The Validity of Head and Shoulders Patterns

At Friday’s close, technicians were generally pretty bearish on equity indexes, based on the head and shoulders pattern identified below. (Click images to enlarge.)

spx-7-10-09

Of course, this particular setup hasn’t panned out well so far:

spx-7-15-09

In the jargon, this week’s rally decisively violated the neckline and pushed up to attempt a retest of the right shoulder. I am unsure whether there are any vaunted technical analysis conventions allowing for mutant patterns featuring two right shoulders, but yesterday’s move certainly sent some analysts scrambling.

Long time readers know that I’m not the world’s greatest fan of technical analysis (TA), at least as it’s practiced by a majority of its proponents. In trading, subjectivity is your enemy, not your friend, and far too many technical analysts rely on interpretive, intuitive, and unquantifiable factors when making decisions. Contrast this with what David Aronson calls evidence-based technical analysis, that is, analysis that can be formalized and tested empirically on historical data by a computer. Subjective TA strikes me as an unverifiable waste of time and money; any particular objective TA indicator might also be useless, but will have the insuperable advantage of being testable on that point.

Head and shoulders patterns like the one above might look like perfect candidates for dismissal as subjective bunk. But apparently in 2000 Andrew Lo and some colleagues developed an approach for automatic pattern recognition of some favorite setups from the world of subjective TA. The literature since then has been mixed on H&S patterns, with criticism from Carol Osler and support from Savin et al. Depending on whom you believe in that literature, this most recent failed pattern might be the exception that proves the rule.

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Jared Woodard specializes in trading volatility as an asset class. With over a decade of experience trading options and other volatility products ... Read More

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