Another Head and Shoulders Pattern in the Stock Market?

Is another Head and Shoulders pattern forming in the stock market ($SPX or S&P 500 for this post)?

Late yesterday I heard someone mention that a possible head and shoulders pattern could be forming in the major market indices.

When I heard this I remembered the last time people were talking about the same thing. It was a few months ago in late June/early July 2009.

At the time, there were so many people talking about the possibility of the pattern unfolding, that I imagine many people got out of their long positions towards the bottom of the right shoulder. This also happened to be right before the reversal to the upside occurred and the beginning of the next leg higher.

Now, 4 months later, the same potential pattern may be unfolding. While this post may be early, being early will allow you to watch your charts as the potential pattern does or does not unfold. Doing so and preparing yourself now, rather than later, will allow you to position yourself to take advantage of potentially profitable trades.

For example: If the S&P 500 is indeed tracing out a Head and Shoulders pattern, then we are currently at, or fast approaching the top of the right shoulder. Any sign of strength reversing into weakness would be a potential good entry point for short positions if you feel the pattern is indeed unfolding and that the market will be moving lower from here.

Taking a look back to the most recent high on the chart, if the right shoulder does form and hold, you would be entering on a lower high, which is just about the best short entry point you could ask for (behind the exact high of course). The top of a right shoulder is also point “3″ in a 1-2-3 pattern, another great entry point/signal.

Taking a closer look at the chart you can see that back in late June the price level broke down through the 50 day Moving Average line briefly before moving higher into the potential right shoulder formation. Compare that with the recent price movement and you’ll see the exact same thing so far.

These are common characteristics of the beginning of a right shoulder forming in a Head and Shoulders patter. That is- a move lower on weakness from a recent high, followed by another attempt higher on “lower volume”. You can see the lower volume when the right shoulder began back in late June as well as the beginning of this month. Both instances also display weakening RSI and MACD levels.

So what’s different this time? There are many things different now but one thing noticeably different on this chart this time is in the volume. Take a look at the volume during the last “Head” formation back in June- it was basically a bit lower or at the same level of volume as in the right shoulder during late June/early July.

Now take a look at the recent “Head” formation. I see an increasing amount of volume that occurred as the top of the “Head” was unfolding. To me that appears to be a sign of distribution in large amounts, possibly giving us the signal that a major top has been put in place. Of course this is my opinion and yours may be different. If so, feel free to add your comments below to express your point of view.

The last time the pattern began to unfold and failed as can be seen on the chart. This time we will have to wait and see but as I mentioned above, a good entry point for potential short positions would be at/near a high (right shoulder). This would be a better short entry point than waiting for a breakdown through the neckline, only to be caught in a reversal as happened the last time. I’ve drawn the necklines on the chart for these price levels to be aware of.