Are the Nasdaq and S&P 500 creating a head and shoulders pattern?
Apr 20, 2022
Written by: John McDowell
Is the market putting in a head and shoulders pattern right now? That’s the question I think we are all wondering. We’ve had a fantastic bull run since the lows of the covid crash, but are we in need of a nice long slow reset?
If you’re unfamiliar with the head and shoulders pattern, head over to our tutorial on it here. Now, let’s see how it might be playing out in the market right now.
IS THE STOCK MARKET MAKING A HEAD AND SHOULDERS PATTERN RIGHT NOW?
Over the past few months, the market has been in a correction. After that historic bull run from the lows of the covid crash in March of 2020, we’ve been on a stellar run. However, markets can't always go straight up.
The big question most investors are asking right now is whether or not the current correction is a premonition of something much bigger, or just a pause before we go higher. To that end, if we are putting in a much larger correction, a head and shoulders pattern could be the logical reversal pattern that we are seeing play out, right now.
Let’s take a look at the current SPY chart as an example:
Notice in the image above, the SPY, which is the ETF for the S&P 500, appears to be forming a head and shoulders pattern. However, we noted in the blue circle that it recently found resistance as it rallied into the overhead 50-day moving average. It is in areas like this that you can anticipate weakness in a downtrend for short entries.
You’ll also notice that the stock has since rallied despite breaking through its 200-day moving average (black line). For this reason, it could be difficult to gauge a proper “neckline” break on this pattern.
It is also typical for a head and shoulders pattern to increase in volume on the right shoulder. This often indicates heavy selling pressure as market participants use each rally to sell their longer-term positions into any strength left in the asset.
The SPY does seem to have a general sense of volume increase, but it could also be interpreted as support along the lows of the current correction.
USING BEAR FLAGS FOR THE RIGHT SHOULDER
If the bear case actually plays out here, what we might see is a complex bear flag playing out. As we have talked about before, bear flags typically consolidate in a tight flag formation. It doesn’t appear to have this structure, but it could be forming some sort of bear market rally regardless.
Here is what a bear flag looks like:
Notice how in each case, price is pausing in an otherwise downtrend. It could be that we are seeing this play out on the indices at this very moment.
For the SPY, it doesn’t really appear to be a clean bear flag at this moment. But that doesn’t mean we aren’t forming a distribution pattern here.
On the flip side, it is quite possible that we are witnessing a reversal of the broader head and shoulders pattern. How could that happen? Well, we could actually be witnessing an inverted head and shoulders, like this:
WHAT IS AN INVERSE HEAD AND SHOULDERS PATTERN?
An inverse head and shoulders is the mirror image of a head and shoulders pattern. It often signals a reversal in a downtrend. Why? Glad you asked.
Notice that the downward price thrusts begin to weaken. The first shoulder is an indication that selling pressure is subsiding. Then the head pokes through the prior lows as early buyers give up their shares and short sellers begin covering. The result?
As selling pressure subsides, buyers step in at lower prices to push the stock higher. This creates the pattern we understand to be the inverse head and shoulders.
Now, how might this be playing out with the SPY right now? Let’s take a look at it:
Notice that we are currently having a hard time making new lows. It is also occurring on heavy volume. Either we are simply allowing institutions the time they need to divest their holdings before going lower, or they are taking this opportunity to buy back shares at a lower price.
It remains to be seen, but if the right side of this chart finds support along the channel lows, or near the lows of the left shoulder, we could find ourselves with an inverse head and shoulders pattern.
How To Trade in the Current Market Environment
What might become of this pattern? Who knows, right now. It’s simply our job as traders to find the best risk to reward opportunities each day and each week. To that end, if the SPY shows weakness, you might consider some intraday shorting opportunities until it finds its footing again along the lows.
Most stocks follow the broader markets. Therefore, when the SPY is weak, many stocks will present opportunities to go short. When the SPY is strong, many stocks might be rallying. Use this to your advantage to create a bigger picture trading plan.
HOW TO PRACTICE THE HEAD AND SHOULDERS PATTERN
The best way to spot patterns is through implicit learning. That means, repetition. The more you see something, the more you’ll be able to anticipate it in the future.
For that reason, we recommend that you get in the simulator here at TradingSim and find as many of these head and shoulders patterns as possible. Simulate trades with them and find what works best for you.
Ask yourself these questions as you backtest your strategy:
Bull flag trading patterns are one of many patterns that traders study in the markets. Trading patterns are a way to simplify the markets and condense information into repeatable, visual formations....