This Indicator Works Best at Extremes… and the trend is not so favorable!

In the past two days (Wed/Thu), the market was trying to make new highs and it did so big time during the day but failed to keep the gain by closing as it nearly gave up all the gain at the end of the day. Today was another losing day although it was trying to recover the initial loss during the day as well but failed at the end.  This sort of price action is quite bearish by itself and bearish negative divergence is seen for all the timeframes!  VIX calls now are 10+ times more expensive than puts for the next two weeks and 20+ times so for the later this month. What does it mean? Well the VIX traders are telling us they expect a significantly higher volatility in the next few weeks, which is usually associated with bearish price actions for stocks. In other words, be prepared for a potential plunge of the market that may happen any moment now. The market is really in kind of insanity with blinded bullishness without any fear. This is the exact moment that one should be very fearful. I'm adding more and more bearish trades now.

As I said before, I'm getting a lot of market information everyday, feeded by various sources of mine. As you may have already noticed, I've been trying to share some interesting and important up to date market information here that may help interested friends for their investing and/or trading decisions. Here is one I got today about one unique indicator most likely not familiar to most folks out there. I think it may be telegraphing something to those who are willing to listen to😎 

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Tracking the size of the options market gives great insight into the level of enthusiasm for a trend and whether it's at risk.

But first a note of caution… there is no single indicator that predicts all market moves.

But at extreme levels, options indicators are predictive.

So, let's take a look at American International Group (AIG), the top performer in the top performing sector during this recent "melt-up" phase as Jeff Clark called it earlier this week…

First, I'm going to go over a couple of terms…

The first one is open interest, which represents the total number of option contracts that are open. For every call or put option bought, an option contract is sold until those contracts are closed. Net open interest, which I'm using, is the difference between all the calls and all the puts.

Now, in the chart below, AIG's net open interest (black line) is overlaid on the price action of AIG (green line) leading into the pandemic and up to the end of this August…

When this indicator is positive, it tells you how many more calls are out there vs. puts – a signal that the options market is bullish. And when it's negative, it means there are more put contracts out there.

I marked four areas on the chart – A,B,C, and D – to show where this indicator diverges from the trend and when it supports it…

But then the indicator found a bottom and diverged the other way in the section marked B.The A indicator marked the exact peak of AIG right before the reality of the pandemic sunk into financial markets. You can see how the indicator started to drop sharply, yet AIG continued to rise. The rest is history… as AIG, along with everything else – collapsed.

Although there are nuances with this indicator, it did signal major weakness for this stock all the way into October – a stretch where pretty much everything else was rising in the market.

But the entire trend that started in October 2020 – marked C – all the way to August 2021 was supported by a corresponding trend in rising net open interest.

But right now, we're at D, which marks a big divergence for the top performing stock in the top performing sector. This kind of divergence is called the "alligator jaws" pattern, where two opposing forces are creating a lot of pent-up energy.

And like previous instances at extreme points in the market, it signals that the trend may not be your friend at this point.

So, with the S&P 500 above 4500, I recommend treading lightly and being very nimble.

Investors need to be picky here and play the risk management game more than just buying what looks good.

Also, keep an eye on financials. A breakdown in market leadership as we enter a seasonally weak period would likely mean we're not bouncing from the 50-day MA for an eighth time.

Eric Shamilov