Does Technical Analysis Work?

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 |  Includes: AGNC, DSCM
by: Hobbes Investment Research

There are three general opinions of technical analysis: (1) it is a science that works, (2) it's a pseudoscience that works because its practitioners all do the same thing when a chart is a certain way, or (3) it's a bunch of hogwash.

I'm somewhere between (2) and (3), but am more open to (1) after tracking Adam Hewison's predictions on spot gold for a couple of months. I would like for (1) to be true, as would most people, for obvious reasons.

Certain chart and volume patterns are supposed to foretell a stock's (commodity's, ETF's, etc) future price movement. Occasionally, if I come across such chart patterns I'll post about them. Then, I'll check back after a while to see how the predictions turn out. With enough such experiments, it'll hopefully be possible to either confirm or deny (3).

Since a stock can go either up or down from any given point, there's a 50% chance for each prediction to turn out correct (I'm ignoring the possibility that it'll stay the same). If technical analysis doesn't work, predictions should be right around 50% of the time. If it works, predictions will be right or wrong the significant majority of the time. What constitutes a significant majority of the time will be determined by the number of predictions made. If it seems wrong to say that technical analysis works if it's wrong almost all the time, remember that it is just as hard to be wrong most of the time as it is to be right most of the time when you have a 50% chance of being right or wrong. Put another way, if it's wrong most of the time, technical analysis can be very useful, as we can do the opposite of what it predicts.

A major thing that can skew results is that I can easily misread charts. For this reason, I'll stick to the so called archetypal patterns: double top, double bottom, head and shoulders, cup and handle, etc, that are easy enough to identify with software.

Today, I'll look at two chart patterns, the "double top" and the "double bottom."

The double top chart has two peaks that are roughly around the same level, with a moderate dip in between. It is supposed to be a bearish signal when the stock goes below the level of the dip between the two peaks.

Here's one stock that has a double top chart: American Capital Agency (NASDAQ:AGNC). The pattern manifested over the last seven or so days, in the right corner of the image below. AGNC closed at 19.13 on 12/10/08. Let's see where it will be at the end of next week.

click to enlarge

Click to enlarge

A double bottom is essentially the opposite of a double top. It is two about equal dips with a moderate peak in between. The chart is supposed to be a bullish indicator when the stock's price goes above the peak.

Drugstore.com (NASDAQ:DSCM) closed at $1.19 on 12/10/08. The double bottom for DSCM started out in mid November:

Click to enlargeSo, let's see how these stocks do in the near future. We're looking for DSCM to go up and AGNC to go down.

Disclosure: I hold no positions in the securities mentioned above.