<i>TSC</i> Options Forum: Back to Basics - TheStreet

Steve, can you tell me about the put/call ratio and how it is calculated and how it works?

Thanks, A.J.

I can tell you how it's calculated and how it's

supposed

to work.

The put/call ratio is simply the volume of all puts divided by the volume of all calls that trade on a particular day. While many people still use the Chicago Board of Trade numbers, a more accurate reading (especially since the Chicago Board Options Exchange has been losing market share to the International Securities Exchange) would take the total the volume traded on all five options exchanges. The ratio can be calculated for an individual stock, index or futures underlying contract, or can be aggregated in a variety of ways.

For instance, many people like to look at the equity-only reading. They feel that excluding index options -- in which large transactions and heavy volume can be dominated by institutional traders -- provides a truer sentiment picture. Along the same lines, online brokerage firm OptionsXpress generates both a long and a short put/call reading based on the trades in its customer accounts. "I think this provides a much better measure of retail and individual investor sentiment than the all-exchange," said David Kalt, president of OptionsXpress.

Generally speaking, a reading over 1.0 indicates more bearishness than bullishness, because a high level of put buying indicates a rising level of fear. Typically, traders like to see the put/call hit 1.5 or higher to get an oversold signal. On a big down day, such as a "market crash," it can hit extreme readings of 4 or greater. On the other hand, a reading of 0.50 or below indicates a high level of bullishness.

Another variation uses a dollar-weighted put/call ratio. This uses not only the volume of the various options, but the price. The two are multiplied together, then the sum product for puts is divided by the product of the calls. The dollar-weighted ratio attempts to measure how much money is being allocated to puts relative to calls.

Because a large transaction, especially in an individual issue, can skew any single-day reading, many people like to look at a moving average. Popular time frames are the 10- and 20-day moving averages. This also is a better gauge of general sentiment over an extended period and is more useful for traders with a longer time horizon. Single and intraday put/call readings are generally only of interest to daytraders.

I have a question on open interest in contracts as it pertains to the volume of contracts actually outstanding. More specifically, is there a direct correlation between option liquidity and/or spreads on particular options and the level of open interest? And, does open interest indicate the actual number of contracts that have been purchased/sold, or are there ways by which "actual" open interest can be much larger than what's displayed in each contract?-Phil

Open interest is the total number of options contracts outstanding, but it has no relationship to volume or outstanding shares in the underlying stock.

Open interest reflects all transactions, spreads or otherwise. There's no distinction between a sale and purchase because both are needed to consummate a trade. Unlike stocks, which have a finite number of shares available, option open interest is unlimited. It's also a zero-sum game (also unlike stocks, where the overall value can rise or fall as the share price and market cap changes) in which the dollar amounts net out at expiration -- some people win, some lose. Here's a past article in which I discuss some issues regarding

open interest and what it may or may not be telling you.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.