Small Caps Topping

11/10/09 09:23:12 AM

by Alan R. Northam

The Russell 2000 Small Capitalization exchange traded fund has gained over 80% this year and now looks to be topping out.

Security: IWM
Position: N/A

Figure 1 is that of the daily chart of the Russell 2000 small-capitalization stock index (iShares ETF stock IWM). IWM started its rally in March of this year and since then has gained approximately 80% in value. Over the last three months, the Russell 2000 small-cap stock index (IWM) has been forming what looks to be a complex head & shoulders pattern made up of a double left shoulder and a double head. Head & shoulders patterns are known as trend ending patterns. However, sometimes head & shoulders patterns develop early in a trend and, when they do, are found to be unreliable. However, after an 80% runup in price, a developing head & shoulders pattern becomes a more reliable indication that the trend is in the process of ending. Further, complex head & shoulders patterns are more rare than normal head & shoulders patterns and as such are considered to be an even more reliable indicator of a trend change. One of the tenets of technical analysis is that the rarer the pattern, the more reliable the pattern. So let's take a look at this head & shoulders pattern.

FIGURE 1: IWM, DAILY. Note the developing complex head & shoulders pattern. This figure also shows the MACD above the price chart and OBV below.

Graphic provided by: AmiBroker.com.

Figure 1 shows that during August, IWM formed a double left shoulder with the second shoulder higher than the first. In addition, a double neckline was formed with the second slightly higher than the first. The double neckline then forms a support zone instead of a single support line as shown. Then in September and October, IWM formed two heads of approximately equal price. Note that at the end of October, IWM came down and touched the neckline just as it did after forming the second left shoulder. One of the identification marks of a true head & shoulders pattern is symmetry, and so far, the development of the current complex head & shoulders pattern shows this symmetry. While not all true head & shoulders patterns have to have symmetry to be real, when a developing head & shoulders pattern does show symmetry, it provides confidence that a true head & shoulders trend ending pattern is being developed.

In Figure 1, I have drawn two horizontal blue dotted lines. These dotted lines are used as construction lines to show the price levels at which the two right shoulders should develop. The first right shoulder should form at the higher of the two lines and the second right shoulder the second if symmetry is to prevail. If symmetry does not,, then we could see these right shoulders develop at different price levels than shown or perhaps only one right shoulder develops. Upon completion of the right shoulder or two right shoulders, IWM needs to penetrate the neckline support zone and make a lower low closing price to complete the double head & shoulders topping pattern, which will then signal the completion of the upward rally and the beginning of a new downward trend.

In support of the analysis that a double head & shoulders trend ending pattern is developing, I have added the moving average convergence/divergence (MACD) and on-balance volume (OBV) indicators. From Figure 1, note that the MACD is now below its zero line. This indicates that the 13-day EMA has crossed to below the 34-day EMA. This can also be seen by the red circle on the price chart. The crossing of these two moving averages signal a reversal in trend. The crossing of these two moving averages therefore confirms that a double head & shoulders trend ending pattern is in work. In addition, the OBV has formed a lower high followed by a lower low, signaling that volume is now in a downtrend. Downtrending volume signals that selling pressure is greater than buying pressure, which should then work to drive price lower. Again, OBV confirms that a double head & shoulders trend ending pattern is working.

In conclusion, all indications signal that a a very reliable double head & shoulders trend ending pattern is at work. Upon completion of the right shoulder and a close below the neckline, the support zone will complete the pattern and signal the reversal of trend from up to down. However, a move higher to form a new higher high will negate the double head & shoulder pattern and signal that the upward trend remains intact. As traders, we are currently stuck in limbo; we don't know if IWM is going to continue higher or move lower. The developing double head & shoulders pattern suggests that the higher probability is for IWM to reverse direction and start a new downtrend, but we must wait for confirmation by a breakdown below the neckline or a new breakout to a higher high to signal the future direction of IWM.

Alan R. Northam

Alan Northam lives in the Dallas, Texas area and as an electronic engineer gave him an analytical mind from which he has developed a thorough knowledge of stock market technical analysis. His abilities to analyze the future direction of the stock market has allowed him to successfully trade of his own portfolio over the last 30 years. Mr. Northam is now retired and trading the stock market full time. You can reach him at inquiry@tradersclassroom.com or by visiting his website at http://www.tradersclassroom.com. You can also follow him on Twitter @TradersClassrm.

	Garland, Tx
Website:	www.tradersclassroom.com
E-mail address:	inquiry@tradersclassroom.com

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HEAD & SHOULDERS

Small Caps Topping

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