How to Forecast Changes in Investor Psychology

It is often believed that the financial markets are influenced by investor psychology. You are able to regularly hear market commentators refer to the mood and sentiment as being the main motive influencing the market. Many technical analysts, therefore, analyze charts and indicators in an attempt to foresee approaching turns in trader sentiment.

One of the more popular barometers utilized to measure trader mood is the Put Call Ratio. The Ratio uses exchange volume of options contracts as a measurement for market sentiment. An options contract gives the owner the right, but not the obligation, to purchase or sell a specific quantity of shares at a specified price at a later date.

A trader that is expecting a stock to slide may invest in put contracts (the ability to sell at a future date) while an investor who expects the market to go up may purchase call contracts (the ability to buy at a later date).

The most popular technique for assessing the put call ratio utilizes the trading activity of options contracts. It is determined by dividing the quantity of puts bought and sold by the number of calls traded. For instance, if 8,000 puts were bought and sold during a trading session but merely 2,000 calls, the ratio would be 4.

Although utilizing trading volume to calculate the put call ratio is considered the most popular technique, some traders opt to use the dollar amount exchanged or the level of "open interest" for a stock. Open Interest refers to the total volume of contracts which have not yet been closed or expired. The Open Interest Put Call Ratio divides the total amount of put contracts still open by the overall volume of call contracts. By way of example, if there were 80,000 puts still open and 160,000 call contracts, the Open Interest Put Call Ratio would equal .5.

The put call ratio is usually fairly volatile day-to-day, rendering it challenging to spot general trends. For that reason, many market technicians will look at weekly charts or calculate a moving average to help lessen the fluctuations, thereby exposing longer-term trends and extreme situations.

The put call ratio is frequently used as a contrarian indicator. When the ratio is exceptionally high, i.e. there are a lot investors anticipating a drop in prices, contrarian traders will seek out an opportunity to buy the market. Conversely, if the ratio is lower than average and many traders are betting on higher prices, they'll look into selling the stock.

It ought to be pointed out that the put call ratio is most often analyzed in conjunction with other sentiment indicators and not just as a stand-alone method. Additional sentiment indicators include the Volatility Index (VIX) and the Advance Decline Ratio.

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