The Market Could Hit the Wall This Week

After hitting a low of 1,074.77 on October 4, the S&P reached a high at 1,292.66 a few weeks later. This was the first leg of a rally that is still going on. It measured 217.89 points and is highlighted by the first two dashed lines in the chart below.

If you add the 217.89 points to the low that was made the day after Thanksgiving at 1,158.66, you get a projected target for the second leg of the rally at 1,376.55, where the arrow is pointing at the extreme right side of the chart. This is just 11 points above Friday's close.

Traders have often observed that the first leg of a rally or decline is the same length as the second leg. So there is concern that the party may be over for a while if the S&P encounters the upper border of its channel at 1,376.55 on Wednesday.

There are other reasons for traders to be worried. An important source of concern is the ratio between put and call stock options traded on the Chicago Board Options Exchange.

A stock option is a contract between a buyer and seller that conveys the right, but not the obligation, to trade stock at an agreed upon price, regardless of its current value. A put option gives the buyer the right to sell 100 shares of stock at a defined price. A call option gives the buyer the right to buy 100 shares at a defined price.

A lot can be learned about trader expectations from the number and variety of options being traded. When traders are bullish, the ratio of puts to calls drops sharply. Bullish traders want the right to buy stock at current prices even if prices move higher. When traders worry that the market is about to fall, they buy more puts than calls, and the ratio moves higher.

The chart below reflects the difference between puts and calls. When the brown line rises, it shows that traders are worried, and when it drops, it shows that they anticipate a market rally. However, it is significant when the line reverses after reaching an extreme. Now it is hitting a low and is about to reverse to the upside.

I've drawn vertical lines to show where the S&P was trading when the indicator hit previous lows. It appears that the lows correspond to market highs, and there is a good chance that such a reversal is about to occur. The possibility of a reversal now has extra significance to me, because the S&P is about to reach the target of its second leg at 1,376.55. (Click here to learn more about this.)

Here's a closeup of the previous chart. The indicator is still falling, but at a slower rate. The next time the put/call ratio increases -- because traders start trading more puts or fewer calls -- the indicator will move higher and give a sell signal.

Not every reversal is followed by a market decline. I've circled one instance where the opposite occurred. Last March, the indicator dropped simultaneously with the S&P, but note that the indicator did not reverse. So let's look only at those times when the indicator hits a new low, as it has now.

— Fred Goodman, a registered investment advisor and Certified Financial Planner, publishes MarketMonograph, a daily, Web-based subscription service specializing in technical stock market analysis and the application of economic indicators to market timing. You can reach him at fred@marketmonograph.com.