I just can't wrap my head around why the put-call ratio makes sense. Whenever there is a put buyer, there is a put seller, same goes for a call buyer/call seller. In other words, if there are a lot of call options for a given stock or index, there is an equivalent number of people who have sold those calls that are being traded. So the number of bulls is the same as the number of bears. For example, let's say there are 10 calls and 20 puts bought for the S&P resulting in a put-call ratio of 2 which should interpreted as bearish sentiment. But, equivalently, there are 10 call sellers (bears) and 20 put sellers (bulls). What am I missing here?
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1$\begingroup$ Many people would agree with you. Ultimately it is an empirical question whether a "traditional indicator" like this works or not. It does not seem to make sense, so your skepticism is warranted. $\endgroup$– nbbo2Commented Sep 4, 2020 at 16:00
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$\begingroup$ I would say you care more about the break down of buyers and sellers - i.e. if the positions are being bought/sold for speculative positions or not. $\endgroup$– willCommented Sep 4, 2020 at 17:33
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$\begingroup$ Assuming the parties on both sides of a transaction each act as if the option they are buying or selling exists in a vacuum will lead you astray. Options may be zero-sum but they don't exist in a vacuum. People's intentions on each side of a transaction may differ significantly making them both part of a larger game that is not zero-sum. Equal volume dosen't mean equal amounts of bullishness and bearishness. $\endgroup$– amdoptCommented Sep 4, 2020 at 18:04
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I think you are missing an important point regarding who initiates options positions.
We know that put options are more expensive than theory would indicate as discussed in Bondarenko (2014). Simply: put option buyers are especially motivated to initiate positions, more so than put sellers. Thus put open interest is a measure of put buyers initiating positions.
We cannot just look at the put option open interest, however; that might be larger or smaller just due to increased trading. Instead, we scale the number of puts by the number of calls. That corrects for fluctuations due to trading activity.
Given that put buyers are more likely to initiate a position than put sellers, the put-call ratio helps us estimate when put buyers have been more motivated as a fraction of the market.
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$\begingroup$ But, there is always a put seller whenever there is a put buyer right? So, I mean, the put call ratio should be moot, have 0 meaning? I feel like it's a bit like checking how many shares of a stock are shorted. Since every share is owned by someone, it doesn't matter, wherever there is a short person, there is a long person. Could you clarify a bit on how the put-call ratio actually can describe bearish vs bullish sentiment as that was the core of my question. Thanks! $\endgroup$– Ludvig WCommented Sep 4, 2020 at 18:19
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$\begingroup$ Do you have any source(s) for "put option buyers are especially motivated to initiate positions, more so than put sellers" that conclusively show this without significant bias? I'd be interested to read if you do. $\endgroup$– amdoptCommented Sep 4, 2020 at 18:20
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$\begingroup$ Yes, every seller is matched with a buyer. However, the whole point of Bondarenko (2014) is that put buyers are more motivated to initiate. Read the article -- and all of the articles it inspired. $\endgroup$– kurtosisCommented Sep 4, 2020 at 20:30