Over the course of the past few weeks I have suggested the market may be at a top. The indices have been on the rise, gaining nearly 15% at the peak, and are in good position to see profit taking, consolidation or correction. Add in the fact we are on the cusp of a fourth quarter of negative earnings growth and the chances for correction only grow. Price action in the S&P 500 over the past two weeks is certainly consistent with consolidation and is tracing out what could become a classic head & shoulder reversal. The caveat is that this pattern is not completed yet, this discussion is intended to establish a possibility, its implication to the market and some ideas for option trading.

Before moving on I'd like to touch base on what a head & shoulders reversal is. It is a price pattern which can occur in any time frame in which a high is reached, prices retrace to support, move up to set a new high, retrace to the same support, move higher once more but not setting a new high, returning once again to the original support level and then breaking through to new lows. The pattern looks like a central "head" rally flanked on either side by two smaller "shoulder" rallies. While indicative of consolidation it is not confirmed as a truly bearish signal until the neck line is broken, and even still not fully confirmed until new resistance is confirmed. The pattern often forms at the top or bottom of major market movements and the boundaries of trading ranges.

Time frame, trend and market conditions are important when timing this pattern and its implication to your trading. In this case the pattern is showing on charts of daily S&P 500 price action and likely to play out in the near to short term. I take this stance because the secular trend is up, as are long term trends, with sign of consolidation in both but no looming reversals. Fundamentally this pattern will, in my view, driven by earnings expectations and results. Near term expectations are poor, long term expectations are positive which lead me to believe a near to short term correction. This leaves the near to short term looking as if reversal is imminent, with longer term support not too far below. In terms of time it looks like if a correction occurs it is likely to last a few weeks to a few months only, near term.

SPX, Monthly Candles

Knowledge And Preparation Key To Timing

Looking at the daily chart it is a easy to see what I mean. The rally begun in February has extended itself and begun to move sideways. This action is occurring within a zone of potential resistance and showing signs of topping out. The resistance zone is consistent with previously important support/resistance levels just below the all time highs and potentially strong. Major support target, also potentially strong, is at the multi-year up trend line.

SPX Daily Candles - Consolidation Within Resistance Zone

The pattern in question began in mid March when the index broke above 2020 resistance and entered the resistance band. As could be expected it began to consolidate within it. Price action has, to date been consistent with the definition H&S pattern, first making a new high, retreating to support, making another new high and is now retreating back to support. The target neckline, current support, is at the 2,020 level but yet to be confirmed. Confirmation comes as the neckline is broken and then reconfirmed when the neckline provides resistance. The rally was driven on strong momentum as indicated by MACD and stochastic but that momentum is waning, both MACD and stochastic are now indicating lower prices through bearish crossovers. It is still early to say for sure but it does begin to look like a correction is certainly possible, a test of the neck line at least looks probable.

SPX, Daily Candles - Early Signs Of H&S Reversal

SPX Daily Candles - What A Confirmation May Look Like

A Few Thoughts On How To Trade This Pattern

Now that a potential for a pattern has been established its time to get an idea of how to trade it. Based on the size of the first shoulder and the head, 7 candles and 10 candles(so far), we can expect this pattern to complete in about 2 to 3 more weeks, a time frame consistent with the start of earnings season and reports from the first 30% or so of the index. If, in that time, a break down of support does not occur, for whatever reason, a reevaluation of the situation will be due.

Down side targets should be considered as well as time frame if bearish positions are to be taken. Since longer term trends are up, and the index is only a few percent above a major long term trend line, downside potential is limited. A break of the trend line is certainly possible, it was broken earlier this year, but at this time there is little indication of longer term corrective action. My target, based on previous levels, is for a correction to near 1,950, about 5%, with rallies back to the recent highs or higher, perhaps to the all-time high, later in the year.

Long puts, put spreads, covered calls and bull calendar spreads are all possibilities depending on your end goal and how you are trading the index. One consideration is if you want to own the index when the trade is through or if you are merely looking for short term gains.

There are several potential entry points for directional traders, the first and most risky is at the top of the right shoulder, another might be when the neck line is being broken. The safest entry occurs after support is broken, the markets makes a low and then returns to retest resistance. Confirmation of resistance is the final move of the reversal pattern and can be traded with confidence of a quick descent.