Could Oil Prices Intensify a Stock Selloff?

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK (Options Trading Signals) -- Reports this past week showed that the unemployment rate in the U.S. was improving markedly.

In addition, sentiment numbers confirmed my speculation that market participants were becoming more and more bullish as the S&P 500 edged higher. In fact, sentiment hasn't been so bullish since Feb. 11, 2011.

The table below illustrates the most recent sentiment survey.

The current bullishness is interesting considering the notable headwinds that exist in the European sovereign debt markets, the geopolitical risk seen in light sweet crude oil futures, and the potential for a recession in Europe.

Source: the American Association of Individual Investors

To further illustrate the complacency in the S&P 500, see the daily chart of the Volatility Index below.

The VIX has been falling for several weeks and is on the verge of making new lows this week. If the index works down into the 16 to 18 range, a low-risk entry to get long volatility may present itself. For options traders, when the VIX is at current levels or lower there are potentially significant risks associated with increases in volatility.

My expectations have not changed considerably since last week. However, I continue to believe that the bulls will push prices higher in what I believe could be the mother of all bull traps. Let me explain. As shown above, we have strong bullish sentiment among market participants paired with general complacency regarding risk assets.

As I pointed out last week, my expectation is for the S&P 500 to top somewhere between 1292 and 1325. A lot of capital is sitting on the sidelines presently, and if prices continue to work higher I suspect that a move above the 1292 price level will trigger a lot of long entries back into stocks or other risk assets.

We could see prices extend higher while the "smart" money sells into the rally. Retail investors and traders will point to the inverse head-and-shoulders pattern on the daily chart of the S&P 500 and the breakout above the key 1292 price level. The pervasive fear of missing a strong move higher will help fuel long entries from retail investors.