Short term double bottom/top formations contradict technical analysis theory

Published 30 June 2017

A research report from Investtech based on 19 years of data from the Oslo Stock Exchange in Norway shows that short term double bottom/top formations contradict established technical analysis theory. The results indicate that classical technical analysis theory should be revised.

The theory states that a double top formation is a top formation which marks the end of a rising period. The formation consists of two tops of approximately the same width and height, see figure 1. The formation of a double top mirrors increasing pessimism among investors and signals the beginning of a falling trend. Double top formations are especially useful in predicting long term market trend reversals, but are also used in the shorter term.

There is an opposite version of this formation; the double bottom formation, see figure 2. This is a bottom formation which marks the end of a falling period. A double bottom formation signals increasing optimism among investors and the start of a rising trend.

In technical analysis terminology, a break down from a double top formation triggers a sell signal. Similarly a break upwards from a double bottom formation triggers a buy signal. We have studied the price movements following short term buy and sell signals from such formations on the Oslo Stock Exchange in Norway in a period of 19 years, from 1996 to 2014.

Investtech's computers identified a total of 796 buy signals and 908 sell signals in this period.

The chart below shows average price development following short term buy and sell signals from double bottom and double top formations. The signals are triggered on day 0. Only days when the exchange is open are included, so 66 days equal approximately three months. Buy signals are the blue line and sell signals are the red one. The shaded areas are the standard deviation of the calculations. Benchmark index is the black line.

Figure 3: Price development after buy and sell signals from double bottom and double top formations on the Oslo Stock Exchange identified by Investtech’s automatic algorithms in short term price charts. Click the image for bigger version.

Figure 3 shows that stocks with buy signals from short term double bottom formations on average developed weaker than benchmark following the signals. A month after signal they had a negative excess return of 1.9 percentage points, which increased to 3.1 percentage points after three months. Stocks with sell signal from short term double top formations developed stronger than avaerage benchmark following signals. A month after signal they had an excess return of 0.5 percentage points, which increased to 1.5 percentage points after three months.

The results are the opposite of what is expected according to technical analysis theory. Sell signals were followed by increasing prices and excess return. Buy signals were followed by negative excess return.

Note that these results are valid for short term formations identified in Investtech's short term price charts. For long term formations, we have results that confirm the established theory. Thus it appears that the time perspective of the formations is an important factor when it comes to their predictive power.

See more results and details in the reserach report here >> .