Variable predictive power in sell signals from head and shoulders formations

Published 12 November 2019

New research results from Investtech show that sell signals from head and shoulders formations appear negligible in the short term, but give some negative excess return in the long term. In the medium term, they gave an annualised negative excess return of 9.8 percentage points in the period 1996-2018.

Identification of geometric price patterns in stock prices is an important area of technical analysis. The idea is that these patterns describe the investors’ mental state, i.e. whether they will want to sell or buy stocks in the time ahead, and they thereby indicate the future direction of the stock price. Head and shoulders formations are one type of such patterns.

A head and shoulders formation indicates that investor pessimism is increasing and that the stock enters a falling trend. Formations like this are considered some of the most reliable formations in technical analysis. They are used to predict long term market trend reversals, but are also used in the shorter term.

Investtech’s algorithms identify such formations for you. In our price charts, head and shoulders formations are shown by code HS and a red downwards arrow. The arrow shows theoretical price target. A current example may be Tetra Technologies, which triggered a negative signal from a head and shoulders formation on November 8th.

Figure 1: Tetra Technologies, In (TTI.US) Close: 1.46 (-0.08), Nov 11, 2019

Our subscribers can find stocks with these negative signals using for instance the tool Signals.

We wanted to see what statistical results these sell signals have yielded and therefore studied return from Norwegian, Swedish, Danish and Finnish stocks following buy signals from inverse head and shoulders formations and sell signals from head and shoulders formations identified in Investtech’s price charts in the short, medium and long term. We had up to 23 years of data, from 1996 to 2018.

The chart below shows average price development following sell signals from head and shoulders formations identified in Investtech’s medium term price charts in the Nordic markets. The signals are triggered on day 0. Only days when the exchange is open are included, so 66 days equal approximately three months. The thick red line shows the development of sell signal stocks. The shaded areas are the standard deviation of the calculations. The thin red line shows benchmark development in the same period as the sell signal stocks.

Sell signals from short term head and shoulders formations have given a negative excess return of 0.1 percentage points after one month, which equals an annualised negative excess return of 1.5 percentage points.

Sell signals from medium term head and shoulders formations have given a negative excess return of 0.2 percentage points after three months, which equals an annualised negative excess return of 1.3 percentage points. However, after 22 days (one month), return for signal stocks is 0.1 per cent, which is 0.8 percentage points less than benchmark. This gives an annualised negative excess return of 9.8 percentage points.

Sell signals from long term head and shoulders formations have given a negative excess return of 0.7 percentage points, which equals an annualised negative excess return of 2.6 percentage points.

The data sets are quite small and the difference in return from signal stocks vs benchmark is not convincing in all time perspectives.

It seems that signals from medium term head and shoulders formations are good signals for the next four to five weeks, with relatively good statistical significance. Sell signals from long term head and shoulders formations also appear to indicate future negative excess return vs average benchmark, while statistical measures suggest that short term sell signals are insignificant when it comes to predictive power.

Please find more details and results in the research reports here:

Inverse/Head and shoulders formations, short term

Inverse/Head and shoulders formations, medium term

Inverse/Head and shoulders formations, long term