Once again, the most reliable indicator I know is flashing a sell signal for equities… I’m declaring my prediction — today is the top of the current rally in the stock market.

What’s the indicator you intelligently ask? I went long on a broad stock market index this morning!

All kidding aside, I think the equity markets will continue to rally for about a month (if not longer) and that’s why I put on a trade. I bought some near the money calls on the OEX index that should do well if the rally continues. My reasoning follows…

The OEX is the S&P 100 index, basically the largest of the large cap stocks. It is currently at $636 (or it was when my order was filled), and I bought a November 06 call with a strike price of $645 for $3.60. The current price of the index is 2.0% away from my break even point (the strike + premium) and the option has 30 days to live. I expect the time value to disappear quickly on this one, so I consider the entire premium paid to be at risk.

Why not just buy OEF outright since it’s a nice ETF that tracks the OEX? After all, OEF has tighter bid/ask spreads than the options… The main reason is that I expect this to be a short trade, and because the options are cheaper than a stop-loss. My call premium is 0.5% of the current price of the underlying index. To have an equivalent stop loss, I would need to buy OEF (currently $63.60) and set a stop loss at $63.28 to have the equivalent money at risk. I’m not silly, so I wouldn’t do that — instead I would set a stop loss point further out, thus putting more at risk (and more at risk means smaller position size). Trading OEF would result in a larger risk and a smaller reward.

On to the main point… Why would I want to go long the market right now? The case for the long side is simply that the trend is in place and it is continuing with nary a blip. Ultra-mega-super-large caps like the Dow are plowing higher, and the money flow definately favors the big guys right now. While the Dow is great and all, I like the S&P 100 a little more — it’s more diversified, and a little easier to trade options on.

I’ve been hoping for a moderate dip (2-3 down days in a row) before I entered a long position, but I’ve watched the market go up the last three weeks waiting for just such an event to occur. Sometimes you have to buy at a new high and see if the market will take care of you or not. The worst case scenario is that I bought at the top (I certainly bought at the top of today’s range) and my premium evaporates.

Actually the worst case is that I am both right and lose money — that the market continues up, but doesn’t clear my break-even point. More psychologically frustrating than anything…

The biggest reason for strength in the OEX though is sentiment. There are too many people waiting for the indexes to stumble, who want to pounce and go short. Sentiment is still firmly bearish despite the price increases, and sentiment is a contrarian indicator. A rally can go on for quite a while as sentiment is slowly turning. This is the wall of worry that the rally will/could continue to climb. Slowly, the bears will be turned around and some may even join the long side.

When sentiment is overly bullish, that should mark the top to the rally. I’m not sure if it will be in a week or a month or 3 months, but I like this trade for exposing me to the upside while curtly limiting my downside.