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The market might be 'topping out'

Red flag
Red flag

(Soman/Wikipedia Commons)

The way two groups of investors on Wall Street are trading options suggests that stocks may be leveling off.

Early on Thursday, the Dow threatened to end nine straight days of gains and seven consecutive sessions of hitting new highs.

According to Randy Frederick, managing director of active trading and derivatives at Charles Schwab, the behavior of institutional investors and retail traders in the options market may be foretelling a flattening of the recent trend.

Retail traders tend to use equity options to chase the market's direction for profit, often with a delay. So equity call options tend to rise after big market gains because traders are reacting to an up market.

Late last week, Frederick started to see equity options activity showing a fairly bullish bias a few weeks into the current uptrend.

"We see equity traders just now starting to take on bullish perspective," Frederick told Business Insider, "meaning they've become comfortable with the up trend that we're in now."

"Especially on the retail side, it can oftentimes be a little bit of a contrarian [indicator] if the equity traders get a little bit too complacent. That could be a sign that we may be topping out just a little bit."

The red flag goes even higher when the institutional investors start hedging against a downturn while retail traders keep chasing the market's direction.

"I don't think we're quite there yet, but it does seem like we're starting to get to that point, and that's one of the number of reasons why I feel like the markets are probably leveling off here," Frederick said.

That's not to say Frederick is arguing that stocks are certainly headed lower, or that the current bull run in stocks is about to end.

Meanwhile, institutional investors — like large mutual funds and hedge funds — are not making big upward or downward bets on stocks with S&P 500 index options, which they primarily use to hedge large portfolios against sharp moves.

This has kept the Chicago Board Options Exchange Volatility Index quite low. This gauge of implied volatility, which reflects SPX options activity, is currently near its lowest level in two years.

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