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Put Call ratio: Why it's wrong as an investing tool.

Missed AB

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Traditional thought is that the put to call ratio can be used to find tops and bottoms in a market cycle. It is an market contrarian indicator. However through deeper understanding, it is not an accurate tool at all.

The number of puts divided by calls = N.

The problem is call sell to open = bearish call buy to open = bullish
Put sell to open = bullish put buy to open = bearish.

For each put and call there is a bearish and bullish force acting on each.

For every person who is bullish that ABC will reach X dollars/share and buys the option, it is being sold by another person who does not feel it will reach that level. If the individual selling the call option felt that level + premium would be exceeded, then they would not be willing to part with the stock at a lower price.

The same is true for the Put's. An individual who sells the put does so because stock ABC will not fall below level X. If the individual felt ABC would fall below level X, then they would sell the holding outright, hence bullish. The buyer of the Put is doing so because they fell the stock will fall below level X, and is willing to pay a premium to sell that stock at level X.

Put and calls are neither bullish nor bearish alone. There is a bullish person on one side of the trade, and there is a bearish person on the other side of the trade.

By using a put to call ration as a gauge is a fallacy based on an inaccurate understanding of the measured tools.
 
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