• August 30, 2010

Just How Successful is the Head and Shoulders Pattern?

by Donald Harder

Our research on how stock patterns have fared since Thomas Bulkowski provided his wonderful research continues with the bullish inverted head and shoulders chart pattern.

As we mentioned in related articles, we decided to do our own research in order to see just how much things have changed since Bulkowski last updated his own research. It was our feeling that typical technical analysis has been losing its edge due to wide knowledge and usage of the subject. Our research has strengthened this suspicion. The interesting news is that our research has also uncovered hidden edges and opportunities that are as yet underexploited. So let’s get started.

A Head and Shoulders Bottom, or inverted head and shoulders pattern is a major reversal chart pattern that forms after a downtrend.

Bulkowski writes “Head-and-shoulders tops are the best performing bearish chart pattern in a bull market. Even in a bear market, they are reliable performers, but a pullback occurs nearly two-thirds of the time.”

It appears, however, that this pattern has lost its ‘oomph’ over the past few years, however, and it’s a big however, we have uncovered an unusual trading opportunity with the head and shoulders top as we will discuss below.

We researched the success rate of this pattern over the past two years and we made the following assumptions:

• A successful move is one that extended at least 10% after the breakout
• A failed move is one that broke through the right shoulder resistance of the pattern without first dropping 10%.

In addition to the chart pattern, we made the assumption that the success or failure rate would be tied to the performance over the overall market and the volume on the breakout, so we measured each individual stock’s volume and we juxtaposed each stock against the following S&P 500 factors:

• Investor sentiment level (overly bullish +75, overly bearish +30)
• Strength of market trend (ADX +30 = strong trend)

Results:

Overall Success Rate: 40%

Volume:

We found no significant correlation between success or failure and volume.

Sentiment:

We found no significant correlation between success or failure and market sentiment.

Trend Strength:

We found no significant correlation between success or failure and the strength of the trend.

Conclusion:

Selling short when the price breaks the neckline does not offer a profitable trade with only 40% of the breakouts moving 10% or more. Keep in mind the market has been in an uptrend for almost two years now. When the market moves back into a downtrending situation these numbers will no doubt change.

Hi Probability Trade:

We did, however, find a high probability trade with this pattern. A whopping 71% of all failed breakouts led to an upward move of 10% or more. Most failed moves, in fact, led to new price highs resulting in gains significantly more than 10%.

The bottom line is that this pattern offers a very profitable contrarian trade if you buy after the neckline is re-pierced from below after the price has failed to move significantly lower.

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