the 0.7 marks, the market can be expected to stay bullish in the short term.

Extreme Put-Call Ratio Indicator

The ratio may, however, be too high or too low, beyond the range stated above. That is when it becomes a good indicator for contrarian trading. Such trade strategies work for investors who tend to move against the crowd.

A ratio on the high extremes implies the markets are too bearish. This means a market turnaround is due and is thus a bullish sign under contrarian trading. When the ratio is on the lower extremes, the market is overly bullish. A contrarian strategy views a pullback in prices as imminent, making it a bearish sign.

Conclusion 

The put-call ratio is a good trading indicator for those who know how to read through the ratio. This article has highlighted the various ways the ratio may be analyzed, equipping readers with the required tools for making sound market predictions.

The ratios are, however, never fixed in the definition. What is too high or too low now may have been moderate just a year back. Keeping up with market trends is, therefore, key to good put-call ratio analysis.

Traders and investors are also advised to view this ratio in tandem with other market analysis tools, a good one being the Moving Average Convergence Divergence.

Adam is an outgoing young lad who likes adventures and discovering new things. Despite his boring life, he loves writing about cryptocurrencies and exploring what blockchain technology can do for the coming digital world where all adventures will be virtual.