Where next?
Here is a price chart. Where does it go next?
Ten charts, six months of daily prices each. For every chart, call the next month: up or down. A chartist reads each chart too, and tells you why. Then you see what happened.
Five chartists, one chart
The head and shoulders is the most famous chart pattern there is: three peaks, the middle one highest, and a "neckline" under them. When price closes below the neckline, the textbooks say sell. Here is one chart. Tap each chartist to see what they find on it.
Counting what the five chartists see on 500 more charts…
Why the chart could not tell you
Every chart on this page was made by a coin. Each day's move was a fair draw, up or down, with no memory of the day before. Only the size of the moves was allowed to cluster, calm spells and stormy spells, because that is what real prices do and it makes the charts look real. There was nothing to read. The chartist read it anyway, with confidence, and so did you.
That is not a trick on chartists alone. In A Random Walk Down Wall Street, Burton Malkiel describes students who drew a stock chart by flipping a coin. A chartist he showed it to wanted to buy at once.
Can a head and shoulders be tested at all?
In 1999 Kevin Chang and Carol Osler of the New York Fed turned the pattern into a rule a computer could follow: peaks only count after price turns by a set amount, the head must top both shoulders, the shape must be balanced. They noted that the eight textbooks they read disagreed on the details. On currencies the rule had a little forecasting power. On stocks, Osler found traders "would be equally served by following a random signal."
David Aronson later tested 6,402 rules of this kind on 25 years of the S&P 500. Once he allowed for how many he had tried, not one of them, the best included, beat the market by more than luck would.
The honest counterpoint
People are not blind to prices. In 2010 Hasanhodzic, Lo and Viola ran a "financial Turing test": with feedback, people could tell real price charts from shuffled ones. Real markets are not coin flips. But telling real from fake is a different job from calling next month, and the patterns in this game are named after shapes, not after any tested edge.
Before you trust a chart pattern, ask: would it have called a coin flip just as confidently?
Sources
- Chang and Osler, "Methodical Madness: Technical Analysis and the Irrationality of Exchange-Rate Forecasts", Economic Journal 109 (1999), 636–661.
- Osler, "Identifying Noise Traders: The Head-and-Shoulders Pattern in U.S. Equities", Federal Reserve Bank of New York Staff Report 42 (1998).
- Aronson, Evidence-Based Technical Analysis (Wiley, 2006), chapter 9.
- Malkiel, A Random Walk Down Wall Street (W. W. Norton).
- Hasanhodzic, Lo and Viola, "Is It Real, or Is It Randomized?: A Financial Turing Test", arXiv 1002.4592 (2010).
- The charts are made fresh in your browser: fair daily coin flips whose size follows a GARCH(1,1) rule, so calm and stormy spells cluster. The chartists' head-and-shoulders rule follows Chang and Osler: swings measured in multiples of daily volatility, from 1.5 to 4.