Okay, SPY broke out downwards through its blue megaphone bottom and downwards through all of its purple megaphone VWAPs.
That means we now know that SPY is headed all the way to its silver and purple megaphone bottoms at roughly 176-176.50 (depending on when it gets there). This means SPY is likely building a significant top, but that we have probably not yet seen the high before the big correction.
There are some mandatory retraces on the chart coming up. First, SPY must retest its blue megaphone VWAP at roughly 183.65. It can reverse hard before going much lower and go straight up to it before completing the move to the purple megaphone bottom, or it can finish the trip to the purple megaphone bottom and then return to 183.65.
If SPY returns to the 183.65 blue megaphone VWAP before reaching the purple megaphone bottom, it will still need at least a retrace to the purple megaphone VWAP after reaching the purple megaphone bottom. Right now that VWAP is at roughly 181, though that level may change if SPY spends a lot of time near the purple megaphone bottom.
SPY can then reverse at the purple megaphone VWAP and crash down out of the purple megaphone bottom (purple or green scenarios on chart above). But it’s more likely that SPY will return to the purple megaphone top. Then it will either break out of the purple megaphone top, form a topping formation along the top, and reverse hard, or it will return to VWAP after reaching the top and reverse there for a major breakout through the purple megaphone top (pink and orange scenarios on the chart).
SPY Donchian/Turtle Short Signal
SPY broke out downward from its 20-day price channel Friday (dark green on chart below) when it got pushed down through roughly 181.20. That triggered selling from a lot of Donchian and Turtle-type system traders. That selling was what pushed SPY through its purple megaphone VWAP.
You see a lot of these Donchian/Turtle 20-day price channel downward breakouts in the dip before the head of head and shoulders formations. (If you back test this type of signal, you’ll find it only pays off roughly 1/3 of the time, but is still profitable because the size of the payoffs is so large relative to the losses when you get stopped out.)
After one of these signals you generally see some follow-up selling from system traders who only check their charts at the end of the day. Then the market tends to move up again to eat these traders’ stops. That buying tends to propel the market through other critical stops, and much of the trip into the head of the H&S is essentially a short squeeze. Once the market breaks out past the old high, it triggers buying from these same system traders and more stop eating from shorts who placed stops a little beyond the old high.
On a long-term chart, it may look something like this:
ES Suggests an Overnight Swoon
The ES megaphones require a much deeper drop than the SPY megaphones require, suggesting a significant overnight swoon coming up that you may wish to take advantage of if you trade futures.
Watch Out for Interior Megaphones at Megaphone VWAP Areas
The reason the megaphone and interior megaphones on the above charts have been forming is that sophisticated traders are using every opportunity to sell off large positions without driving down the price too much. That means we’re likely to continue seeing interior megaphones form around megaphone VWAP areas and tops and bottoms. We will also see interior megaphones spawning their own interior megaphones.
It’s generally a good idea to avoid over-trading the middle of a megaphone. If you got out of long positions on the breakdown from the small orange interior megaphone the other day, just stay out until the price reaches the purple and silver megaphone bottoms. Try to reenter your long position on another breakout of some kind, such as an upward breakout from a bottoming formation down there.
If you’re still holding long-term long positions, I’d ride out this drop until at least a retest of the purple megaphone VWAP, wherever that turns out to be at that time. Depending on what happens there, I’d ride out longs to the purple megaphone top, and watch the action there.
Signal to Just Jump Ship
A genuine breakout downward through the trend line from November 15, 2012 to today (navy blue on middle chart above) would be a warning to just jump ship. But be careful, because we’re likely to see a small fake breakout through that trend line on this dip.
A sign of a fake breakout would be a surge in volume on a break of that line without a large move in price, followed by a recrossing of the trend line upward and no follow-up selling past the original breakout low.