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HEAD & SHOULDERS, ALGORITHMICALLY
Though it is my belief that all who go to the effort to advance or even attempt to advance their knowledge should be applauded, I must nonetheless deplore author Giorgos Siligardos’ inappropriate use of the term “head & shoulders” in his April 2013 S&C article (“Head & Shoulders, Algorithmically, Part 1”).
That term, adopted a number of years ago by his predecessors, was intended to apply to a specific chart formation identified according to certain rules. Those rules were set down in detail by early writers in the field of technical analysis, such as the writings of Robert Edwards & John Magee most famously, dating, if memory serves, from the 1940s. The charts displayed in Siligardos’ article do not fit those rules, at least as I recall them (unfortunately, I do not have a copy of the book). I must apologize in advance if your own investigation shows my memory to be faulty in some respect.
I do recall, however, that there was general agreement among technicians of the 1950s–60s that the neckline must be level or downsloping to the right, and that volume declination across the three peaks was also required. Volume is nowhere mentioned in his piece, and the necklines of all his figures are upsloping.
It should be further noted that there were good and valid reasons for those requirements, which reasons I presume do not require specification here (though I do not resist discussion if Siligardos feels it appropriate).
I realize he is not the first to improperly use this description to apply to patterns that do not qualify under standard head & shoulders rules; that other technicians have already preceded you I view as irrelevant. Their failings have not been set down in print in technical analysis before (at least not that I have seen). I have objected to any improper use of the term directly to those technicians involved whenever I have become aware of the error. Perhaps this mischaracterization has come about as a consequence of the growth of the Internet and of the failure of the current generation of students to actually read the works of their predecessors in print form. Likely, they have relied on word of mouth, or upon abbreviated Internet definitions that communicate the ideas of the earlier technicians only in vague and superficial terms. Unfortunately, it remains for another — that is, one who actually possesses a copy of the earlier written word — to come forward to correct the definition as set down in Wikipedia and other references to which folks like Siligardos can be directed. I can place only comments where I have no direct written reference capability; that is as it should be.
I invite Siligardos’ reply, as well as any interchange he feels appropriate.
Author Giorgos Siligardos replies:
The purpose of my April 2013 S&C article, “Head & Shoulders, Algorithmically, Part 1,” as well as the second part appearing elsewhere in this issue, is to provide a flexible and customizable recognition method, not a trading system. If you would you like to call the formations found by my algorithm a “potential” head & shoulders (H&S) rather than an actual H&S, that is okay. However, the essential point of the article is that this is a novel, unique method — one that is simple, scale-free, and computerized — for identifying the most popular technical analysis formation (again, I consider the formation an H&S; if you don’t consider it a true H&S, then you can refer to it as a pattern by another name). In addition, the algorithm provides milestone points that you can use to add any kind of additional filters you want (volume, neckline, slope, and so on) to rank the formation for qualification standards regarding its expected performance according to any of your personal preferences.
Apart from my article, and with respect to the issues you raise regarding volume, neckline, and any possible mischaracterization of terminology, here are my comments, and references to cite from several widely accepted sources.
Regarding the “head & shoulders” designation: This is basically a dogmatic definition issue. I use the term H&S to refer to a specific price formation, and nothing more. Your requirement that there must be specific volume behavior or specific neckline slope for the formation to be called an H&S is not unlike requiring, say, high volume during an upward breakout of more than 3% from a resistance line in order to actually consider it a breakout; it is at the trader’s discretion to either call it a low-quality breakout or not call it a breakout at all.
On the other hand, there are markets where in fact you can’t compute the real “trading volume” (take forex, for example). According to your thesis about the role of volume in the designation, there should be no H&S at all for these markets.
Regarding the importance of volume: In their book Technical Analysis Of Stock Trends, authors Robert Edwards & John Magee do stress the importance of volume behavior during an H&S in stock market charts but only up to the point where the volume during the development of the right shoulder is lower than both the volume during the development of the left shoulder and the volume during the development of the head. John Murphy, in his book, Technical Analysis Of The Financial Markets, stresses the same, but more important, he notes (on page 108) that, “...volume is less critical during the completion of market tops.”
Regarding the slope of the neckline and its importance for the H&S top formation: According to the Edwards & Magee book (page 63), “It is sometimes said that a downsloping neckline indicates an unusually weak situation. This is so obvious that it is apt to be given even more weight than it deserves. A share of that excessive weakness, it should be noted, will have already been discharged by the time the downsloping pattern is formed and prices have broken the neckline.” Note also that in all charts of H&S formations presented in Edwards & Magee’s book, the neckline is either upsloping or flat.
According to pattern expert Thomas Bulkowski (thepatternsite.com/hst.html): “Patterns (H&S) with upsloping necklines perform better.”
According to Murphy’s book (page 112), “Once in a while, however, a top neckline slopes downward. This slope is a sign of market weakness and is usually accompanied by a weak right shoulder. However, this is a mixed blessing. The analyst waiting for the breaking of the neckline to initiate a short position has to wait a bit longer, because the signal from the downsloping neckline occurs much later and only after much of the move has already taken place.” In all charts of H&S formations presented in Murphy’s book, the neckline slope is either positive or zero (flat).