To print article, click
Print on your browser's File menu.
Go
back
Posted
7/25/2002 |
Related Resources
What
stocks are hot or not?
What
are the top-performing
industries?
Related Sites
"Identifying
Noise Traders: The Head-and-Shoulders Patterns in U.S.
Equities"
The
Speculator
Recent articles:
• 5 ways to give
acquisitions the inquisition, 7/18/2002
• We blinked
when we should have bought, 7/11/2002
• The market's
shaken, rattled and ready to roll, 6/27/2002
More...
|
|
| sponsored by: |
 | |
The Speculator
Don’t bet the rent on technical
analysis
Common sense sits head and shoulders above even the most
widely accepted charting strategies. Here are the numbers to prove
it.
By Victor
Niederhoffer and Laurel Kenner
In times of great disaster and stress, we like to
think of great ship commanders and generals heading toward their
goals with cool calculation while the guns are blazing. Therefore,
rather than succumb to the temptation to join in the general angst
as Americans watched their lives pass before their financial eyes on
Tuesday, we tried to stay calm in order to figure out how to survive
and make our next buck. Among other things, we were thinking about a
post that came across our monitors two weeks from a hedge fund
manager whom we call Miss X.
“The technical
action in the S&P since the big-cap rally last week is being
threatened by a massive head-and-shoulders going back to January
1998,” she wrote. Since then, the S&P took out the January 1998
low and headed straight down to April 1997 levels. On Tuesday, it
broke through 800.
Our correspondents point out that if one
uses the classic Edwards-Magee head-and-shoulders method to project
the “downside target” for S&P futures, 540 or so is the likely
next stop. As for the Nasdaq 100, it’s headed for negative 2,690
under the same method of reckoning.
Does the apparent success
thus far of Miss X’s gigantic pattern mean that head-and-shoulders
trading works? More to the point, how does knowing this help right
now, as the foundations of the financial world appear to be
crumbling?
Worthless nostrums and
superstitions
First of all, it always helps to know what
works and what doesn’t. In times of plague, worthless nostrums and
superstitions flourish. It’s important to keep a clear head and take
the long view.
As to whether head-and-shoulders patterns
work well enough in the stock market to be profitable -- they don’t,
as we’ll show.
Head-and-shoulders trading has been around
since before 1930. The pattern consists of three peaks, the highest
being in the middle. A horizontal line -- the “neckline” -- is drawn
to connect the troughs between the shoulders and the heads. The
crossing of the neckline is supposed to signal that prices will
continue down away from the head. An inverted pattern is read as
bullish.
45 years of
testing
We’ll start by saying that we avoid all vaguely
defined “technical” indicators requiring visual evaluation by a
gifted interpreter. Moreover, in 45 years of trading, Vic and his
staff members have tested every indicator to which value is
ascribed. If it works, he would be using it. Head-and-shoulders
trading is a trend-following strategy -- and as we have explained,
“the trend is not your friend.” We believe that any wealth that
accrued to Miss X over the past two weeks as a result of trading
this pattern -- and we do congratulate her for it -- was a lucky
event, not a sure indicator of future success.
However, any
important question deserves to be tested, and the results made
public. Haphazard anecdotes, confident assertions and appeals to
authority -- even, or especially, our own authority -- will not do.
As Steve Stigler writes in his magisterial “Statistics on the
Table:”
If a serious question has been raised, whether it be in
science or society, then it is not enough merely to assert an
answer. Evidence must be provided, and that evidence should be
accompanied by an assessment of its own reliability. We have
tested the head and shoulders strategy on S&P 500 futures and
will report the results below. But we also will take the opportunity
of passing along to our readers the results of a remarkable study by
Carol Osler of the New York Federal Reserve that concluded
head-and-shoulders trading in individual equities is, on balance,
unprofitable.
Osler’s tests were rigorous, and she presented
her conclusions with great clarity in a study called “Identifying
Noise Traders: The Head-and-Shoulders Patterns in U.S. Equities.”
Osler wrote a computer program to identify
head-and-shoulders patterns, based on the descriptions in eight
technical manuals. She applied it to 100 companies with price data
spanning July 2, 1962, to Dec. 31, 1993, selected at random from the
Center for Research on Securities Prices at the University of
Chicago.
All of the manuals were ambiguous about the criteria
for exit, but they agreed that a head-and-shoulders pattern
signified a major change of trend. Osler therefore wrote her program
to require that a position be held until the price stops moving in
the predicted direction, with a stop loss of 1%.
Irrational speculation
Her conclusion:
Head-and-shoulders trading is unprofitable and “does not qualify as
rational speculation.”
Amazingly, head-and-shoulders trading
is quite popular. Osler estimates that such trades account for as
much as one-quarter of an average day’s volume around the time of
the “neckline crossing,” the signal to put on a trade.
How to
account for the popularity of an unprofitable trading strategy?
Certain peculiarities of the human mind may account for its
acceptance, Osler says. People are prone to see nonexistent
connections between groups of things. They tend to be overconfident
in their own judgment. And they remember pleasant or successful
experiences (e.g., profitable head-and-shoulders trades) with far
greater clarity than they do unpleasant experiences.
A few
successes may bring the head and shoulders trader fame and funds,
encouraging new entrants. As Osler notes, cognitive psychologists
have shown through experiments that beliefs and behaviors are
difficult to “extinguish” when they are randomly reinforced.
Osler’s data ends in 1993, and we wondered whether the
picture might since have changed. Fortunately, we were able to
interview her earlier this month. She told us that she is updating
the database.
We have heard many market players say they
don’t believe in head-and-shoulders trading or any other technical
analysis patterns, but like to know what such traders are doing so
they can eat their lunch. Not likely, says Osler. Even before
transactions costs, trading against head and shoulders traders is
just not profitable in individual stocks.
Next month, Osler
will leave the Fed to take a professorship in the international
economics and finance department at Brandeis, where she plans to
research the role of stop-loss and take-profit orders in the
currency market. One area of interest is the possible clustering of
orders at round numbers. She doesn’t have any plans to extend her
head-and-shoulders work to S&P futures. “Technical analysis is
just not a hot topic,” she explained. “It’s not the sort of thing
you can make a big splash with.”
Follow the algorithms
Always ready to
jump into the breach, we tested the head and shoulders strategy on
S&P futures prices beginning in 1996. Shi Zhang, Vic’s
computation assistant, wrote a program based on Osler’s description
of her head-and-shoulders algorithm.
Zhang’s program looked
for six points on a bearish head and shoulders pattern -- the right
shoulder, the right trough, the head, the left trough, the left
shoulder and “neckline” crossing. The time between points had to be
at least five days and no longer than 180 days. Various distances
were used to make sure that no patterns were missed.
After
running his computer nonstop for 10 hours, Zhang came up with seven
patterns, which he then evaluated for profitability 1, 2, 3, 4, 5,
10, 20, 30 and 60 days out. The results appear below:
| Number of days after neckline
crossing |
|
1 |
2 |
3 |
4 |
5 |
10 |
20 |
30 |
60 |
| Average profit/loss |
0.3% |
1.6% |
1.2% |
1.1% |
1.3% |
-0.7% |
0.7% |
-0.2% |
-2.6% |
| Standard Deviation |
0.01 |
0.03 |
0.01 |
0.02 |
0.02 |
0.02 |
0.02 |
0.04 |
0.1 | |
We
conclude that head-and-shoulders trading does not work either as a
signal of a trend change or as a profitable strategy.
We
will therefore go back to picking up good stocks at prices unseen in
five years, and we’ll try to restrain ourselves from using the rent
money.
End Note
As we went
to press, we received an e-mail forwarded by our friend and fellow
columnist, behavioral finance expert Brett Steenbarger, from Scott
Larson, an assistant professor at National-Louis University.
Professor Larson has been studying the number of companies that are
selling below their cash and marketable securities minus total
liabilities. He has counted 200 companies. Some, alas, are bankrupt,
but he found some with positive cash flows. “Anytime I can buy cash
for 80 cents on the dollar, I need to start thinking about getting
bullish,” he wrote. As we have not evaluated the list, we will pass
his findings along to readers who wish to perform their own
detective work along those lines.
|
