Head and Shoulders Trading Strategy: Backtest and Example for a Tactical Approach
We were not able to 100% quantify a head and shoulders trading strategy. The formation is too difficult to put down into specific backtest rules. However, we were able to find some statistics done many years ago by Thomas Bulkowski and this serves as a proxy for our backtesting.
Some investors and analysts turn to technical analysis and chart patterns to analyze price movements and determine the right time to place their trade orders, and one of the most common chart patterns they focus on is the head and shoulders pattern. Let’s take a look at this chart pattern.
The head and shoulders pattern is a chart pattern formed by three consecutive price rallies and two intervening pullbacks, with the second rally being the highest among the three. The pattern, when seen in an uptrend, is considered a bearish reversal sign, indicating that the uptrend is about to turn into a downtrend.
Want to know more about this chart pattern, its inverse type, and how to analyze them? Keep reading.
What is the head and shoulders pattern?
A head and shoulders pattern is a chart formation used in the analysis of price movements to indicate a potential reversal in the direction of price. The pattern is based on historical price action — chartists study previous price swings to know if they form a shape that looks like a head with a shoulder on either side.
A typical head and shoulders pattern is characterized by an initial rally to a peak (the first shoulder) followed by a short swing low. This is followed by another rally to a higher peak (the head), and then, the price falls again to around the previous swing low before rallying to a third peak (the second shoulder) at about the same level as the first peak. Theoretically, this third peak (the second shoulder) indicates the end of the uptrend, as the price fails to make a higher high, and the potential beginning of a downtrend or a prolonged decline in price. But this cannot be confirmed until the price falls below the support level formed by the previous swing lows, also known as the neckline, which implies that the price has a consecutive lower high and lower low — the characteristics of a downtrend.
Thus, the head and shoulders pattern is a predictive chart formation that usually indicates a reversal in the trend, as the market makes a shift from bullish to bearish direction. It has long been hailed as a reliable pattern that predicts trend reversal. Both traders and analysts often use the pattern to determine primarily whether a downward trend is likely to take place. While the chart pattern is most commonly used on stocks, it is also popular in foreign exchange, commodity, and cryptocurrency trading.