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Forex Signals: the Put/Call Ratio

  On this page you how important the Put/Call ratio is in your arsenal of Forex signals

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The Put/Call Ratio in Forex Signals

One of the more efficient ways of evaluating the price action in the forex market is using options market data for understanding the spot market. Many traders prefer to trade forex in the options market instead of the spot market to control risk better, and many more trade in both markets in order to diversify their trades and and apply more creative and productive strategies. Using the put/call ratio allows us to combine the knowledge derived from an analysis of the options market with the information distilled from the spot action, and in this article we'll take a look at this subject in greater detail for those of us who trade forex online.

A put option gives the trader the right to sell an underlying currency pair. A call option grants the right to buy the same currency pair. In other words, the equivalent of a sell order in the spot market would be the purchase of a sell option on the same currency pair (albeit with different maturity terms and exercise conditions). The call option is similar to a buy order in the same manner. As such, any extreme positioning in the spot market ought to be reflected in the options market, and vice versa. If we see an extreme amount of sell options being bought in the options market, the implication would be that the market is becoming oversold, and a reaction (and often a violent one) may soon be expected.

The problem is that the raw amount of the put or call standings do not tell us much about which value is high or low. Due to the nature of the forex market, any number that appears high in terms of the past data may be exceeded by the trend if more money enters the market. In order to deal with this problem traders use the put/call ratio to place the numbers in to a context and to derive clearer, better signals.

The put/call ratio is used in combination with past data to give hints on reversals. For example, if the market reversed at a ratio of 3 (where there were 3 times the number of put options, in comparison to call options) many traders expect a bottom to be established at around this value again in the future. Conversely, when the put/call ratio reaches a low value below one where the market reversed in the past from an uptrend, the expectation is that the uptrend will be eliminated, or at least checked on a temporary basis.

Due to the lack of a centralized forex exchange, it is not possible to use volume data for the creation of forex strategies. The put/call ratio is very useful because of its value as a gauge of market sentiment on the basis of the volume information provided by options contracts. We can regard the put/call ratio as the volume-sentiment indicator, and by combining it with other indicators, we can derive signals that complement the value of the other, price-based indicators efficiently.

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