Basic Techniques  |  NOV 1998

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. 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 Trea-sury 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.

by Alex Saitta