Follow the Options!

I have been watching Citigroup (C Quote) and trading it on the short side. The stock is way up from the $35 level, where it opened on the morning of Sept. 21. Two days ago it touched $48.35, a big run with no correction to speak of.

The stock is back up to the neckline of a head-and-shoulder top that formed between April and August of this year. This should present the stock with a formidable barrier.

Here's something even more ominous: I checked the option pricing for Citigroup yesterday and found the call options for the stock very underpriced. For example, the November 50 call -- theoretically priced at 0.70 -- finished the day bid only 0.40. This out-of-line pricing suggests that the "smart money" expects the stocks to be under pressure. In my experience, the options lead the stock. I shorted Citigroup calls as well as stock.

Another stock whose calls are also underpriced is Krispy Kreme (KKD Quote). The stock also put in a well-defined negative one-day reversal two days ago. I shorted calls on the stock.

From the macro perspective, I think the market is due for a pullback. When the market was bottoming on Sept. 21, it was thought that a reasonable target range for a rally might be 1090 to 1100 on the S&P 500, which was the last bottom of significance. (A prior support area turns into resistance when approached from below.) Last Wednesday, the high for the S&P 500 was 1107; the target range was hit, perhaps even slightly exceeded.

Heavy sellers appeared at that level, which resulted in a sharp retreat by the close. After a two-day decline, the S&P got back as high as 1098 on Tuesday morning and then sold off.

My feeling is that this failure reinforced the negative message of the prior week's reversal. The put/call ratio on Tuesday's failed attempt also revealed a lot of optimism, as the CBOE equity ratio spent much of the day below 0.35. This is the most call-buying in several months, and must be rated as a negative.

Further support for a pullback here comes from a five-day TRIN reading for the Nasdaq, which is below 4.00, well into overbought territory. Many sessions of late have also produced high plus "tick" readings, another condition associated with overbought markets. The VIX also has descended below 33, the low end of its recent range, reflecting less fear and suggesting market vulnerability.

Even as I present this evidence for a pullback, it also should be noted that the steady diet of frightening news can have resulted only in a strengthening of the underpinnings of the market as countless people have been shaken out. This means the market is in proverbial "strong hands." This condition should temper any decline from here, and I think that any approach to the Sept. 21 lows is a remote possibility. We may see a 50% retracement, but that's it.