The latest panic was caused by a reversal in 10-Year Note yield and a possible invalidation of a head and shoulders bottom that has been forming since 2015.
I had a discussion with a quant trader the other day and he argues that use of technical analysis by traders is better for his fund’s profitability. I also agree especially in an environment of lower liquidity with dominant modes being passive investing and short-volatility trades in the last three years, although this may change this year.
Needless to say that anyone who trades chart formations without having an idea of the expectation and probability of win is too naive to survive this game. But there is a suspicion that some who claim to be quants also do this, i.e., although they assert they use algos, in reality they depend on chart reading. I suspect this because in 2013 when there was another head and shoulders bottom in yields, as shown in this article, some quants went short bonds. They got crushed with yields reversing and dropping to all-time lows and some went out of business.
The inverse head and shoulders bottom in 10-Year Note yield is shown in the weekly chart below:
It may be seen that the panic to TA land was caused by the reversal in yields and a test of a neckline. A drop of the yield below 2.62% will invalidate this formation.
However, the formation is probably random to start with, regardless of future course of yields. But even if it is not, what is the probability of success? No chartist can answer this; it is all subjective and based on experience or confirmation bias, or both. Would you bet any serious money on a rise of yields near 4% based on this formation? I would only if I knew with high confidence that the probability of win is larger than 80%. Expectation in the case of chart formations that take more than three years to complete is of little use although naive arguments use it as an excuse. I explain why in this article.
Head and shoulders patterns form even in random data, Here is an example from my book Fooled By Technical Analysis.
The price series is random in the above chart but a head and shoulders was formed.
The head and shoulders, top or bottom, is an unreliable pattern formation although it is considered a flagship pattern. It is also a primary target for professional traders to fade and profit from weak hands.
If you have any questions or comments, happy to connect on Twitter: @mikeharrisNY
Charting and backtesting program: Amibroker
Quantitative analysis of Dow-30 stocks and 30 popular ETFs is included in our Weekly Premium Report. Market signals for longer-term traders are offered by our premium Market Signals service. Mean-reversion signals for short-term SPY traders are provided in our Mean Reversion report.