A leading indicator of the sentiments is the call-put ratio. This indicator is calculated by dividing the volume of call options by the volume of put options.
A call option gives the holder a right to buy. If the number of call options are more than the number of put options, it indicates that more people are interested to own the stock. In other words, a call-put ratio of more than one indicates a bullish sentiment. The higher the ratio, more is the bullishness. A call-put ratio below 1 indicates a bearish sentiment. A call-put ratio of one indicates a neutral view prevalent in the market.
While the call-put ratio indicates sentiment, a look at the trend over a period of time can also be a good indicator. Even though the call-put ratios are greater than one over a period of time, it may not really indicate bullishness if it is falling over a period of time. Conversely, call-put ratios even if it is always less than one need not indicate bearishness if it is a rising trend. Other words call/put ratio is a market sentiment indicator not a trend confirmation indicator.
To calculate the Put/Call ratio, divide the volume of put option contracts by the volume of call option contracts. Chicago Board Options Exchange (CBOE) calculates this ratio.
To smooth out the rapid changes in this ratio, a 10-day moving average is often used.
When the market is very bullish, the volume of call options will be much larger than the volume of put options because traders are optimistic about future price movements. The Put/Call Ratio may be around 0.6. Because bullishness has reached an extreme level, many traders anticipate a downtrend at this level.
When the Put/Call Ratio is around 0.8, the market attitude is considered neutral. Naturally there is a tendency for more calls to be sold than puts.
The volume of call options will be smaller than the volume of put options, when the market is very bearish because traders are pessimistic about future price movements. At this time the Put/Call Ratio may be around 1.1. When the Put/Call Ratio rises above 1.0, many traders anticipate a new uptrend because bearishness has reached an extreme level.
The Put/Call ratio gives an indication of the level or bullishness or bearishness in the market because a put/call ratio indicator is considered a sentiment indicator. Because it indicates a possible reversal of trend, a sentiment indicator is interpreted in a contrarian sense. It warns of a downturn in the market when there is extreme bullishness. It is also interpreted as a precursor to an upturn in the market when there is extreme bearishness.
The McClellan Oscillator or the Arms Index can be used as further confirmation of an indicated trend reversal in conjunction with Call/Put ratio.
Naked options trading is very risky - many people lose money trading them. It is recommended contacting your broker or investment professional to find out about trading risk and margin requirements before getting involved into trading uncovered options.