One of the Most Powerful Momentum Indicators

Harness the power of herd mentality, and you set yourself apart.

Easier said than done, though.  Right? 

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?

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Let’s use Manpower (MAN) as an example.  In June 2016, the UK voted to exit the European Union.  Stocks, such as MAN plummeted because a good deal of its revenue is derived from the UK.  The stock would fall from $77.50 to $57.50 in days on fear.

You’ll first notice that relative strength; MACD and money flow all confirmed an oversold situation on the chart.  But there was a fourth indicator that told us the herd was overreacting.

The Put-Call Ratio (PCR)

Once MAN plummeted as it did, there was a very high PCR of four, 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.

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