Predicting returns with the Put-Call Ratio

Abstract

Over 22 billion derivative contracts were traded on different stock exchanges globally during the year 2010 of which almost 50% were futures while the remaining 50% were options. An overall 25% increase in such contracts was registered as compared to those traded in the year 2009 (International Options Market Association (IOMA) Report, 2011).Investors often use a wide array of trading tools, market indicators and market trading strategies to get the best possible returns for the money that was invested. The main objective of this paper is to focus on the use of market sentiment indicators, specifically the Put-Call Ratio (PCR) as a predictor of returns for an investor.The Put-Call Ratio is defined as a ratio of the trading volume of put options to call options. It is called a sentiment indicator because it measures the “feelings” of option traders. Additionally, it has longed been viewed as an indicator of investors’ sentiment in the market (Put-Call Ratio, 2012) and is possibly the most favoured description of market psychology (James, 2011).