If Weakness Hits, It Should Be Soon

08/29/08 9:25 AM EST

Good Friday morning...We begin the day with a modest dip in the pre-market futures.  That might be a bit of a victory for the bulls given that the economic and earnings news since yesterday's close haven't been all that positive, Oil is rebounding, the Dollar is dropping and foreign markets are only modestly positive.

A couple of times lately, we've touched on various aspects of the options markets, either the Equity-only Put/Call Ratio or the behavior of the smallest of options traders.  Yesterday's rally brought another of the indicators to an extreme, this time in the form of the ISE Sentiment Index.

This indicator is really a call/put ratio, so a high reading means that traders were buying a lot of call options relative to put options and is a sign of excessive speculation.  The chart we post to the site wraps Bollinger Bands around the ratio and its moving averages, so we can see if the ratio exceeds two standard deviations from its six-month average.

It did just that yesterday for the first time since July 3rd.  Over the past six years, it has exceeded this band 58 times and over the next three trading days the S&P 500 showed a positive return 43% of the time with an average of -0.2%.  That's not terrible, but it's also not so great considering the bullish market environment in force almost that entire time.

Since last July, there have been 7 such instances and it should be no surprise that the results were more negative.  Three days later, the S&P was up only 1 time and overall it averaged a return of -1.0%, with an average maximum risk (-1.6%) that was twice as great as the average maximum reward (+0.8%) over those three days.

Yesterday we went over a couple of stats related to the price pattern that we've seen, and they were consistently negative over the short-term of two to three days (they were related to multiple up days then a gap up open, and also a large gap up right before an exchange holiday).  The S&P pushed higher after the open yesterday, but was still within the average maximum gain seen after those prior instances.

However, if we're going to see weakness, then it should be very soon - like today and possibly Tuesday as well.  Given the recent pickup in call buying and the excessively overbought nature of our short-term guides, I'm betting that the August high in the S&P (around 1315ish) won't be taken out just yet, and I would rather sell against this 1300 - 1305 area in the index.