There’s a thin line between being cautious and being bearish. I crossed that line on Friday.

Regular readers know I’ve been cautious on the stock market for most of July. We came into the month thinking that while there might be a little more upside potential for stocks, the downside risks were growing. So, I suggested traders should consider taking profits on any rally early in the month.

But, I wasn’t willing to bet against the stock market until we got the sort of extremely overbought conditions that typically show up at intermediate-term tops.

We got some of those conditions last week. 

So, as the S&P 500 rallied to a new all-time high heading into the final hour of trading on Friday, as most traders were getting ready to shut down for the weekend, my inner bear came out of hibernation. And, I told my subscribers to buy put options [Delta Direct subscribers can see this trade here].

The trade may or may not work out. We won’t know that until after the fact.

Nothing is ever guaranteed. All we can do as traders – especially when trading from the short side of the market – is to wait patiently until the proverbial rubber band is stretched just about as far as possible in one direction. Then we can bet on the rubber band snapping back.

Conditions got quite stretched to the upside by the end of last week.

The Volatility Index (VIX) traded at its lowest level of the year. The Investors Intelligence sentiment index of newsletter writers (a BIG contrary indicator) shows bullish sentiment is near its highest level in 30 years. And, the CBOE Put/Call ratio (CPC) closed below 0.80 on two consecutive days.

It’s that last condition that really prompted me to buy put options.

You see, the Put/Call ratio is an outstanding short-term contrary indicator for the broad stock market. It compares the action in call options to the action in put options. A reading above 1.20 shows extreme bearishness among speculators and can indicate a good time to buy stocks for the short term. A reading below 0.80 shows extreme bullishness and could indicate a good time to sell. And, for most of the past year, this indicator has been “dead-on” accurate at timing short-term reversals in the stock market.

Here’s the chart…

The CPC closed at 0.73 last Thursday. That’s one of the lowest readings of the past year, and it tells us traders were jumping over themselves to buy call options. Previously, that sort of bullishness has led to solid pullbacks in the market within just a couple of days.

The declines over the past two months were never too severe, though – just enough to shake overly optimistic traders out of their positions before the market started to move higher again. So, while the previous CPC signals had me leaning cautious on the broad stock market, I wasn’t willing to try to trade from the short side.

This time, though, there are enough extreme conditions in place to suggest the market may be primed for a more significant decline. I’m not looking for a massive selloff – at least not yet. But, it wouldn’t surprise me at all if the market gave back most of its gains for the month over the next few days.

Best regards and good trading,

Jeff Clark