All too often, traders freak out when others do.
They sell because every one else does, never once questioning what it is they’re doing.
But what if you could harness the power of excessive fear, and know when to buy?
We already know that following the herd blindly can have major consequences and potential losses, especially given that it has become very easy for one trader to influence other traders. As an individual investor, though, you have a choice.
Either you can get caught up in the wave of herd thinking, or you can break free of it and act against the irrational thinking patterns of the herd.
We’ve already spoken about how to do that with technical pivot points, such as with Bollinger Bands, moving average convergence divergence, money flow, directional movement, Williams’ %R, and even with the use of candlesticks.
Now what if we could pinpoint the exact point where the herd begins to get too crazed?
Let’s use Royal Caribbean (RCL) as an example.
In February 2016, the stock was slaughtered. It became oversold at double bottom support. MACD, RSI and Money Flow were all screaming, “Buy me.”
Yet, traders were still betting on further downside in the options pits. Traders were fearful of another drop. But they got so fearful it became our buy indicator based on the put-call ratio.
Once RCL plummeted as it did, there was a very high PCR of five, telling us that for every one call-option, there were four put options. It served as a contrarian indicator. Shortly after, the stock would bounce back in a big way.
Simply put, a put-call ratio simply tells us the ratio of puts to calls in a particular option, or the number of put option contracts divided by call options on a particular option. It’s used to gauge sentiment and activity in options markets. And they’re quite popular.
If puts far outweigh calls – five to one for example – traders may be attracted to what’s happening behind the scenes. Is there reason to be bearish? Or is herd mentality so out of hand, indicating a potential buy based on what may be an irrational herd reaction?
When a stock's PCR climbs above one, it indicates a stock is may be becoming oversold and reversal is nearing. When the PCR hits two or three, panic is climbing to unsustainable levels.
Well above four, it may begin to indicate fear is so great that a turnaround is inevitable.
However, put-call ratios should not be used as standalone indicators, just as with others.