Head and Shoulders and Divergences on Daily SP500

Jul 2, 2009: 6:54 PM CST

It’s being broadly circulated around the analysis circles, but there appears to be a distinct Head and Shoulders forming on the daily chart of the S&P 500.  I’m picking up volume and momentum divergences as well, hinting that lower prices are yet to come but let’s take a look at these structures and what they might mean for traders.

With today’s 3% free-fall (Trend Day Down) in the broader stock market, it appears now that the dominant technical pattern is the developing Head and Shoulders on the S&P 500.

It’s not guaranteed, of course, but according to classical technical analysis patterns, we would expect the next move in price to be a ‘magnet trade’ down to test key support about the 885 level in the index.

This support is strongly established as the February highs along with the May lows.  This level also forms the “Neckline” of the expected reversal pattern.

A break (and clean close) below 880 could trigger a flood of short-sell orders (and stop-losses from buyers) which could create a ‘self-fulfilling prophecy’ as traders and investors push price lower.

The classic measuring move is the distance from the Head to the Neckline (about 75 points) which is subtracted from the neckline at 885 to give us a target from 800 to 810 for the next level of possible pattern support.

Take a look at Volume, which has been steadily trailing lower as price has creeped its way higher.  That serves as a non-confirmation of higher prices and hints at an impending reversal.

Finally, look at the 3/10 Momentum Oscillator – as price has been inching higher, the 3/10 Oscillator has been making lower highs along with price, and has even set-up the dreaded “Three Push” reversal pattern (a triple negative momentum divergence, which you see if you look closely).

As a caveat, there’s no guarantee price has to break these levels, and one astute reader (Michael) even noted in the comments of the prior post, because the Head and Shoulders pattern is so obvious, it might be ‘faded’ or fail to materialize because so many people are watching it.  No one said trading had to be easy!

Until we see something different, this is the current price structure of the S&P 5oo as we head into the holiday weekend.

Find more information about our new Weekly Inter-market Technical Analysis and the Daily Idealized Trades member service which have just launch at the Premium section of Afraid to Trade.

Corey Rosenbloom, CMT

18 Comments

18 Responses to “Head and Shoulders and Divergences on Daily SP500”

  1. Wall_St_Cheat_Sheet Says:

    Great analysis, Corey. I just started reading you on Mike Bellafiore's recommendation. I'm really liking what I see. Have a nice 4th. Damien.

  2. Micheal Says:

    I think the 3-push pattern is the most encouraging for the bears/worrisome for the bulls. The potential break of the 50day (probably too close to call a break at this point) is also of interest. The volume divergence… it's summer so you expect volume to tail off anyway, so that may just be a function of the time of year rather than a sign of weakness in the market.

    The general 880 area “should” be strong support. Several candles tested it from below before the breakout, and immediately after the breakout I count 6 candles that tested it as support from above.

    Also, let us not forget the bearish rising wedge from mid-April! We had a volume divergence, we had a 3/10 momentum divergence, and price was hitting up against the February highs. Perfect place to take some shorts and I took some that Friday afternoon, risk/reward seemed quite good so why not. Over the weekend as I surfed around the blogosphere I kid you not – every single blog I visited was bearish and almost all had that same pattern posted and right away I'm thinking “uh-oh…” LOL! So on Monday we have a monster gap down and I'm thinking “ok, maybe it will sell off after all”, but after the gap there was very little follow through and we ended up finding support at the 20day ema and shooting up to new highs 2 weeks later. Which was to the surprise of pretty much everyone – including me!

    In any case a break of that neckline would offer good risk-reward, so probably a good trade. Can't get ourselves psyched out worrying “what if it's a fake-out”… just have to take our positions and let the market do what it's going to do.

    Incidentally – I notice that if you bought FAZ at the top of that false rising wedge when the S&P was around 875 you'd have paid around $10. Now with the S&P at 896, basically one more down day away from being back at 875, FAZ is just over $5 – nowhere near the $10 you paid for it. So if the S&P gets back to 875 there's no way FAZ will be back to even – it'll probably be around $6 or so. If you shorted ES at 875 and not stopped yourself out you're one down day away from being even. If you had done the same with FAZ you're nowhere near even and who knows how low the S&P would have to go to get you back to even! Scary!!!

  3. pipercolt Says:

    Everyone is looking at this HS but with the extra confirmation u're doin here is testament that it may happen. Incidentally the man uses nomenclature of 3 push as an impulsive elliott wave. I'm an amateur myself but have to see it. and don't ask me about the pshycology of these patterns. still in the dark on that one.

  4. Taseer Raza Says:

    Corey, i think you rock. Great job on this article. I'm a frequent visitor. this is my first post. check my website out as well. http://www.moolahstreet.com

  5. James Says:

    Sure enough, I think EVERYONE in the markets will be watching this. What happens depends on who wins when the bulls and bears go to war at the neckline. A break of support could lead to the self-fulfilling prophecy where everyone starts shorting and selling. The opposite scenario could happen if the bears are overwhelmed by dip buyers. As has been said already 875-880 has held many times so this will be a tough battle, could last a while too. Very interesting.

    On the subject of head and shoulders – there appears to be an inverse head and shoulders forming in gold. The only problem is those patterns are supposed to form at bottoms, not at all-time highs like we are at in gold. Does that make any difference?

  6. Bob Says:

    James… you're right on the nut about the S&P; a battle at the $880's level is likely.

    Gold does seem to be linked here too. With Gold near all time highs there, what's needed is some catalyst that would cause a herd like flight to safety. A break in the S&P might just cause the general investor to panic, fearing a replay of the last downturn. I'd think, a break of $880 in the S&P might push Gold to test the $1,000 neckline, but unless the institutional players participate, a reversal there is more likely.

    I doubt the intitutional investors are too exposed right now. They've likely hedged their bets. However, if the S&P price tests the $810 level, I'd expect institutional buyer's will feed. And, if that level were to then break,… it would be an interesting scenerio; trapped longs; a broader panic; institutional participation. Gold might then get the necessary energy to make a break for higher ground.

  7. Mike Says:

    I think what people fail to look at a lot of the time is LEADERSHIP. The Energy Complex and Natural Resource and Commodity stocks lead this market up and had a very strong bid in them, until recently. I would look for either these groups to “stabilize” ( such as the OIH between 88-90 ) or another group to emerge as a leader. This will be key to whether or not 880 SPX holds in my opinion.

  8. Jerry Says:

    I'm sorry, but I really don't see anything that significant with the showing of the “momentum divergence” given that a narrowing of the rally is typically expected as groups/sectors become overbought and just about every sector has been rotated into.

  9. Corey Rosenbloom, CMT Says:

    Thanks Damien!

    You as well.

  10. Corey Rosenbloom, CMT Says:

    Mike, that's a lot to cover! Thank you for sharing. I mentioned your comment in a recent post.

    I'm waiting for the neckline break and confirmation – would love to see a powerful candle form beneath it as well as a surge in volume – would be irresistible to resist an aggressive trade (close stop in case the break winds up to be false – which would be frustrating).

    You hit on something I'm campaigning against – long-term position or even month-long swing trades in 3x funds. Those are best only for experienced, aggressive, risk-seeking day-traders (and they can do some amazing things with them) but better for the general public to tread lightly in these funds – for the reason you mentioned.

  11. Corey Rosenbloom, CMT Says:

    The psychology of the pattern is that on the left shoulder, people are still bullish and there's little reason to be bearish. The head makes a new high, but on weaker volume. Still the public is bullish – pros start to notice the non-confirmations. As the right shoulder forms, the public is still optimistic but they can't push price to a new high, and when price breaks the support line, many stops are triggered and many pros get short – that's the psychology as I interpret it.

  12. Corey Rosenbloom, CMT Says:

    Bob and James – a “war” and “battle” are excellent terms to use to describe this – no one *knows* which side will prevail – they're both entrenched and will be using all they can to support (or break) the market.

    It's better to go with a Mark Douglas style philosophy – identify key inflection/turning points in the market, watch as price comes into this level, then join (long or short) once price begins to break through or bounce off these levels – with a stop just beyond the line (a comfortable distance). This is trading neutral and not allowing emotions or biases to overtake you.

    For example, the worst thing to do is convince yourself that we're going to break down hard from these levels, put on a massive position now, and then if price bounces up from here, add to your position as price kept going up because you think “there's no way the market can keep going up.”

  13. Corey Rosenbloom, CMT Says:

    Please refer to my many blog posts that reference the principle “Momentum Precedes Price.”

    A momentum divergence often precedes reversals because of a decline in buying 'momentum' or pressure as swings contract or narrow.

  14. Corey Rosenbloom, CMT Says:

    True – excellent point. We can look to other related leader/laggard markets as confirmation/non-confirmation and clues. For example, it looks like Crude Oil may be hitting (and coming down from) confluence resistance which hints that the S&P may be doing the same.

    There's so many things to use for conf/non-conf.

  15. Why 880 in SPX is So Important | Afraid to Trade.com Blog Says:

    […] have now officially broken this confluence level, as well as the Neckline on the Head and Shoulders formation – that’s clearly a bearish […]

  16. Why 880 in SPX is SO important Says:

    […] have now officially broken this confluence level, as well as the Neckline on the Head and Shoulders formation – that’s clearly a bearish […]

  17. buygold Says:

    Corey,

    Great work. I have been short this market since early June. I've been seeing the volume price divergence since May. Now the question is how bad is the correction going to be. Any ideas?

    Take a look at my post/chart from the early June where I prepared readers to short the dow.

    Be Prepared to Short Dow

  18. buygold Says:

    Corey,

    Great work. I have been short this market since early June. I've been seeing the volume price divergence since May. Now the question is how bad is the correction going to be. Any ideas?

    Take a look at my post/chart from the early June where I prepared readers to short the dow.

    Be Prepared to Short Dow