“Why is nobody talking about the inverse head and shoulders,” an acquaintance named Craig Lucas said off the cuff as I was about to leave his home. I had just spent the previous 3 hours listening to some sage wisdom on the role fibrinogen plays in stopping a bleeding wounding. I wasn’t altogether sure if he was changing the subject to scoliosis or if he knew something about the stock market.
“Right,” I said with a lengthy pause giving him time to explain as I desperately tried to conjure an image of the SPY.
“I mean," he continued, "the S&P 500 is making an inverse head and shoulders pattern but I’m not hearing a big buzz about it”. It was at that moment that I discovered we shared a passion for trading. Thanks for the article idea Craig.
The Head and Shoulders Pattern
The head and shoulders pattern is not some flaky concept without any evidence to back it up. I will reference one recent paper called, The Predictive Power of “Head-and-Shoulders” Price Patterns in the U.S. Stock Market, by Savin, Weller, and Zvingelis – the revised version of October 19, 2006.
They found that the head and shoulders pattern does have some predictive power, particularly as a continuation pattern for low momentum stocks. Momentum theory states that stocks underperforming over a period of 3, 6, or 12 months will continue to do so. Thus, some of the gains of the head and shoulders pattern could be attributed to momentum. The HS pattern is sort-of acting as a signal for the next leg down. But momentum does not explain all of the price moves. It seems there is some excess gain tied directly to the pattern for some reason.
- How did these researchers trade the pattern?
When the prices crossed the neck-line, they shorted and held for 20 and 60 days. They were able to achieve excess gains around 5-7% when averaged over the year. This may not sound like much, but to consistently beat the risk-free rate of T-bills by 5-7% is no small feat. Especially is this true when trying to program chart recognition patterns into a computer algorithm.
*One other interesting point in the article is that the paper breaks the excess gains down using the 3 Factor Model by Fama and French. Thus you can see how much profit is attributed to value and size, as well as the aforementioned momentum.
The Inverse Head and Shoulders Pattern
The S&P 500, or the SPY, is sitting almost on the neckline as of when this article was written. Granted, the pattern isn’t perfect, but it could very well be a continuation pattern from the high momentum gains since the beginning of September.
It just so happens that pattern is happening right on the resistance of the low 1340’s. As we sit with bated breath with an inverse head and shoulders staring me in the face, I feel there is a strong chance that the next week in the market will deliver an upwards pop. From there, the next 20 to 60 days should be nice bull trading.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.