May 28th, 2010

Ever See An "Ascending Broadening Wedge"?

A subscriber to Instant Alerts asked: “So, is this formation over the past three days a ‘head and shoulders’ formation?” I wasn’t quite sure what he was referring to since the head and shoulders I have been focusing on stretched back not three days but all the way back to October. It was the described in “Elongating the Head and Shoulder Top” of just a few days ago when I wrote:

“the bull market that has been running from the March 2009 low to when the market began really struggling to make new highs in December seems to be about to turn into a Bear Market (defined as a decline of 20% or more)…..

So I went to a 15-minute bar chart covering the previous ten days and, sure enough, there it was, the following inverted head-and-shoulders chart (click on image to enlarge):

That was around noon and I was in a quandary since I had a nice profit in SDS, the double-short ETF on the S&P Index. At noon, the Index seemed to be stalled at around 1094 so the question was whether to act on this short-term bottom pattern in the anticipation of a 5% move up to the target 1150 or to hold on to the ETF, take the pain of a short term loss while waiting for the downside move to resume. Here’s a longer-term view of the Index and the head-and-shoulder top I had been focusing on:

The more I looked at that “elongated head and shoulders”, the more I began seeing a different pattern emerging: a chart pattern that looked more and more like a megaphone or, as known by its technical name, an “ascending broadening wedge” [to be contrasted with the more conventional “descending converging wedge”]. Over my many years of charting, I had rarely come across an ascending broadening wedges but when I have, it rarely had a good ending.

According to Thomas Bulkowski’s Encyclopedia of Chart Patterns , “The ascending broadening wedge is a chart pattern that tends to rarely appears in a bear market. Most often, you’ll find them in a bull market with a downward breakout …. 73% of the time.” These downward breakouts usually occur after a turnaround at about the mid-point of the wedge (or in the above chart at around 1140-1150). If the turnaround is followed by a breakdown through the bottom boundary, the subsequent move tends to be approximately equal the height of the wedge or, in the current situation, down to around 925-950.

My response to the subscriber:

“there will probably be a recovery move out of what looks like a inverted head-and-shoulders bottom but, traditionally, the extent of the move will approximately equal the distance from peak of head to neckline. In this case, it’s around 5% and should carry the market back up to around 1150 which, coincidentally, is a significant resistance/support level. At the point (if all this comes about), we’ll have to wait to see what market participants want to do then …… buy bargains or get out of the way for another push down”.

While a move to 1150 will be uncomfortable, a turnaround at that point will turn the decision to not sell the SDS into a good one. It will, however, be a tense and anxious 3-4%.

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