Inverse Head & Shoulders?

10/04/10 10:03:54 AM

by Alan R. Northam

What looks like an inverse head & shoulders pattern does not mean it is. Through the analysis of how volume relates to price it is possible to make a distinction between what looks to be an inverse head & shoulders reversal pattern and what is not.

Security: SPY
Position: N/A

The inverse head & shoulders pattern is recognized as a major trend reversal pattern. The inverse head & shoulders is a bottoming pattern and formed after a significant price decline, indicating that a major bottom has formed and price has reversed to the upside. Inverse H&S bottoms are recognized when price makes a final low price separated by higher low price on both the left and the right sides. The final low price is called the head and the higher low price to the left of the head is called the left shoulder and the higher low price on the right is called the right shoulder.

Ideally, the left and right shoulders are equal in price and equally spaced in time. However, in the real world of price movement there is usually some lack in symmetry. The two peaks between each shoulder and the head is known as the neckline. Ideally, this neckline is horizontal but again in the real world, it can slope either to the left or to the right. The formation of the inverse H&S pattern is complete once price breaks out above the neckline, signaling that a major trend reversal had been completed.

FIGURE 1: SPY, DAILY. This chart shows what looks to be an inverse head & shoulder major trend reversal pattern.

Graphic provided by: MetaStock.

Figure 1 shows the daily bar chart of SPY. SPY is an exchange traded fund (ETF) that mimics the Standard & Poor's 500. This chart shows that an inverse head & shoulders pattern has developed from late May to late September 2010. Note that this pattern is nearly symmetrical, with both shoulders close to equal peaks and the neckline is horizontal. The only nonsymmetry about the pattern is the time period between each of the shoulders and the head. Note also that price broke out above the neckline in mid-September, completing the inverse H&S pattern and signaling a reversal in the major trend from down to up. This appears to be a classic inverse head & shoulders pattern, but I don't think so, and here's why:

From the head to the price peak between the head and the right shoulder, I see a rally with overlapping waves. From the Elliott wave theory, a rally with overlapping waves is corrective and not impulsive. An impulse wave forms in the direction of the next larger trend and is made up of five nonoverlapping waves. In addition, I see the selloff from the price peak between the head and right shoulder to the right shoulder that has formed with a small upward one-day rally that developed midway through the selloff. This is a classic Elliott wave zigzag that normally occurs during a market correction. As a result of the wave structure that has developed from the head to the breakout of the neckline in mid-September, the waves have formed a classic ABC zigzag, and what looks to be an inverse head & shoulders trend reversal pattern is not an inverse head & shoulders at all.

Now, lets take a look at volume. Volume normally increases in the direction of the main trend and decreases during market corrections. In Figure 1, I show four regression lines on the volume chart to show the direction of volume during each price wave from mid-June to the end of September. From mid-June to the end of July, the market sold off while volume increased. Thus, volume is signaling that the main direction of the market is down. From July to early August, price rallied upward while volume decreased. Here, volume is signaling that the direction of the market correction is upward. Again from early to late August, price sold off while volume increased. Again, volume is signaling that the main direction of the market is downward. Finally, from late August through the end of September, price rallied higher as volume decreased. Volume is signaling that the direction of market corrections is upward.

In conclusion, I do not believe that what looks like an inverse head & shoulders reversal pattern is a true inverse head & shoulders pattern and that it does not signal a major trend reversal. What looks like a duck may not be a duck. The wave structure from the price low at the beginning of July through the end of September is an ABC zigzag corrective wave structure as defined by the Elliott wave theory. It is through the analysis of volume and how it relates to price that has allowed this distinction. As a result, expect SPY to resume its downward selloff once the price correction is complete.

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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Inverse Head & Shoulders?

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