Ah Ha! Head and Shoulders!
BY MARTIN GOLDBERG, CMT | july 16, 2009
The head-and-shoulders (HAS) reversal is one of the most useful but misunderstood patterns in technical analysis. At this moment in time, following a four day rally (still in progress), it has shown to be both useful and misunderstood at the same time. It is important to remember that one must always be both skeptical and mindful of patterns as they develop. This may seem like an enigmatic statement, so please hear me out. Below is a chart of the S&P 500 as it appeared last weekend.
The important feature at that time was the importance of 880 as a significant technical level, along with the developing HAS pattern. One could have suggested the June 23rd low as a point of the neckline; and if that were the case, the level of 880 would have been a “break” of the neckline. However, as of the close of last week’s trading, the neckline at 880 was cinched. There were four (4) straight closes right on 880 confirming this as the neckline somewhat. In addition, note the blue arrows signifying a high volume day where 880 was confirmed as an important technical level. Finally, since in this case, the proposed HAS was being evaluated as a reversal pattern (from up to down), the more bearish horizontal neckline deserved the benefit of the doubt versus the June 23rd lows which would make the pattern more bullish since the neckline would have been a rising one. (More ideal would have been a plunging neckline which is even more bearish than a horizontal neckline.)
Strategically, Monday’s open at near 880 was perhaps the most risky point to initiate a short position in the S&P 500 index in spite of the fact that a lot of folks were screaming, “Ah-Ha; Head and Shoulders!” A pattern is not a completed pattern until the pattern is completed. A long position near 880 with a stop loss at a close below the June 23rd lows would have been more appropriate. This is because until the pattern was completed (by a decisive close below the proposed neckline, below the June 23rd lows), what we had was simply an oversold market and nothing more ominous than that.
It is also important to note that except for the time of the market crash from about June of ’08 to March of ’09, the S&P had not corrected by more than about 8% in any one wave for many years. This is more evidence that as of last weekend, the market was simply oversold.
While in this case the HAS pattern was not completed, that is not to say that HAS patterns are not meaningful. In today’s markets they are meaningful for establishing oversold markets ready to rally sharply because the rallies off of failed HAS patterns tend to be sharp. In addition, they are also meaningful because when (if) individual issues and markets begin completing their HAS patterns, that will signal a change in market character, and a likely change in the intermediate to long term trend.
As you can see in the chart below within four trading days the S&P 500 index has moved back to near its not-so-old highs around 945, having come pretty far pretty fast. This is the technically important area of the chart. A decisive break over 945 confirms the action from early May to the present as a correction or continuation pattern within a longer term uptrend. It would be wise to be careful because a move just above 945 would get a lot of folks excited about “new highs,” and these folks would be as vulnerable as those who got excited about the “completed” head-and-shoulders pattern. About 950 (with appropriate stops entered) may turn out to be the perfect selling opportunity.
Have a great evening.
Copyright © 2009 All rights reserved.