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Chart: How to trade the S&P 500's W-pattern

A screen displays news on the Dow Jones Industrial Average on the floor of the New York Stock Exchange, Oct. 15, 2014.
Brendan McDermid | Reuters
A screen displays news on the Dow Jones Industrial Average on the floor of the New York Stock Exchange, Oct. 15, 2014.

Over the past few weeks there has been an inconsistency in the US indexes; the behavior of the Dow Jones Industrial Average and that of the S&P 500 and Nasdaq differed.

The Dow developed a pattern usually associated with an uptrend ending, suggesting traders should sell short. The S&P and Nasdaq, meanwhile, have just showed a pullback in the context of a strong uptrend. A pullback is associated with a buying opportunity on the long side.

This is a two-to-one vote in favor of a pullback and rebound so traders waited for evidence of the rebound before entering new long positions — and a new rebound pattern has emerged and been confirmed on the S&P 500.

This is a W pattern. The left side of the pattern was created on August 25 with a plunge to near 1,870 points. The rally and subsequent retreat is an integral part of this W pattern.

Aggressive traders went long around 1,900 in anticipation of the rally moving above the pattern high near 2,000. Conservative traders waited for confirmation the rebound rally to close above 2,000. This higher close confirms a higher probability that this is a W pattern.

The rebound rally has a significant resistance level to overcome before it can reach the projected target for this type of pattern. The projected target is calculated by measuring the height of the middle of the pattern from the support level to the middle peak of the pattern – the center of the W – which is shown as point A on the chart.

When this value is projected upwards from 2,000 it gives a value near to 2,125. This is the resistance level that constrained the rise in the S&P from May to July 2015.

But the S&P must first move above the lower edge of the long-term support level – now a resistance level - near 2,040. A move above 2,040 is also a move above the upper edge of the long-term Guppy Multiple Moving Average on the weekly chart.

The move towards 2,125 will not be smooth so traders should anticipate volatility as the S&P moves towards this target level. This signals a resumption of the longer-term uptrend but the pattern of behavior also indicates longer-term uptrend weakness. In the longer-term traders monitor how this W rebound pattern may develop as part of a much larger end-of-up-trend pattern that could develop over three to six months.

Note: A W pattern is a rebound pattern following a trend correction. A double-bottom pattern develops after a significant, prolonged trend change and signals a new long-term uptrend.

Daryl Guppy is a trader and author of Trend Trading: The 36 Strategies of the Chinese for Financial Traders, available at www.guppytraders.com. He is a regular guest on CNBC Asia Squawk Box and a speaker at trading conferences in China, Asia, Australia and Europe.