Elliott Wave Articles

Today’s Lesson will focus on the Head & Shoulders pattern and we’ll look at the S&P-500 Chart and use Head & Shoulders (H&S) Analysis to predict the near future in SPX.

First of all, the term “Head and Shoulders” is used to describe a chart formation in which a stock’s price:

1. Rises to a peak and subsequently declines.
2. Then, the price rises above the former peak and again declines.
3. And finally, rises again, but not to the second peak, and declines once more.

The first and third peaks are shoulders, and the second peak forms the head.

NOTE: this Commentary relates to the Bearish H&S pattern only and not the Bullish Inverted H&S.

Now, let’s learn about how to USE Head and Shoulders Analysis to forecast price movement and set some Targets as well as a Protective Stop Loss level.

Once we have a good-looking pattern where the head is above the two shoulders and the shoulders are somewhat near the same price, it’s time to draw the neckline. .. Looking at the two valleys between the head and each shoulder, draw a line connecting the lowest point of each valley to each other .. then extend that line to the right (ahead in time). .. This will be the line that we will wait for a Break Below of.

Once this is done, it is an interesting exercise to extend that neckline to the left (back in time) and see if it forms any previously unknown Resistance levels .. if so .. this would seem to Strengthen the importance of that line, IMHO.

So after a wait, the neckline does get Broken Below . . now what?

1. draw a line Down from the head (high-price) vertically to the neckline .. then look to the right and approximate that price-level
2. subtract that neck price-level from the head (high-price)
3. this gives you the measure of the expected move Down from the neckline break
4. take the approximate value that the neckline was Broken Below at and subtract the measured value from the previous step . . . THIS is the Target

Assuming you went Short on the neckline Break (Buying Put options OR Shorting the Stock), you’ll want to have either a mental level or actually place a Stop-Loss Order where you can limit your losses if the Stock moves back Up against you too much. Here are the possibilities:

• after breaking the neckline, a stock will often go back up and retest that neckline .. this is called “Throw-back” and is not a cause of worry .. yet! . . . so, a conservative place to limit loss/risk would be a little bit above the neckline to allow for that Throw-back to occur without stopping yourself out of what might be an eventual good Short.
• since Head and Shoulders patterns have a very good reliability of working (continuing Down), a popular yet riskier level to have a Stop-Loss is back up at the Right-Shoulder .. a little bit above it. . . This gives every chance for the H&S Pattern to “work”.

So, the Trade we had in the SPX after it Broke Below its H&S neckline has the following characteristics:

• Shorted somewhere above 880
• Target = 824 or so
• Stop Loss at 901 or 933 . . I’m leaning towards the 901 because of the large distance to 933 . . . you could always take the smaller loss at 901 and then Short again later if it rises higher.

Good Trading !!!