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Head and shoulder formations are one of the most fundamental technical patterns. They are arguably one of the easiest to recognize on a chart and are almost always found at turning points in price. Right now we are seeing the S&P 500 Index (SPX) carving out what looks to be the right side of a head and shoulder formation:
The defining element of this patterns is not only the striking silhouette it leaves behind on price charts but also the volume that accompanies it. For downtrending reversals, like this one, we want to see heavy volume come in as the right shoulder is created. Ideally, a burst of activity both in price expansion and volume cements the pattern as it decisively breaks through the neckline.
It remains to be seen how this will play out. But if prices do continue to firm up, we may see this classic pattern play out. If it does, watch for the corresponding volume. You have to be careful to not read too much into the sudden volume collapse at the turn of the year since that is normal.
The slope of the neckline is clearly downward, which is normal for an inverse
head and shoulder pattern. Anything from horizontal to downward is fine for such a neckline. An upward sloping one however, would be a bad sign.
Reversal or Continuation
Although most people categorize head and shoulder formations as reversal patterns, it is possible for them to be continuation patterns as well. There is a key difference.
The current pattern developing in the S&P 500 chart above, however it resolves, can not be a head and shoulder continuation pattern because in a downtrend, this would have to take the shape of a head and shoulder top (not bottom).
In other words it would have to look like an M not a W in shape. The other difference is in the required volume pattern. Instead of it showing more volume on the left shoulder and head and less on the right shoulder, a continuation H&S pattern will show diminished volume on the three points.
The prevailing sentiment is too optimistic right now, which from a contrarian point of view makes it less likely to make this a lasting bottom. But sentiment is just one aspect of the market. There is also technical and fundamental. And some would say fund flows.
So this potential head and shoulder formation is just one more aspect of this crazy market that we have to consider and throw into the pot.
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