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BASIC TECHNIQUES
Reversal Formations:
Predictive Power?
by Alex Saitta
Do classic chart formations such as the head-and-shoulders or the double bottom/double top hold up to close scrutiny? Here's a look at a test of these two formations in the Treasury bond futures market.
A few years ago, I read a Federal Reserve Bank report entitled "Head-and-shoulders: Not just a flaky pattern." The authors of the piece had rigorously tested the profitability of a trading strategy based on the head-and-shoulders pattern in the foreign exchange market. The results indicated the head-and-shoulders had some predictive power for the German mark and the yen.
I was taken by the study's objective approach to what has always been looked upon as a subjective pattern. I wondered if tests of the head-and-shoulders as well as of the double top/bottom would yield similar results in the Treasury bond futures market.
APPROACH
I started with the head-and-shoulders pattern. My definitions and approach are somewhat similar to those used in the Fed's study. My definitions are:
- Reactionary high: A reactionary high is a local maximum price, which is more than 1 point or 32 ticks above the previous reactionary low.
- Reactionary low: A reactionary low is a local minimum price, which is more than 32 ticks below the previous reactionary high.
For example, in Figure 1, the moment the market drops more than 32 ticks below the initial peak, that peak is labeled a reactionary high. Following the market, the downmove continues for a while before it ends. After the market rises 32 ticks, the end of the downmove is considered a reactionary low. Successive reactionary highs and lows are labeled this way as the market swings up and down more than 32 ticks.
FIGURE 1: REACTIONARY HIGHS AND LOWS. Once the market has reached a level of at least 32 ticks below the initial peak, that initial peak is labeled a reactionary high (H). When the market turns, and then rises at least another 32 ticks, the end of the down move is labeled a reactionary low (L). This labeling process is continued for each alternating 32-tick change or more.
Alex Saitta is a vice president of Salomon Smith Barney. Yuxin Li provided research assistance.
Excerpted from an article originally published in the November 1998 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 1998, Technical Analysis, Inc.
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