At the October 15 low, S&P 500 reversed at the exact bottom of a potential three-year price channel (pink on chart).
On Friday it confirmed the price channel by reversing at the exact top of the channel.
That means SPY is now at the critical decision point for this price channel. There are four things it can do here.
The Four Price Channel Scenarios (Red Scenario Most Likely)
It can continue down from Friday’s high all the way to the bottom of the channel to continue moving up the channel. That would be unusual in a channel this big, so I haven’t even drawn this scenario on the chart.
It can continue down from Friday’s high into the middle of the channel (likely to ES 1937.50/SPY 194.20ish) for a partial wave down, and then break out the channel top into a steeper channel. This would usually lead to a series of steeper channels and a melt-up. (Green scenario.)
It can collapse from here through the channel bottom to put in the low before the head of a head and shoulders formation. (Purple scenario.)
Or it can reverse after little or no further retrace to break out through the top of the pink channel (red scenario on chart).
Sometimes a red scenario breakout here would retest the channel top and then move into a series of steeper melt-up channels. But usually the lack of coiling we’ve seen since the October 15 low would lead to the price crawling up along or across the top of the pink channel, often forming one final rising wedge, before collapsing back into the pink channel and then through its bottom, completing the head of a major head and shoulders pattern.
The Set-Ups
So here are the set-ups.
A Likely Fake Head and Shoulders Set-Up on ES
Normally, I would say here to short on any small topping pattern that breaks out downwards for a trip to at least ES 1937.50/SPY 194.20ish and possibly as far as a breakout through the 3-year pink price channel bottom. But ES actually broke out downwards through the necklines of a small head and shoulders at Friday’s high, and then a larger head and shoulders on its 5-minute chart.
I’d be telling you right now to go ahead and get short except that ES also formed a falling megaphone (pink on chart below) in the move down from the high. You don’t see falling megaphones in real head and shoulders patterns. ES closed on Friday retesting the neckline of that larger H&S.
That pink falling megaphone strongly suggests that ES will violate the H&S patterns and break out here through the top of the 3-year pink price channel. That makes the red scenario on the top chart most likely, with an immediate move into a series of melt-up channels possible but a lot less likely than a crawl up the channel top until the move fizzles out.
The confirmation that the red scenario is coming would be a fake breakout past the Friday afternoon low on Sunday night or Monday. That will suggest a megaphone right shoulder is forming, and a megaphone right shoulder almost always means a higher high is coming.
The Price Channel Breakout Set-Up
That higher high would break the price out of the 3-year pink price channel. That’s an obligatory set-up to go long if you’re not already long, because there’s a small possibility of a melt-up, and you wouldn’t want to miss that. But even if the melt-up scenario fizzles as expected, you may make a little money on the crawl up the channel top.
The Crawl Set-Up
If SPY breaks out of its 3-year pink price channel, and then you start seeing the price clinging to or recrossing that channel top, you can forget about the melt-up and just watch for any formation to complete that you can short when it breaks out downwards. The formation will most likely be one final rising wedge or rising megaphone.
If it’s a rising megaphone, on the final wave up everyone will be talking about how strong the market is looking.
The first target for the downward breakout would be roughly the October 15 low, though the move could get messy on the way.