Monday, November 21, 2011

Take you neck down a notch

Below is a daily chart of the $SPY ( ETF of the S&P 500). As I have marked on the chart, there is reason why traders may look at the below chart and conclude a retracement to roughly 111 will result in a bullish inverse head and shoulder patter, with right shoulder outlined in green, the low being the head, and the target for the right shoulder outlined by a green rectangle in the lower right hand quadrant of the chart.

Now, before we make any conclusions, we must acknowledge an extremely important factor of this formation, and that is the neckline. The neckline of an inverse head and shoulders pattern is the level where the left shoulder peaks at and begins to go down again to form the head, and the head pauses at the same level and retraces to form the right shoulder. perhaps the neckline is best illustrated with a picture of an ideal inverse head and shoulders pattern:

The line that puts the cieling on prices during the formation is the neckline. So a breakout of the neckline tends to mean the formation was successful.

But, what would make an inverse head and shoulders even more potent is a downward slanted neckline. A downward slanting neckline is especially bullish because all of the sellers are trying to put pressure forming a very tight range, and still, the lows cannot be tested. So in short this is bullish because all of the present sellers are showing their hands during the right shoulder formation, and still the sellers are not strong enough and a higher low is made.

So, logic may dictate while a downwards sloping neckline adds bullishness to an inverse head and shoulders pattern ,that an UPWARDS slanting neckline extracts bullishness from this pattern. Reasoning being the opposite of the downwards slanting neckline. In the case of the upwards slanting neckline, the bulls are putting upwards pressure breaking out of the range to the upside, but has little strength, and cannot make a new high. So here too, buyers are showing their hand too early and using up a lot of energy on an unsuccessful attempt to make a new high.

So both tweaked necklines, is a case of bulls (upwards slanting) showing their hands too early and not making a new high , and bears (downward slanting) showing their hand too early and not being able to make a new low.

Right now, on the $SPY, we have a case of the former. The neckline is slanting up, implying that bulls used too much energy and showing their hand too early, and failing to make new highs while breaking the range. Showing that their ammunition was deeply dipped into and revealed to the bears. Here is the first chart showing this:

Now, since the bulls have wasted alot of energy too soon, they may not have enough energy to defend the lows of this year, and a new low may be made before the bulls can gather more strength,, which may turn into a broadening bottom formation :

So we see a pattern here. When the volatility expands or contracts to quickly, it skews the results. When we break to the upside before completing the formation, we cause an upwards slanting neckline, inviting the possibility of exhausted bulls allowing a new low to form. When volatility contract too soon before the formation is complete, bears exhaust themselves causing a downwards sloping neckline and a more explosive upwards breakout can occur. Note that with a broadening bottom, even though a breakout to the upside is slightly in favor(53%), an inverse head and shoulders is wildly bullish (95%), so this new development of an inverse head and shoulders turning into a broadening bottom does massively hinder the bullish connotations (a 42% decrease)

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