Option Pain | Put Call Ratio | Share Market Learning Series | PCR Interpretation | Option Max Pain Theory

Option Pain & PCR

In this post, lets see about Option Pain, Put Call Ratio and how to interpret them w.r.t Price movement.

Option Max Pain:

• Max pain is the strike price where minimum loss is experienced by option writers and maximum loss is suffered by option buyers.
• It is seen that 90%+ options expire out of the money. Since most options buyers lose money in options trading, the price of the underlying stock somehow must be adjusted / manipulated to close in a way that benefits option writers at the time of options expiry.
• The loss incurred by options buyers is also termed as “Options Pain” for our discussion.

Option Max Pain Theory:

• Options Max Pain Theory suggests, “On option expiration day, the underlying stock price often moves toward a point that brings maximum loss to option buyers.”
• We need to calculate the strike the price at which the option buyer loses the maximum amount of money. This is also the point at which option writers will payout the least amount of money.
• Traders can utilize this concept to their advantage. Option writing can be done near expiry based on this theory, provided other technical indicators also favor the trade.
• No trade should be taken without extensive study (of technicals or fundamentals of the underlying).
  

Put Call Ratio:

PCR is a ratio to check the mood/strength of the market. It compares put activity and call activity.

PCR Interpretation:

• If the PCR value is above 1, say 1.3:
• then it suggests that there are more Puts being bought compared to Calls.
• This suggests markets have turned extremely bearish, and therefore sort of oversold.
• One can look for reversals and expect the markets to go up.
• Low PCR values such as 0.5 and below:
• indicates that there are more calls being bought compared to puts.
• This suggests markets have turned extremely bullish, and therefore sort of overbought.
• Once can look for reversals and expect the markets to go down.
• All values between 0.5 and 1:
• attributed to regular trading activity and can be ignored.
• Needless to say, this is a generic approach to PCR. What would really make sense is to historically plot the daily PCR values for say 1 or 2 years and identify these extreme values.
• For example for Nifty value such as 1.3 can indicate extreme bearishness, but for say Infy something like 1.2 could be extreme bearishness.
• You may wonder why the PCR is used as a contrarian indicator. General opinion is this – if the traders are bearish/bullish, then most of them have already taken their respective position (hence a high/low PCR) and therefore there aren’t many other players who can come in and drive the positions in the desired direction. Hence the position will eventually be squared off which would drive the stock/index in the opposite direction.
• So that’s PCR for you. You may come across many variants of this – some prefer to take the total traded value instead of OI, some even prefer to take the volumes.

PCR w.r.t Price Movement:

4 ways to interpret ‘Nifty Put Call Ratio Live Chart’ and Nifty Spot Correlation:

1. If the PCR (Put Call Ratio) is increasing during correction in the up trending market  –  this is very bullish indication. It means, the Put writers are aggressively writing at dips. Look for retracement percentage of last rise during correction while keeping an eye on this chart.
2. If the PCR is steadily rising during the day along with Nifty spot  –  also considered bullish
3. If PCR is declining while the Nifty spot is near resistance level  –  bearish indication. This implies that bulls are fearful of bears.
4. If PCR declines during correction in the down trending market  –  this is very bearish indication. It means, either call writers are aggressively writing at every rise or Put writers are closing there positions cutting losses

Golden Rule:

• If PCR ratio stays below the previous day closing PCR, then market is likely to be bearish and I look for short trade setups.
• If the PCR ratio stays above the previous day closing PCR then I search for long trade patterns only

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