Excess return following buy signals from inverse head and shoulders formations

Published 12 November 2019

Geometric price patterns are used in technical analysis to predict future price development. New research results from Investtech show that annualised excess return following buy signals from inverse head and shoulders formations in the medium term was 13.7 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. Inverse head and shoulders formations are one type of such patterns.

An inverse head and shoulders formation indicates that investor optimism is increasing and that the stock enters a rising 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, inverse head and shoulders formations are shown by code IHS and a green upwards arrow. The arrow shows theoretical price target. A current example may be American Express CO, which triggered a positive signal from an inverse head and shoulders formation on November 6th.

Figure 1: American Express CO. (AXP.US) Close: 120.90 (-0.57), Nov 11, 2019

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

We wanted to study the statistical results yielded by these buy signals 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 buy signals from inverse 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 blue line shows the development of buy signal stocks. The shaded areas are the standard deviation of the calculations. The thin blue line shows benchmark development in the same period as the buy signal stocks.

Buy signals from short term inverse head and shoulders formations have given an excess return of 1.2 percentage points after the first month, which equals an annualised excess return of 9.8 percentage points.

Buy signals from medium term inverse head and shoulders formations have given an excess return of 1.2 percentage points after three months, which equals an annualised excess return of 5.2 percentage points. However, after 22 days, return is 2.4 per cent for signal stocks, equal to 1.0 percentage points excess return compared to benchmark. This gives an annualised excess return of 13.7 percentage points.

Buy signals from long term inverse head and shoulders formations have given an excess return of 2.4 percentage points after three months, which equals an annualised excess return of 10.5 percentage points.

It seems most likely, with relatively high statistical significance, that buy signals from inverse head and shoulders formations in Investtech’s price charts indicate future good absolute return and excess return compared to benchmark.

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