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Harvard Study on H&S Patterns

Harvard Study on H&S Patterns

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Published by Peter L. Brandt

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Published by: Peter L. Brandt on Jun 22, 2012
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07/10/2013

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HeadandShoulders:NotJustaFlakyPattern
C.L.OslerInternationalMacroeconomicsFunctionResearchandMarketAnalysisGroupTheFederalReserveBankofNewYorkP.H.KevinChangStemSchoolofBusiness
ABSTRACT
Thispaperevaluatesrigorouslythepredictivepowerofthehead-and-shoulderspatternasappliedtodailyexchangerates.Thoughsuchvisual,nonlinearchartpatternsareappliedfrequentlybytechnicalanalysts,ourpaperisoneofthefirsttoevaluatethepredictivepowerofsuchpatterns.Weapplyatradingrulebasedonthehead-and-shoulderspatterntodailyexchangeratesofmajorcurrenciesversusthedollarduringthefloatingrateperiod(fromMarch
1973
toJune
1994).
Weidentifyhead-and-shoulderspatternsusinganobjective,computer-implementedalgorithmbasedoncriteriainpublishedtechnicalanalysismanuals.Theresultingprofits,replicableinreal-time,arethencomparedwiththedistributionofprofitsfor10,000simulatedseriesgeneratedwiththebootstraptechniqueunderthenullhypothesisofarandomwalk.
 
Results:Thehead-and-shoulderstradingruleappearstohavesomepredictivepowerfortheGermanmarkandyenbutnotfortheCanadiandollar,Swissfranc,Frenchfranc,orpound.Nonetheless,ifonehadspeculatedinallsixcurrenciessimultaneously,profitswouldhavebeenbothstatisticallyandeconomicallysignif-icant.Takenindividually,profitsinthemarketsforyenandmarksarealsosubstan-tialwhenadjustedfortransactionscosts,interestdifferentials,orrisk.Theseresultsarerobusttochangesintheparametersofthehead-and-shouldersidentifi-cationalgorithm,changesinthesampleperiod,andtheassumptionthatexchangeratesfollowaGARCHprocessratherthanarandomwalk.Theseresultsareincon-sistentwithvirtuallyallstandardexchangeratemodels,andcouldindicatethepresenceofmarketinefficiencies.(JEL#F31,GJ2,
G14)
 
I.Introduction!
Technicalanalysis,thepredictionofpricemovementsbasedonpastpricemovements,hasbeenshowntogeneratestatisticallysignificantprofitsdespiteitsincompatibilitywithmosteconomists'notionsof"efficientmar-kets."Inthestockmarket,excessprofitsbasedontechnicaltradingrulesaredocumentedbyBrock,Lakonishok,andLeBaron(1992),andintheforeignexchangemarketsuchexcessprofitsarefoundbyDooleyandSha-fer(1984);Logue,Sweeney,andWillett(1978);Sweeney(1986);andLevichandThomas(1993).Testsoftechnicalanalysishavelargelylimitedtheirattentiontotech-niquesthatareeasilyexpressedalgebraically,namelyfilterrulesandmov-ingaverages.Practitioners,however,relyheavilyonmanyothertechniques,includingabroadcategoryofexclusivelyvisualpatterns.Typi-callyknownbyfancifulnames,thiscategoryincludes"headandshoul-ders,""roundedtops"and"bottoms,""flags,""pennants,"and"wedges."Highlynonlinearandcomplex,tradingrulesbasedonthesepatternsnor-mallycannotbeexpressedalgebraically.Thepurposeofthispaperistobeginevaluatingthislargesetofvisual
1
WearegreatlyindebtedtoPeterTordoforhelpwithimplementingouralgo-rithmsonthecomputer.TariqHaider,DennyWong,andKeithYanowitzpro-videdexcellentresearchassistance.WeacknowledgehelpfulcommentsfromseminarparticipantsattheFederalReserveBankofNewYork,Wharton,NewYorkUniversity,andLondonBusinessSchool.
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