S&P 500 forms a bearish pattern & provides a potential trading opportunity

The S&P 500 index has traced out a bearish rising wedge pattern that could provide an excellent trading opportunity.

Having made a low on 4 June at 1,266.74, the S&P 500 rose in a series of higher highs and higher lows. In doing so it traced out a classic rising wedge pattern.

The rising wedge pattern is a bearish reversal pattern that begins wide at the bottom and contracts as prices move higher and the trading range narrows. This type of pattern typically forms over a 3 to 6 month period and can mark an intermediate or long-term trend reversal.

It takes at least two, and preferably three, reaction highs to form the upper resistance line, and each reaction high should be higher than the previous high. Similarly it also takes at least two reaction lows to form the lower support line with each being higher than the previous one.

As the pattern develops, the upper resistance line and lower support line converge and the advances from the reaction lows (lower support line) become shorter and shorter, which makes the rallies unconvincing. This creates an upper resistance line that fails to keep pace with the slope of the lower support line and indicates a supply overhang as prices increase.

A 4 month chart of the S&P 500 indexA 4 month chart of the S&P 500 index

Source: StockCharts.com

Earlier today the S&P 500 broke through the lower support line in a convincing fashion and confirmed the pattern as bearish. It is likely that the broken support line will be retested and will then become overhead resistance.

Some traders will wait to see this retest before going short. They will also wait to see an expansion in volume to confirm the bearish move.

According to StockCharts.com, “The rising wedge can be one of the most difficult chart patterns to accurately recognize and trade. While it is a consolidation formation, the loss of upside momentum on each successive high gives the pattern its bearish bias. However, the series of higher highs and higher lows keeps the trend inherently bullish. The final break of support indicates that the forces of supply have finally won out and lower prices are likely. There are no measuring techniques to estimate the decline – other aspects of technical analysis should be employed to forecast price targets.”

My initial downside target for the S&P 500 is around the 1,303 area, and if that fails to hold it is likely that we will retest 1,266.

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