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HEAD & SHOULDERS


Head & Shoulder Pattern Reverses The S&P 500

07/02/10 10:06:17 AM
by Alan R. Northam

A head & shoulder pattern has developed and signals a major trend reversal for the S&P 500.

Security:   SPX
Position:   N/A

Head & shoulder patterns are recognized as major trend reversal patterns. H&S topping patterns are formed after a significant market advance and indicate that a major market top has formed and the market or stock is reversing to head lower. H&S bottom patterns, or inverse H&S patterns, are formed after a significant market decline and indicate that a major market bottom has formed and the market or stock is reversing to head higher. H&S tops are recognized as a market peak that is separated by a lower peak on both the left and the right.

Ideally, these two lower peaks are of equal amplitude and equally spaced in time. However, in reality there is usually some lack of symmetry. The peak between the two shoulders is known as the head. Finally, the H&S top is identified by two troughs or valleys between each shoulder and the head, which forms what is known as a neckline. This neckline is horizontal but in reality can slope either to the left or to the right. If an identified H&S pattern is significantly distorted from a symmetrical formation and the neckline slopes severely, then it most likely is not a true H&S pattern. A head & shoulder pattern is completely formed once the market or stock has broken down below the neckline.

From Figure 1, we can easily identify a H&S topping pattern. The head & shoulders top has formed after a significant market advance in which the Standard & Poor's 500 almost doubled in price from March 2009 to April 2010. In addition, the pattern is nearly symmetrical, with both shoulders close to equal peaks and the two shoulders fairly equal in time. In addition, the neckline is horizontal. Finally, we know that the H&S topping pattern is complete, as the S&P 500 has broken down below the neckline. This head & shoulders pattern is a good example of a true H&S pattern.

FIGURE 1: DAILY, S&P 500. Here's a head & shoulders topping pattern and measured price target that also turns out to be an important support shelf.
Graphic provided by: MetaStock.
 
The head & shoulders pattern has two predicting attributes. First of all, it marks a major top and reversal in trend. Second, it predicts a lower price target. The lower price target is measured by taking the distance between the peak of the head and the neckline and projecting this same distance down below the neckline. I have shown these two construction lines in blue and labeled them as VL1 and VL2, for vertical line 1 and vertical line 2.

Vertical line 1 measures the distance between the peak of the head and the neckline. Vertical line 2 is the same length as vertical line 1 and is used to measure an equal distance below the neckline. The end of vertical line 2 is the expected price target for the next move lower. I have shown a green horizontal support line at the lower end of vertical line 2 because it also lines up with a lower low made in July 2009 and two peaks made in January and February 2009 that form a line of support.

The lower end of vertical line 2 does not mean that a market bottom will be formed at this point that also corresponds with the green support line. The end of vertical line 2 is simply a measured price target for the next downward move by the S&P 500. It is certainly possible for this market to extend well below this price target. It is also certainly possible for the market to reverse back upward once price reaches the low of vertical line 2.

Ideally, since H&S patterns are major trend reversal patterns, we should expect a major downward trend to develop. And when we think of major trends, we think of a market that is going to make a new lower low, which means a move well below the green horizontal line. However, in the real world of technical analysis, this may or may not be the case.

To determine whether the market will extend lower or turn back upward at the support line, a detailed Elliott wave analysis can be performed as well as other methods of technical analysis. Further, the developing wave structure as the market continues to move lower will be a sign as to whether the stock market continues lower beyond the horizontal support line or if the market turns back upward to start a new uptrend. For now, the major trend has reversed down until proven otherwise.



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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