I was a bear from the start I will admit it, but after listening to some technical traders on YouTube I realized a personal bias on market direction can really hinder your chances of making a successful trade. So like I mentioned in my previous post I will walk you through some of my reasoning on why I am expecting this downtrend to be much worst. Counter arguments are welcome
Start with A major index such as Dow. (Note: Only reason I am showing the Dow is because I previous setup this chart. The S&P and Nasdaq follow very similar analysis if you draw out the Head and Shoulders pattern).
This chart is the Weekly Dow Jones industrial average from 2007 to present. It shows 4 Head and Shoulders patterns. These can be debated but as i see it the theory of Head and Shoulders patterns fit well within the observations. What is a Head and Shoulders? In short, it is a peak, and larger peak, then a smaller peak, followed by a break down (this is for a bearish uptrend reversal, the bullish downtrend reversal is the opposite of this demonstrated by the Cyan lines above).
Are they common? In every market and time frame you will be able to notice Head and Shoulder patterns. In the Dow, i looked back and the last Head and Shoulders pattern I could see on this weekly target was in 2002 which was a breakdown drop almost double its projected target. Arguably you could say there was failure of this prediction in 2006, but compare them to the ones charted out and you can see it isn't well defined.
This breakdown occurs when the pattern is completed by a close below the neckline which is traced out for all four head and shoulders patterns in the above picture. Why I think this pattern holds value? The right shoulder that is created fails to make a new high, which indicates that the Bulls were not strong enough on that last attempt to make new highs. The pattern is stronger when volume for right shoulder is declining with respect to the volume during the head. I will discuss that below when i talk about other indicators on the graph.
The neckline is drawn from the lows after the left shoulder to the lows of the head. The rational for the breakage of the neckline triggering a drop to the target value i will leave up to others sites that can explain it better that I can. So talking about target values.....
Looking at the Purple lines for each year, I follow it with a yellow line that is the same length of the respective vertical purple line. The target for a head and shoulders pattern once broken down is the distance from the top of the head to the neckline in the breakdown (or up) direction. As you can see, in two of the three completed Head and Shoulders pattern in the chart, this projection was relatively accurate. I will explain my reasoning on why i think the first H&S pattern in 2007 was not as strong and didn't meet the predicted target.
So what is the target for the DOW?! On the graph i market it as 8414. But there is reason to believe that 38.2% retractment of the last major move could be the first significant bounce. That would bring the dow to 8327. Notice how close the prediction is to the fib retractment. What is Fib retractment? Again, better explanations are out but simply they are likely values that a stock might correct towards. Remember stock markets always go up and down, never always up so even if you are in an uptrend, corrections that might bring you much lower are likely and necessary to maintain a strong uptrend.
So To answer the question to be a Bear or not to be a Bear?
It does not make sense right now to be a Bull, until we close above the 9780 mark. This is because in the current H&S pattern, the neckline last week was broken. The neckline was at 9779 and the market closed at 9695 (approx). which is 80 below the neckline.
If you go against this trend you might be right, but the odds are not in your favor, and it would be safer to just wait until this significant technical analysis pattern is broken (getting up above the neckline and closing) to continue to go long.
Other Indicators:
I am going to quickly go through this since i have already wrote a lot than i thought i would. Mainly because this will be the basis of my trading strategy until this pattern is proven incorrect.
Good sight to explain these is at:
Volume:
A stronger H&S pattern is when the right shoulder's volume is weaker than the head's volume. This doesn't always hold and isn't always a necessity for the breakdown to occur. In our current case it is definitely the case. There is higher volume on this right shoulder which means this pattern is more likely to be a good prediction.
MACD:
The cross overs of the lines indicate sell and buy signals. If the blue crosses below the white that is a sell signal and if it crosses above it is a buy signal. In this case we had a cross over and the lines are not looking like they are going to cross over any time soon; they are diverging from each other. MACD also shows momentum, so currently the momentum is down.
Slow Stochastics:
This can be used to determine if a stock is overbought or oversold. Anything above 80 is overbought and anything below 20 is oversold. This will indicate that there is a likely bounce in the reverse direction of the trend that is currently being followed. This also is a momentum indicator, and notice the sharp change from upward momentum to downward momentum.
NOTE: In the weekly we are not oversold, but in the daily we are. This indicates that there will be a bounce relatively soon. If this bounce takes us above the neckline the H&S pattern would be broken. I am currently waiting on a bounce to enter some short positions. This week or next week will be the bounce and possibly a big move down. If you were playing the index you could wait for the bounce and go short with a stop loss of a few points above that neckline. If it breaks it you are out with minimal loss.
Bollinger Bands:
Very interesting indicator. They are the gream boundaries around the index on the first chart. They are designed to keep the index within the bands, 2 STD = 95% of the time. So if you are above or under the bands you have a 2.5% chance of continue in that direction. This is one example of why technical analysis allows a trader to stack the odds in his/her favor. Why enter into a long position if the stock/index has broke below the Bollinger band? There will be a bounce most likely, so when it occurs enter into your trade.
Moving averages:
I use 20, 50, 200 period moving averages. In many many charts you will see these averages provide strong resistance or support. When your break a support level it becomes resistance. Lets look at the first chart. Strictly looking at the current H&S, you can see that the head found resistance at the 200 week moving average (faint yellow line) and the right shoulder found resistance at the 20 week MA, and with our breaking of the neckline we also broke the 50 week MA which is very bearish because we are now below all moving averages. As an aside, on a daily chart the 50 day MA is about to break the 200 day MA. This is called the "DEATH CROSS" and is very bearish again. Also note that the death cross doesn't happen often.
Wow.... That was a long post but I think it was necessary to set the stage for what potentially could be a significant move in many major stock markets around the world. I am calling this down turn quite early as we have JUST manage to break the neckline but many of the indicators point bearish sediment in the markets. However, there will be a bounce and it is expected. I wish I believed in my speculations as much as i do now, since I would have shorted the last shoulder but that would be been relatively more risky than to wait until the neckline is broken. Another week close below this neckline would be decent confirmation of this pattern.
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