Does Technical Analysis Work?

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 (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



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

So, 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.

Comments

[leh:]

I'm a believer in TA if only for providing a map of sorts in the bestial wilderness that is the market, but it certainly has its limitations.
For instance, the same Adam Hewison that nailed the move in spot gold also called for a big market reversal to the downside recently simply because his beloved trading triangles told him the rally would fall apart. He ignored the best tell out there, which was the market absorbing the horrendous jobs number and then reversing higher. To his credit, I see he has covered his shorts and admitted he blew the call in IBD.

So TA is just another tool in the box, and ought not to be elevated to some mystical status. Very good for helping with specific trade entries and exits however.

2008 Dec 11 08:33 AM

[carey_jim:]

The short answer is, no and the long answer is two or three months of articles and comments on the Seeking Alpha website.

If technical analysis worked, theories would emerge, every three or four months, which predict the future with at least 60-40 accuracy but I've never seen them.

Sure, you can look into the past three or four months and identify theories and methods that were 90-10 accurate but they almost always fall back to the 50-50 mean in the near future.

2008 Dec 11 01:54 PM

[woodsey:]

A judicious use of charts can minimize losses.

2008 Dec 11 02:01 PM

[Urbane Gori...:]

Sorry. This article is wrong People misunderstand charting. Technical analysis is not predictive. This is a common misconception passed around by people that apparently have not read up on the subject.

Technical analysis is used to gauge the underlying movement of a stock, irrespective of the fundamentals. Basically, all the charts tell you are which direction a stock is trending and a good guess as to an entry and exit point, as well as a good point to place a stop.

Fundamentals, on the other hand attempt to provide a good guess as to the worth of a company based on what is known about the functioning of the company its sector and the general economy.

Notice that neither function is really predictive. Nobody knows when Nigerian rebels will attack a pipeline, causing the price of oil to jump, but it does happen. Because fundies and techies can't predict the future, neither can really predict a stock's movement.

What fundies can do for you is position your stock choice for the maximum security based on what is known about a company and sector. What the technicals can provide is a good entry and exit point. Neither are predictive.

jegan

2008 Dec 26 12:15 PM

[masterofnom...:]

technical analysis vs. fundamental analysis:
seekingalpha.com/insta...

Aug 06 08:43 PM