Securities Research Services

Friday, May 18, 2007

Bearish Divergences on Dow

In the options market yesterday, trading on index options was virtually 1-1 puts to calls. In the equities, though, call buyers were buying nearly twice as many calls as puts. Normally we would interpret this as topping action, since options traders are nearly always wrong at market tops. That is, they tend to short dips out of fear on the way up, but then when they start to embrace the trend (near the top) they finally begin to buy calls on the dips.

Because this is options week though, we think there is another explanation for the heavy call activity yesterday. Expiration games, where the market is driven lower on Thursday and cheap call options are snapped up in order to be sold the following day when selling pressure is released.

If we are correct, the market should float higher today in order to give call buyers (which in yesterday’s case likely represent smart money) the opportunity to escape with quick profits.

Yesterday’s trade saw yet again underperformance in the QQQQ and IWM, leaving us to look for a larger correction once the blue chips finally give way. The Dow is extremely extended here and the rule of regression says that we should start looking for a return to the mean, which means a correction back to the 20- or 50-day moving averages it has moved so far above.

Bearish divergences are already showing up on key Dow indicators, so a correction back to the mean could occur any day now.

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