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Heads, Shoulders and QQQs

06/15/01 03:41:09 PM
by David Penn

Everyone's been talking about the head and shoulders pattern at the top of the April rally. But if everyone's waiting for the same breakout, will it still take place?

Security:   QQQ
Position:   N/A

I don't for a minute think that I am the first person to point out the intermediate head and shoulders pattern that has formed--to greater and lesser degrees--at the top of the April rally in the QQQs, SPYs and DIAs. While this H&S looks more like an H&S on some charts (the QQQs) than on others (the DIAs), the tell-tale evidence of a failed rally abounds in the averages. "Failed" is probably too strong a word. The April rally was a tremendous one for those fortunate enough to get long early. For example, from the early April low of 34, the QQQs rallied 50% to 51 by mid-May. In a market as gloomy as this one, a 50% advance (15% from the mid-April, big volume gap up advance) is all the more notable.

But, in the sense that all rallies "fail" eventually, H&S tops can be instructive ways of determining when a rally has spent itself. While the H&S top in the QQQs is really not a major pattern (in addition to not being perfectly formed, the pattern is at the top of a rally, but not at the upper reaches of recent prices), it can still help provide a picture of a market that currently has more reasons to go down than up.

Figure 1: This intermediate H&S top suggests a successful retest of the April lows.
Graphic provided by: MetaStock.
A head and shoulders pattern simply represents a series of attempts to bid prices up. It is no surprise, then, to see H&S patterns begin with a big volume, advancing day. Unfortunately, if in fact a top is being reached, even this significant advance will run into resistance and will retreat. In the case of the QQQs, there are two, "right side" rallies and corrections before the big, mid-May push above 50. But this rally also stalled, here reaching about 51 before selling pressure drove prices once again downward. The lack of buying enthusiasm during the last attempt to rally is indicated as much by the declining volume (seen both in the volume bars as well as in the on-balance volume indicator) as by the increasing number of bearish candlesticks during the final rally. This suggests that selling into strength--often the preferred approach of experienced traders--is taking place, and that a lack of confidence in the sustainability of the rally might also be sinking in.

The downside breakout from the QQQ's H&S top is also worth noting. Writing on Friday, the QQQs have declined for most of the day. The day before, prices fell below the neckline of the H&S formation and, in doing so, managed to fill the gap made when prices jumped up in mid-April. Whether there is much merit to the old saw that gaps are always filled is subject to debate. But between the fact that the first gap has already been filled and the fact that the downside price objective from the H&S pattern is approximately 37, there is the opportunity for both gaps to be filled on the downside.

Should the QQQ break out from their present formation on the downside, the Nasdaq might end up testing its two-year low of 34, set at the beginning of April. While further losses in the QQQs are not good news in the short-term for many who own stocks like Microsoft, Intel and Cisco, it is worth remembering that the Great April Advance began after the QQQs had fallen more than 52% off its January high of 69. If the QQQs are destined to churn for the time being, backing and filling, taking advantage of temporary overbought and oversold conditions between support and resistance zones (i.e. between a two-year low and the neckline of a H&S top) might be among the better ways to spend the season.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine,, and Advantage.

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