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Head & Shoulder Formation In Major Indexes at Trader’s Narrative





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A ‘head and shoulder’ formation is one of the most famous technical formations in price charts, probably because it is one of the most common formations. The name comes from the way that the chart formation looks like the sillouette of a person’s upper torso.

The head and shoulder formation consists of a rally (the head) separated by two smaller rallies (the shoulders), preceding and following it. As with all technical formations, the fractal nature allows for it to occur on a variety of time lines, from minute charts to weekly and monthly charts.

The slope of the neckline can also vary, being horizontal, downward or upward sloping. In all cases, the effect is the same. Upon completion, the expectation is for lower prices:

SPX500 head shoulder formation July 2009

Volume is also an integral part of this pattern. Typically volume is heaviest during the left shoulder, or first tentative rally. Then during the more successful rally that follows (head), volume recedes. And the final, smaller rally has equal or lower volume. As you can see from the chart of the S&P 500, the head and formation that has printed recently follows these volume conventions exactly.

If the Head and Shoulder formation completes, then the target would be 820 for the S&P 500 Index (SPX). I got that by taking 885 as the neckline and 950 as the top of the ‘head’ and then projecting the difference downward. Depending on how you drew the line you may have gotten a slightly different number but I’m sure it would cluster around the same level.

Although instantly recognizable to the trained human eye, this chart formation is extremely challenging to quantify. But there have been more than a few who have taken a crack at it. Over the years I’ve read a handful of research reports that show the results are surprisingly positive. Even those who are skeptical of the efficacy of technical analysis in general, have accepted that a head and shoulder formation is very reliable.

Interestingly, this technical pattern is printing not only in the important Standard & Poors 500 but in the Russell 2000 (small caps) and the Dow Jones Industrial. But not in the Nasdaq Composite as the tech sector’s high relative strength has powered this index to higher highs. On the other hand, you could argue for a double top pattern in the Nasdaq which is equally bearish.

The important thing right now is to watch for the completion of the head and shoulders pattern. If it breaks the neckline, then the projection stands. However, such a formation is not guaranteed to complete. If we have a head and shoulder failure - that is prices break the neckline but do not go lower, then usually what follows is an explosive rally as many people who expected lower prices are caught on the wrong side and have to cut their losses.

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14 Responses to “Head & Shoulder Formation In Major Indexes”  

  1. 1 Dave

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    Although the SPX hasn’t broken its H&S neckline OIH & XLE may be better leading indicators.

    A USDollar bounce will put pressure on commodities & therefore the SPX will be weaker than the Nasdaq. OIH & XLE have already broken necklines on H&S patterns. I think the XLE is particularly vulnerable because its neckline is downward sloping.

    Regards,

    dave

  2. 2 GreenAB

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    “If we have a head and shoulder failure - that is prices break the neckline but do not go lower, then usually what follows is an explosive rally as many people who expected lower prices are caught on the wrong side and have to cut their losses.”

    in my view we exactly got that failure yesterday.
    and you are one of the few who drew the neckline correctly.

  3. 3 jeremy

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    Green, i tend to agree, every technical analyst under the sun is calling a head and shoulder, when there is such a broad confirmation, the opposite often will happen..

    Markets felt more stable yesterday, I am in the sideways camp, and expect more mixed trading rather than down.

  4. 4 blues

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    GreenAB, I guess you are a bulltard who is long the market? Yes I do agree that TOO MANY TA is looking at this pattern and this H&S pattern is too perfect and that even the volume confirm to a text book H&S which will most likely to make it fail… BUT yesterday was not a failure. We have not even break the neck line yet. Look at today, we already making another attempted to reverse all the reversal candle from yesterday already.

    For me, I would think that we need to break the neck line hard and then chop down there sideway for a few day and then pop back above the neck line. THAT WOULD BE A FAILURE. And THAT WOULD BE A BIG BEAR TRAP which would catapult the market higher and fast.

  5. 5 Dave

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    @blues,

    I agree with you 100%. The “failure” calls were/are premature. I would love a true failure & bear trap. From failed moves come fast moves.

    Regards,
    dave

  6. 6 GreenAB

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    @blues,

    i have to disappoint you. i´m neither a bull nor a bear.

    i just commented on Babak´s chart who has the neckline precisely where it has to be (and not at the 880 level like so many others out there).

    so yesterday WAS a failure and we´re seeing another attempt today.

    which way it will turn? i got no idea.

    my gut tells me that if we break below 885 we´re straight on our way to 813 (gap) without stopping at the well tested 875 many bulls believe in.

    but as i´m writing the SKS is NOT condirmed YET. ;)

  7. 7 GreenAB

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    read: SKS are the german initals for ShoulderHeadShoulder. sorry about that.

  8. 8 blues

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    GreenAB, yes, I have the same view, if we break 885 then 875 would be nothing, but not sure what you mean buy 813 gap? You mean gap down 813?! I wish, but then that would be a super big gap which would trigger all the switches at the floor… and a huge crash day.. which I also would enjoy… :)

  9. 9 GreenAB

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    S&P has an open gap around 813.
    so this would be a logical target once we lose major support.

  10. 10 Guru

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    Time horizon, don’t forget to look at multiple time horizons. Babak drew the H S correctly but rather than dumping everything and heading for the hills, you should also take a look at the inverted H S bottom pattern that’s been in the works since last October. This move down … if it stops at around 800 and begins to reverse again …. will form my long-awaited right shoulder of that inverted H S.

    Rather than being a bad thing, this is a good thing because it could be the precursor of the completion of the Financial Crises Crash bottom, the end of the accumulation stage of the Market’s life cycle and the start of the market’s next mark-up phase (bull market) that could carry the Index to 1250 by the end of next year.

  11. 11 dacian

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    It’s true that everybody’s looking at that H&S but as you can see here everybody’s calling for a possible bear trap as well. At the end of the day, stock market is about companies making profits. If you think stocks are cheap here, I invite you to buy strongly; I personally don’t know in which parallel universe these companies are selling their products…

  12. 12 Babak

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    Here’s a recent article from Hulbert talking about the same H/S pattern with Peter Eliades who puts the target at 822 - right around the 820 range I mentioned.

    And here’s Michael Kahn’s take; ihe doesn’t want to join the H/S bandwagon but it is bearish.

  13. 13 Babak

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    Here’s a study on H/S patterns

  14. 14 Lulu

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    Well, it is X-mas time now, and the SP500 in the chart showing up there, did not even break the 860´s… what a way to blow up some portfolios….

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