Yesterday’s Bat pattern reversal we expected has confirmed this morning.  SPX, currently down 7.42, was off as much as 11.90 just after the opening.

Bat patterns complete following a .886 Fibonacci retracement of a significant move — in this case, the 1422 to 1357 drop from April 2 to April 10.  88.6% of that drop was 1414.97, and we exceeded it just slightly before the market reversed course (at 1415.32.)

Cash short positions established at 1415 were up almost 1% this morning.  At-the-money puts bought when SPX hit 1415 were up at least 100%.    If you bought a few, congratulations!  Your pebblewriter membership just paid for itself.

The tricky thing with harmonic patterns is how much of a reversal to expect.  Some harmonics traders, therefore, practice scalping — establishing a position just before the expected reversal (with appropriate stops) and taking a profit shortly after.  This can be very profitable and, if done properly, entails little risk.

The other method is to use these reversals to establish longer-term swing or momentum trade positions.  This method works well if there is a reason to believe the position has more room to run; i.e., other chart patterns or technical analysis hint at a continuation of the new trend.

If you’ll indulge me, I’ll walk us through my thought process.  It doesn’t always work, but it provides a useful framework for the scalp/swing decision.

In this case, the dominant chart pattern is the H&S pattern that completed but didn’t play out back on April 23.  We would expect a busted H&S pattern to go up and take out the head — 1422.  But, this pattern has continued to loiter, and now reverse, at the shoulder line already established.

For that reason, it’s quite possible we’re establishing a complex H&S pattern, which simply means there are more than one shoulder on each side.  There are two shoulders on the left, although they’re not perfectly formed.  But, good enough?  Probably.

We can’t put a number on it, but I did observe the other day that the pattern would be balanced time-wise by today.  While not an absolute requirement, balanced right and left shoulders contribute to a more reliable pattern IMO.  In other words, if the pattern is going to play out, it had better get on with it.  A substantial delay increases the odds that the alternate path to 1462 plays out — without a trip to the low 1300s.

The other chart pattern I’ve written about a lot these past few days is the RSI channel.  Along with the Bat pattern, it correctly forecast yesterday’s turn as a back test of the major trend line (yellow, dashed) running through the middle of the chart.  Note that it can be viewed as a system of fan lines originating from August 8 when SPX had nearly completed its initial 246-point plunge [see: Analog.]  We’ll label this point “a.”

Point “a” was just a point until the Oct 4 1074 bounce.  With the addition of a “b”, we had a trend line/fan line.  The bounce at “c” more or less confirmed it.  Shortly after, we broke the fan line and fell to “d.”

Line a-d now becomes a new fan line, though SPX would go back up and back test line a-b starting at point “e” and continuing for months — until point “g” in February.  Along, the way, a new line was established at “f” — which correlated with the 20-point Dec 19 plunge.

Point “f” established both a new channel (line d-j) and would also serve as the origination point for new fan line f-g that, together with a-g, would form a rising wedge within RSI.  The break and back test (at the apex) of that rising wedge would mark the topping out of RSI, and thus the beginning of the serious divergence that would begin to drag on the bull run.

Note that the 1422 high didn’t occur when RSI peaked at “g” or even later at “j.”  It came at “1” — 4 little peaks later.  Of course, “j” wasn’t just another little peak.  It was a back test of the channel created by d-j and followed a major dip to “i” that correlated with a 23-point drop on Mar 6 — further defining the SPX rising wedge.

Point “i” also helped establish the downward-sloping channel (red, dashed) on which I’ve been so focused lately.  The dashed fan line from “i” to “1” (the SPX high) provided a clue as to the drop to come — since “1” was established during a back test of that line.  When fan line i-2 was broken, it was followed by a 65-point drop in SPX.  And, the corresponding “k” in RSI helped validate the current channel.

Note that i-3 is a third fan line and is simply a segment of the major a-i fan line.  Its back test is what we’re trying to complete right now.  Will it be a short, sweet back test like point “j”, or a long, drawn-out affair like the period from “e” to “g”?

All channels work forever…until they don’t.  So, there’s no guarantee that this one will contain SPX’s moves going forward.  The key points I’ll be watching are the fan line k-4, which was established by the Apr 23 neckline tag (and H&S completion.)  A break of this fan line would really help the bearish case — while a RSI move up through “3” would be bullish, establishing k-4 as the lower bound of a new upward sloping channel.  In fact, a break up and out of the channel at any point would be bullish.

If we do break beneath k-4, the next major fan line is a-k.  Both prior major fan lines got two bounces before they gave way — a common occurrence, so it’s entirely possible this one will, too — especially if it’s still within the channel.

So, which is it?  Will the new channel hold, or will the alternate case play out?   The bulls have their work cut out for them, as an upward move to the apex means not only breaking out of the channel, but through the solid, purple trend line that dates back to November of 2010.  This same TL (or its lower parallel) figured into the reversals on Feb 18, May 2, July 7 and Oct 27 in 2011 — some pretty good company.

The break above it from Jan 9 to April 4 2012 ushered in the 1280 to 1422 melt up.  We broke below it on April 4 — the SPX high — and have back tested it twice in the past week (the highlighted area.)  All things being equal, I suspect it would be much easier to break out of the red, dashed channel than above this TL.

If I haven’t put you to sleep yet…

Therein lies the reason I’m still clinging to the analog as my top scenario and the alternate case as just an alternate.  I think the bullish case is stretched very thin, meaning SPX needs to pull back and gather momentum if it’s going to take a run at 1462-1472.

At these levels, it would have to bull its way through that purple TL in an already extended state.   The much easier way of achieving a higher high would be to go down and bounce off line a-k — corresponding to the low 1300s in SPX — and zip back up to the purple trend line.

A new high on SPX at the century mid-line around 1462-1472, combined with a lower high on RSI would establish another significant divergence that just might unravel the bull run in a much bigger way.  More on that later.

Conclusion:

We started off with the question of whether to scalp or swing.  It’s largely a matter of wits and nerves.   The market is consolidating now, trapped in the channel created by the shoulder line and neck line of a H&S pattern — which is the perfect environment for day trading and/or scalping.

But, one of these days, it’ll break out.  If it’s to the upside, that’s 60-70 points of swing trading that could be very profitable.  If the downside, I expect a swift 80-100 points.  When it does, swing traders will be very happy campers.  Scalpers will be kicking themselves for settling for a lousy 100% return.

Either way, these are the charts we’ll be watching.  It should be exciting!

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BTW, there are still about 12 hours left until the introductory pricing on pebblewriter.com runs its course.  Current Followers get $100 off the price of an annual membership.  And the first 100 annual members, regardless of whether they’re a Follower or not, will have their current annual subscription price grandfathered for the life of the site.

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P.S.  I promise not every post will be this dense.  Some of you want to know what time it is, not how a watch works.  But, there are plenty of guys out there who, for a small fee, will tell you whether the market’s going up or down.   My goal is to teach you why and, together, to discover new ways to make sense of it all.

Good luck to all.