Quick Glance at Head and Shoulders Pattern Statistics
Remember, this blog is like a whiteboard - we are kind of brainstorming here…
I am beginning to play around with quantifying the predictability of patterns, such as the head and shoulders pattern. There is a lot of analysis, running of data and thinking that needs to be done, but I wanted to talk a little about what I am seeing so far. To really understand the usability of certain patterns, you really need to slice and dice the data in various ways to understand what tendency the market/stock/index/whatever might have after a pattern presents itself. As an experiment, I pulled closing data from about a thousand stocks that I had over 10 years worth of data. Presently, I am just trying to get a handle on the H&S pattern across ALL stocks, so I figured I would ignore individual stocks and just look at some global numbers.
I decided to be very simplistic (and practical) and look at the seven day H&S pattern. I am making a HUGE assumption in this next step - I am assuming the general tendency of the pattern will play out within seven days (again, seven to match the length of the pattern). In the future, I plan on looking at days one through pattern length X 2 - or something of that nature - to give use a better understanding of how a pattern evolves once it is recognizable. So, here are some early numbers:
- The average stock showed a 7 period head and shoulders pattern every 349 trading days
- That equates to about .4% of all stocks having a head and shoulders of length 7 at any one time
Okay, those make sense. It seems that patterns like this are relatively rare.
- It seems that only about 400 stocks out of 1000 had a tendency to move DOWN seven days after an H&S pattern
Ooops…
The “head-and-shoulders” pattern is believed to be one of the most reliable trend-reversal patterns.
Okay, let’s dig just a little here:
- Of the 400 odd stocks that showed a tendency to go down after an H&S pattern, the average seven day loss was 1.7%
- Of the 600 remaining stocks that showed a tendency to go UP after an H&S pattern, the average seven day gain was 2.45%
Okay, that is just a little taste. I have plenty of work ahead of me to really see what is going on. Also, if anyone sees any problems in my logic or has questions about how I am calculating things - let me know. I am skipping a lot for ease on my part and trying to get to the deeper issues, but details can be important and that is where the mistakes can be made!
If there is no preceding trend, then why should we expect a trend reversal? If you are looking for price declines after the head and shoulders pattern completes, you need to identify the conditions where the stock has a preceding uptrend on the same timeframe as your h&s pattern. It would be interesting to see how that changes your results.
I surfed in here from Michael Taylor’s blog a few days ago. I like your blog and look forward to visiting it regularly.
Jon - thanks for pointing that out. I was under the impression that H&S patterns were Bearish, not just a “trend-reversal”. I found that quote on Investopedia -> http://www.investopedia.com/terms/h/head-shoulders.asp as I was writting up the notes. Hmmmm… Now I am confused, but your point is right on target. As part of a more comprehensive study, I can look at the trend before the H&S. But more importantly, I need to figure out the “accepted” view of what H&S is predicting.
For the purposes of head and shoulders analysis, I recommend we define a prior uptrend as a series of higher highs and higher lows (you can identify this with correlation too). A head and shoulders will have taken place any time there is one of these uptrends that turns into a downtrend (lower highs and lower lows). Draw with a pencil on paper a zig-zag up line followed by a zig-zag down line without taking your pencil off the paper– you will see a head & shoulders at the top. It becomes much more clear if you zig-zag like 10 higher highs and higher lows, followed by 10 lower highs and lower lows to make a mountain shaped drawing. As far as I know, that is the “accepted” view, although in practice it is always a lot more messy.
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[...] Dang it - I messed up that last experiment in looking at head and shoulders, so we will re-do it to see what difference it makes. Thanks for pointing out my, uh, ignorance! [...]