This Pattern May Be Old, but It Still Works

The head-and-shoulders (H&S) top is one of the best-known patterns in technical analysis. This pattern was first written about in 1930 by a financial editor at Forbes magazine that described how the H&S forms and how it can be traded.

Many readers are familiar with the H&S pattern. On a price chart, there will be three peaks in price at the end of the uptrend, with the center peak (the head) being higher than the other two. The peaks on the sides (the shoulders) should be about equal in height.

Connecting the bottom of the peaks gives us the neckline, and breaking the neckline is the sell signal. Real H&S patterns rarely resemble the precise line diagrams seen in books, and the chart below shows one that occurred in real market conditions. The shoulders are nearly, but not quite, the same height.

USD Chart

The problem with charts is that their interpretation is subjective. Many traders find an H&S in almost every chart they look at because some traders tend to see what they want to see.

Because traders see what they want to see, results vary. Some may find success looking at charts while others will suffer losses.

Using software, we can develop a precise definition of the pattern that avoids the inconsistency of less rigorous approaches. This definition can become complex.

For example, an MIT professor explained that an H&S pattern is a date series where "the magnitudes and decay pattern of the first twelve autocorrelations and the statistical significance of the Box-Pierce Q-statistic suggest the presence of a high-frequency predictable component in stock returns." 

This definition isn't practical for most traders to use because most of us don't know what all those words mean. However, by using definitions like that, objective studies can be done to determine if the pattern works.

The first study on the H&S pattern was done by economists at the Federal Reserve Bank of New York. The researchers wrote:

"Though such visual, nonlinear chart patterns are applied frequently by technical analysts, our paper is one of the first to evaluate the predictive power of such patterns... We identify head-and-shoulders patterns using an objective, computer-implemented algorithm."

The results show "profits would have been both statistically and economically significant."

Studies like this show us that old ideas can be valuable in the market when those ideas are defined precisely and followed with a disciplined approach.

Another old idea in the markets is to buy stocks that go up. During the Great Depression, the entertainer Will Rogers supposedly told his audience, "The way to make money in the stock market is to buy a stock. Then, when it goes up, sell it. If it's not going to go up, don't buy it!"

Rogers was being funny, but we have found similar advice in other books and realized that we can actually follow that advice. Relative strength (RS) is a tool that allows us to find stocks that are going up.

The way to make money is to buy stocks with high RS and sell them when the RS turns down. RS can be precisely defined, programmed and tested. It can also be applied in real time to make buy and sell decisions.

Using this indicator, you could have captured a large gain in Best Buy (NYSE: BBY), one of the biggest winners among stocks in the S&P 500 index in 2013.

BBBY Stock Chart

In this case, the buy signal would be given after the stock starts moving up and the sell signal comes after the decline stalls.

We have found that successful trades like this can be found by using a disciplined approach to trading. The H&S pattern can be traded using only charts, but many traders would be better served by defining the pattern in a software package to help avoid buying and selling based on what they think they see.

The same is true for any trading tool. Some of the best ideas for traders have worked for decades. Those tools can now be applied consistently and objectively with automated processes that should increase profits.

Note: Personally, Michael prefers to use a little-known, 81-year-old trading strategy. The annual compounded growth rate for this simple strategy was 20.1%, compared with just 8.5% for the S&P 500. That's 236% better. Learn more by clicking here.

Traders have very few tools to evaluate volatility on individual securities. This one offers clear and timely signals.

When combined with moving averages, this momentum indicator can provide timely signals on very short-term charts, making this tool a favorite of day traders.

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