The put-call ratio (PCR) is the number of traded put options divided by the number of call options found in stocks, indexes and ETFs.
For our purposes, when a stock's PCR climbs above one, it indicates a stock is becoming oversold and reversal is nearing. When the PCR hits two or three, panic is climbing to unsustainable levels. But we like to use PCRs well above four, which indicate fear is so great, a turnaround is inevitable.
Here’s how to view it.
About 450 sheep jumped to their death in 2005, as reported by USA Today.
One sheep jumped to its death. Then shepherds watched as 1,500 others followed…
They all jumped off that very cliff to sudden death. The ones that survived were lucky.
They landed on soft pillows.
But in many cases, sheep, or in our cases, traders aren’t so lucky. There are no pillows to stop our fall. If we fall, we’re screwed. Much like a herd of sheep, herds of traders can make poor, irrational decisions. It happens every day.
The guy in the office next to you gets a hot tip. He’s buying because hundreds of other guys got the same tip. Problem is not one of the guys bothers to look into the stock. They run right off the cliff and find no pillows to stop their fall.
Splat! Out of money on a bad trade. It happens every day. It’s called stupidity.
The last thing you want to do is get caught up in herd mentality. Instead, you want to exploit the laughable herd, collect their money, and go home.
The herd has a tendency to make irrational decisions. It always has because it’s full of irrational beings conforming to the ideas of others. But if you can buy when the herd says sell, or sell when the herd says buy you can make more money.
It’s contrarian investing at its finest.
If we can identify where herd mentality may prevail, we can exploit it and make money from others’ irrationality.
If puts far outweigh calls by wide margin traders may be attracted to what’s happening behind the scenes. Is there reason to be bearish? Or is herd mentality prevailing, indicating a potential buy based on what may be an irrational herd reaction?
Look at Manpower (MAN) in June 2016.
At the time, every one was losing their minds over the Brexit vote that turned out to be nothing worth getting upset about in the first place. MAN fell because a great deal of its revenue its tied to the UK. The stock sold off in vicious fashion, crumbling from $$82.50 to less than $57 in days. But it was nothing more than an overreaction.
Part of that overreaction could be seen in options pits too where the PCR was above 3:1. That told us fear was reaching an epic point. Any one that bought that excessive fear did quite well, as the stock bounced back to $101.