the honest guide to candlestick patterns -...
TRANSCRIPT
The Honest Guide
To
Candlestick
Patterns
Specific Trading Strategies
Back-Tested for Proven Results
BY
Llewelyn James
Copyright Information
Copyright © 2014 by Llewelyn James
All rights reserved. No part of this publication may be reproduced,
distributed, or transmitted in any form or by any means, including
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For permission requests, email the publisher, subject line “Attention:
Permissions Coordinator,” at the email address below.
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Software.
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Software.
Any mistakes in this Book with regards to incorrect data or code are
my mistake alone and reflect nothing about Amibroker itself.
You can take a Trial of Amibroker by Clicking this Link.
Disclaimer
While the author has used their best efforts in preparing this book, they
make no representations or warranties with respect to the accuracy or
completeness of the contents in this book and specifically disclaim any
implied warranties or merchantability or fitness for a particular purpose.
The advice and strategies contained herein may not be suitable for your
situation. You should consult with a professional where appropriate.
Neither the publisher nor author shall be liable for any loss of profit or any
other commercial damages, including but not limited to special, incidental,
consequential, or other damages.
Past performance is not necessarily indicative of future performance.
Forex, futures, stock, and options trading is not appropriate for everyone.
There is a substantial risk of loss associated with trading these markets.
Losses can and will occur. No system or methodology has ever been
developed that can guarantee profits or ensure freedom from losses. Nor
will it likely ever be. No representation or implication is being made that
using the methodologies or systems or the information contained within
this book will generate profits or ensure freedom from losses.
HYPOTHETICAL OR SIMULATED PERFORMANCE RESULTS HAVE CERTAIN
LIMITATIONS. UNLIKE AN ACTUAL PERFORMANCE RECORD, SIMULATED
RESULTS DO NOT REPRESENT ACTUAL TRADING. ALSO, SINCE THE
TRADES HAVE NOT BEEN EXECUTED, THE RESULTS MAY HAVE UNDER-
OR-OVER COMPENSATED FOR THE IMPACT, IF ANY, OF CERTAIN MARKET
FACTORS, SUCH AS LACK OF LIQUIDITY. SIMULATED TRADING
PROGRAMS IN GENERAL ARE ALSO SUBJECT TO THE FACT THAT THEY
ARE DESIGNED WITH THE BENEFIT OF HINDSIGHT. NO
REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL OR IS
LIKELY TO ACHIEVE PROFIT OR LOSSES SIMILAR TO THOSE SHOWN.
Also By Llewelyn James
The Honest Guide to Stock Trading
Make Market-Beating Returns. Achieve Long-Term Wealth.
Table of Contents Introduction .......................................................................................................................................... 11
Why I wrote this book ....................................................................................................................... 12
How this book is structured .............................................................................................................. 15
Candlestick Chart Basics ........................................................................................................................ 17
What is a candlestick chart? ............................................................................................................. 17
Reading individual candlesticks ........................................................................................................ 18
Candlestick Patterns ............................................................................................................................. 21
Bullish Candlestick Patterns .............................................................................................................. 21
The bullish engulfing pattern ........................................................................................................ 21
The morning star pattern .............................................................................................................. 22
The piercing pattern ...................................................................................................................... 22
The hammer pattern ..................................................................................................................... 23
The bullish kicker pattern ............................................................................................................. 23
The bullish harami pattern ............................................................................................................ 24
The inverted hammer pattern ...................................................................................................... 24
Bearish Candlestick Patterns............................................................................................................. 25
The bearish engulfing pattern ....................................................................................................... 25
The evening star pattern ............................................................................................................... 25
The dark cloud cover pattern ........................................................................................................ 26
The hanging man ........................................................................................................................... 26
The bearish kicker pattern ............................................................................................................ 27
The bearish harami pattern .......................................................................................................... 27
The shooting star pattern ............................................................................................................. 28
Technical Indicators .............................................................................................................................. 30
Introduction to Technical Indicators ............................................................................................. 30
Technical indicators are not predictive ............................................ Error! Bookmark not defined.
The technical indictor filters which are used during the tests. ............ Error! Bookmark not defined.
Moving averages .................................................................................. Error! Bookmark not defined.
Trend definition ............................................................................... Error! Bookmark not defined.
Historical volatility ............................................................................... Error! Bookmark not defined.
Volatile definition ............................................................................. Error! Bookmark not defined.
Relative Strength Index ........................................................................ Error! Bookmark not defined.
Trend strength definition for up-trends .......................................... Error! Bookmark not defined.
Trend strength definition for down-trends...................................... Error! Bookmark not defined.
Stochastics Oscillator ........................................................................... Error! Bookmark not defined.
Bollinger Bands and Keltner Bands ...................................................... Error! Bookmark not defined.
Rate of Change % ................................................................................. Error! Bookmark not defined.
ConnorsRSI ........................................................................................... Error! Bookmark not defined.
Conclusions ...................................................................................... Error! Bookmark not defined.
Testing the Candlestick Patterns.............................................................. Error! Bookmark not defined.
Universal back-test configuration: ....................................................... Error! Bookmark not defined.
Back-Testing questions ........................................................................ Error! Bookmark not defined.
Why have I chosen the particular indicator settings? ..................... Error! Bookmark not defined.
Parameter robustness ...................................................................... Error! Bookmark not defined.
Are delisted stocks included in the database?................................. Error! Bookmark not defined.
Why have I have only tested on stocks over $5.00 and with at least 100,000 shares daily average
volume? ............................................................................................ Error! Bookmark not defined.
Why have I chosen the particular dates used in the sample period? ............. Error! Bookmark not
defined.
Why do entries occur on the day following a signal? ...................... Error! Bookmark not defined.
What about Exits? ............................................................................ Error! Bookmark not defined.
Why do I rank signals in order of largest volume?........................... Error! Bookmark not defined.
What are your tests looking for? ..................................................... Error! Bookmark not defined.
Bullish Engulfing Pattern .......................................................................... Error! Bookmark not defined.
The bullish engulfing pattern rules re-cap ....................................... Error! Bookmark not defined.
The bullish engulfing pattern code .................................................. Error! Bookmark not defined.
The bullish engulfing pattern test results (5 day holding period) .... Error! Bookmark not defined.
What is the best market environment for trading the bullish engulfing pattern? Error! Bookmark
not defined.
Applying indicator filters to the bullish engulfing pattern ............... Error! Bookmark not defined.
Applying stop-losses and profit targets to the bullish engulfing pattern ....... Error! Bookmark not
defined.
The final rules of the bullish engulfing pattern trading strategy ..... Error! Bookmark not defined.
Test results for the bullish engulfing pattern trading strategy ........ Error! Bookmark not defined.
The Morning Star Pattern ........................................................................ Error! Bookmark not defined.
The morning star pattern rules re-cap ............................................. Error! Bookmark not defined.
The morning star pattern code ........................................................ Error! Bookmark not defined.
The morning star pattern test results (5 day holding period) ......... Error! Bookmark not defined.
What is the best market environment for trading the morning star pattern? ..... Error! Bookmark
not defined.
Applying indicator filters to the morning star pattern .................... Error! Bookmark not defined.
Applying stop-losses and profit targets to the morning star pattern trading strategy .......... Error!
Bookmark not defined.
The final rules of the morning star pattern trading strategy ........... Error! Bookmark not defined.
Test results of the morning star pattern trading strategy ............... Error! Bookmark not defined.
The Piercing Pattern ................................................................................. Error! Bookmark not defined.
The piercing pattern rules recap ...................................................... Error! Bookmark not defined.
The piercing pattern code ................................................................ Error! Bookmark not defined.
Piercing pattern test results (5 day holding period) ........................ Error! Bookmark not defined.
What is the best market environment for trading the piercing pattern? ...... Error! Bookmark not
defined.
Applying indicator filters to the piercing pattern. ........................... Error! Bookmark not defined.
Applying stop-losses and profit targets to the piercing pattern strategy. ...... Error! Bookmark not
defined.
The final rules of the piercing pattern trading strategy. .................. Error! Bookmark not defined.
The test results of the improved piercing pattern ........................... Error! Bookmark not defined.
The Hammer Pattern ............................................................................... Error! Bookmark not defined.
The Hammer pattern rules re-cap ................................................... Error! Bookmark not defined.
The hammer pattern code ............................................................... Error! Bookmark not defined.
The hammer pattern psychology ..................................................... Error! Bookmark not defined.
The hammer pattern test results (5 day holding period). ............... Error! Bookmark not defined.
What is the best market environment for trading the hammer candlestick pattern? ........... Error!
Bookmark not defined.
Applying indicator filters to the hammer candlestick pattern. ........ Error! Bookmark not defined.
Applying stop-losses and profit targets to the hammer candlestick strategy Error! Bookmark not
defined.
The final rules of the hammer candlestick pattern trading strategy. ............. Error! Bookmark not
defined.
Test results of the hammer pattern trading strategy. ..................... Error! Bookmark not defined.
The Bullish Kicker Pattern ........................................................................ Error! Bookmark not defined.
The bullish kicker pattern rules re-cap. ........................................... Error! Bookmark not defined.
The bullish kicker pattern code ........................................................ Error! Bookmark not defined.
The bullish kicker pattern psychology ............................................. Error! Bookmark not defined.
The bullish kicker test results (5 day holding period) ...................... Error! Bookmark not defined.
What is the best market environment for trading the bullish kicker candlestick pattern? ... Error!
Bookmark not defined.
Applying indicator filters to the bullish kicker candlestick pattern. Error! Bookmark not defined.
Applying stop-losses and profit targets to the bullish kicker trading strategyError! Bookmark not
defined.
The final rules of the bullish kicker pattern trading strategy. ......... Error! Bookmark not defined.
Test results of the bullish kicker candlestick trading strategy. ........ Error! Bookmark not defined.
The Bullish Harami Pattern ...................................................................... Error! Bookmark not defined.
The bullish harami rules re-cap ........................................................ Error! Bookmark not defined.
The bullish harami pattern code ...................................................... Error! Bookmark not defined.
The bullish harami pattern psychology ............................................ Error! Bookmark not defined.
The bullish Harami test results (5 day holding period) .................... Error! Bookmark not defined.
What is the best market condition for trading the bullish harami pattern? .. Error! Bookmark not
defined.
Applying indicator filters to the bullish harami candlestick pattern Error! Bookmark not defined.
Applying stop-losses and profit targets to the bullish harami candlestick pattern trading strategy
......................................................................................................... Error! Bookmark not defined.
The final rules of the bullish harami pattern trading strategy ......... Error! Bookmark not defined.
Test results for the bullish harami trading strategy ......................... Error! Bookmark not defined.
The Inverted Hammer .............................................................................. Error! Bookmark not defined.
The inverted hammer pattern rules re-cap ..................................... Error! Bookmark not defined.
The inverted hammer pattern code................................................. Error! Bookmark not defined.
The inverted hammer pattern psychology ...................................... Error! Bookmark not defined.
The inverted hammer pattern test results (5 day holding period) .. Error! Bookmark not defined.
What is the best market condition for trading the inverted hammer candlestick? ............... Error!
Bookmark not defined.
Applying indicator filters to the inverted hammer candlestick pattern ......... Error! Bookmark not
defined.
Applying stop-losses and profit targets to the inverted hammer pattern trading strategy ... Error!
Bookmark not defined.
The final rules of the inverted hammer pattern trading strategy ... Error! Bookmark not defined.
Test results for the inverted hammer trading strategy ................... Error! Bookmark not defined.
Section 2. Bearish Candlestick Patterns ................................................... Error! Bookmark not defined.
Trend strength definition for down-trends when going short ........ Error! Bookmark not defined.
The Bearish Engulfing Pattern .................................................................. Error! Bookmark not defined.
The bearish engulfing pattern rules re-cap ...................................... Error! Bookmark not defined.
The bearish engulfing pattern code ................................................. Error! Bookmark not defined.
The bearish engulfing pattern test results (5 day holding period) .. Error! Bookmark not defined.
What is the best market condition for trading the bearish engulfing pattern? ... Error! Bookmark
not defined.
Applying indicator filters to the bearish engulfing pattern ............. Error! Bookmark not defined.
Applying stop-losses and profit targets to the bearish engulfing pattern ...... Error! Bookmark not
defined.
The final rules of the bearish engulfing trading strategy ................. Error! Bookmark not defined.
Test results for the bearish engulfing trading strategy .................... Error! Bookmark not defined.
The Evening Star Pattern ......................................................................... Error! Bookmark not defined.
The evening star pattern rules re-cap .............................................. Error! Bookmark not defined.
The evening star pattern code ......................................................... Error! Bookmark not defined.
The evening star pattern test results (5 day holding period) .......... Error! Bookmark not defined.
What is the best market condition for trading the evening star pattern? ..... Error! Bookmark not
defined.
Applying indicator filters to the evening star pattern ..................... Error! Bookmark not defined.
Applying stop-losses and profit targets to the evening star pattern Error! Bookmark not defined.
The final rules of the evening star pattern trading strategy ............ Error! Bookmark not defined.
Test results for the evening star pattern trading strategy ............... Error! Bookmark not defined.
The Dark Cloud Cover Pattern ................................................................. Error! Bookmark not defined.
The dark cloud cover rules re-cap .................................................... Error! Bookmark not defined.
The dark cloud cover pattern code .................................................. Error! Bookmark not defined.
The dark cloud cover pattern test results (5 day holding period) ... Error! Bookmark not defined.
What is the best market environment for trading the dark cloud cover pattern?Error! Bookmark
not defined.
Applying indicator filters to the dark cloud cover pattern .............. Error! Bookmark not defined.
Applying stop-losses and profit targets to the dark cloud cover pattern ....... Error! Bookmark not
defined.
The final rules of the dark cloud cover pattern trading strategy ..... Error! Bookmark not defined.
Test results for the dark cloud cover pattern .................................. Error! Bookmark not defined.
The Hanging Man Pattern ........................................................................ Error! Bookmark not defined.
The hanging man pattern rules re-cap............................................. Error! Bookmark not defined.
The hanging man pattern code ........................................................ Error! Bookmark not defined.
The hanging man pattern test results (5 day holding period) ......... Error! Bookmark not defined.
What is the best market environment for trading the hanging man pattern? .... Error! Bookmark
not defined.
Applying indicator filters to the hanging man pattern .................... Error! Bookmark not defined.
Applying stop-losses and profit targets to the hanging man pattern ............. Error! Bookmark not
defined.
The final rules of the hanging man pattern trading strategy ........... Error! Bookmark not defined.
Test results for the hanging man pattern trading strategy.............. Error! Bookmark not defined.
The Bearish Kicker Pattern ....................................................................... Error! Bookmark not defined.
The bearish kicker rules re-cap ........................................................ Error! Bookmark not defined.
The bearish kicker pattern code ...................................................... Error! Bookmark not defined.
The bearish kicker pattern test results (5 day holding period) ........ Error! Bookmark not defined.
What is the best market environment for trading the bearish kicker pattern? ... Error! Bookmark
not defined.
Applying indicator filters to the bearish kicker pattern ................... Error! Bookmark not defined.
Applying stop-losses and profit targets to the bearish kicker pattern ........... Error! Bookmark not
defined.
The final rules of the bearish kicker pattern trading strategy ......... Error! Bookmark not defined.
Test results for the bearish kicker pattern trading strategy ............ Error! Bookmark not defined.
The Bearish Harami Pattern ..................................................................... Error! Bookmark not defined.
The bearish harami pattern rules re-cap ......................................... Error! Bookmark not defined.
The bearish harami pattern code .................................................... Error! Bookmark not defined.
The bearish harami pattern test results (5 day holding period) ...... Error! Bookmark not defined.
What is the best market environment for trading the bearish harami pattern? . Error! Bookmark
not defined.
Applying indicator filters to the bearish harami pattern ................. Error! Bookmark not defined.
Applying stop-losses and profit targets to the bearish harami pattern ......... Error! Bookmark not
defined.
The final rules of the bearish harami pattern trading strategy ....... Error! Bookmark not defined.
Test results for the bearish harami pattern trading strategy .......... Error! Bookmark not defined.
The Shooting Star Pattern ........................................................................ Error! Bookmark not defined.
The shooting star pattern rules re-cap ............................................ Error! Bookmark not defined.
The shooting star pattern code ........................................................ Error! Bookmark not defined.
The shooting star pattern test results (5 day holding period) ......... Error! Bookmark not defined.
What is the best market condition for trading the shooting star pattern? .... Error! Bookmark not
defined.
Applying indicator filters to the shooting star pattern .................... Error! Bookmark not defined.
The final rules of the shooting star pattern trading strategy .......... Error! Bookmark not defined.
Test results for the shooting star pattern trading strategy ............. Error! Bookmark not defined.
Conclusions .............................................................................................. Error! Bookmark not defined.
Thank-You for Reading the Honest Guide to Candlestick Patterns ......... Error! Bookmark not defined.
Introduction
"Market action is more important than news"
Munehisa Honma (The Fountain of Gold)
Munehisa Honma is considered by many to be the god-father of technical analysis. Just over
250 years ago, in 18th
Century feudal Japan, Munehisa had figured out that the price of rice
had as much to do with the emotion of the market, as it did to do with the availability of
buffalo to toil the ground or the depth of moisture left after the recent rainy season.
Bearing in mind that Munehisa Honma realised the importance of market sentiment over two
centuries before behavioural finance became a widely known economic theory, it is quite a
feat that he made the equivalent of $10 Billion during his conquering of the Japanese rice
market.
But perhaps the longest lasting legacy of Mr Honma has been the modern day adoption of
Japanese candlestick charting techniques.
This book does not intend to explain the history of candlestick charts. For a complete
examination of the broader topic I would highly recommend that you read Japanese
Candlestick Charting techniques by Steve Nison.
Rather, this book intends to put the 14 most widely known candlestick patterns under the
spotlight.
I should make it clear from the beginning (I know that many of you will be reading the ‘look
inside’ section of the Kindle page), this book will not go into any great detail regarding
money management, trading psychology, portfolio selection, fundamental analysis,
correlations, how to ride trends, etc.
For a far more detailed discussion of the above topics, you can get a copy of “The Honest
Guide to Stock Trading” for less than $3.00.
Instead, this book will contain a number of tests and test results where I have used modern
day technical indicators alongside the various candlestick patterns to build and modify a
variety of specific swing trading strategies that have been proven to extract profits from the
market, regardless of the current market direction.
Furthermore, whereas many other books about candlestick patterns will suggest that they are
a fool-proof method for picking the tops and bottoms of a market, (by using excessive
hindsight in their analysis) the tests in this book may discover that certain candlestick patterns
have no statistical edge whatsoever.
If so, I do not intend to gloss over the fact. If a candlestick pattern doesn’t test well, I’ll tell
you about it.
Either way, if you trade candlestick charts – the test results presented in this book are sure to
provide you with a true understanding of how profitable (or not as it may be) candlestick
patterns actually are.
And perhaps the real benefit to be gained from reading this book is in learning when each
different candlestick pattern should be traded.
By testing each pattern in a variety of different market environments, I have learnt that there
are candlestick patterns that have significantly outperformed the market, but only when the
conditions are right.
Conversely, I have also found that if you trade certain patterns in the wrong market condition,
you are likely to significantly underperform the market.
By the end of this book, you will have learnt precisely how to define the correct market
conditions for each candlestick pattern, and in knowing the above, you will know when each
pattern is most likely to produce a winning trade and a larger gain.
Why I wrote this book I write this book for a few reasons. Firstly, writing my blog has taught me that if there is one
aspect of technical analysis that gets the most attention from aspiring traders, it’s candlestick
patterns.
The problem is that there seems to be an almost blind acceptance amongst novice traders that
candlestick patterns are some sort of ‘holy-grail’ to trading riches. It’s hardly surprising
either.
The next chart illustrates the type of advice that is often sold by so called ‘candlestick
experts’:
Who could blame an unsuspecting beginner from seeing the above chart and thinking “Wow,
buying a hammer candlestick at a 200 day moving average and when the stochastic oscillator
is oversold is a great trading strategy!”
However, such advice is often misguided if not entirely disingenuous. As it happens, buying
every hammer candlestick at a 200 day moving average and when the stochastic oscillator is
oversold does happen to be a profitable setup.
To be specific, over the past 10 years there have been 131 occasions of a liquid stock forming
a hammer pattern at a 200 day moving average and with an oversold stochastic oscillator. If
you had bought each of those stocks on the day following the pattern and held your position
for five days, 58% of your trades would have been profitable with an average gain of 0.60%.
How do I know that?
Hundreds of test results are how I know that!
Knowing the probabilities of a particular trade setup is the type of knowledge that will set
you apart from the majority of traders who prefer to convince themselves that profitable
trading should be easy.
If you have read my other book, ‘The Honest Guide to Stock Trading’, you will know that I
am a strong proponent of having exact rules with which you approach the market.
You will also know that I believe the ‘holy-grail’ belongs to the imagination of an
adventurous archaeologist, not to the mind of an aspiring trader. Trading isn’t a get rich quick
scheme.
I don’t want this book to leave you thinking that all you need to make money from the market
is a certain pattern or strategy; Rather, I want this book to provide you with a realistic
appraisal of how candlestick patterns actually perform and how you can improve the
performance of all patterns with the addition of simple filters or exit rules.
I want to show you exactly how profitable the most well-known candlestick patterns have
been over the past ten years and I want to give you a better foundation to build from than you
will ever receive from a popular trading forum or snake-oil salesman.
Haven’t you ever wondered what your profits would be if you traded every bearish or bullish
engulfing pattern? Have you ever wondered what would happen if you only traded hammer
patterns when the RSI was oversold, or if the pattern occurred at a 50 day moving average?
Or perhaps you are curious what your maximum drawdown would be if you only traded
bullish candlestick patterns in the direction of the major trend, or if you only traded bearish
candlestick patterns when the market is moving sideways.
This book will provide answers to those types of questions and many more like them.
My 13 years trading experience has taught me that mechanical trading strategies offer the
easiest way to religiously follow a trading plan, which is something that the vast majority of
traders have real difficulty in doing.
Trading candlestick patterns is a step in the right direction for many traders because the
patterns can be clearly defined and therefore provide rules which will help you to overcome
the urge of taking a trade simply because you ‘feel’ that it’s a good one.
And unlike many other books about candlestick patterns which suggest that the patterns are
subjective; this book will apply specific rules which can be hard coded. The patterns in this
book will leave no room for interpretation, you either have one, or you don’t.
Knowing the exact rules which govern each pattern will be a great benefit to you because
once the rules are clearly defined; you can simply enter them into your preferred screening
software or back-testing program and find countless trading opportunities within minutes.
But perhaps the most interesting discovery that you will find in this book are that most
patterns have wildly different returns depending on the existing strength or weakness of the
market as a whole.
Knowing when to take a signal, and when to step aside, is the knowledge that will set you
apart from the vast majority of traders who never make a dime.
This book will carry out a vast number of back-tests in an attempt to find the market
conditions where our candlestick patterns have previously excelled, and conversely, where
they have shown no particular improvement to a simple buy and hold of the market.
We may get to the end of the book and find that nearly all candlestick patterns have little use
to us at all. If that’s the case, I’ll probably sell no copies of the book!
It’s a sad fact that beginning traders often come to the market in search of the quick buck.
Titles such as “Candlestick Patterns for Super-Sized Profits” (if that’s a real book, I
apologise to the author in advance!) will evoke excitement in the potential reader, but I know
because you are reading this book – that you aren’t so easily fooled.
There is great merit in knowing the past performance of all various trading strategies,
irrespective of whether the performance has been good or bad.
While past performance is no guarantee of future performance, I hope that you’ll agree that if
our back-tests show certain patterns have significantly out-performed others over the past ten
years, they’re probably better to trade now.
By the end of the book you will have a complete toolbox of candlestick patterns and the
knowledge to know precisely how well they have performed in the past.
I must also stress that this book is not a manual on how to correctly back-test a strategy using
in-sample, out of sample and walk forward data.
Instead, I want the book to be a beginner’s guide to candlestick patterns that doesn’t imply
that the patterns are always going to work. I have read all of the popular candlestick books
available and quite frankly I am amazed at some of the sweeping statements that are made
without any evidence to support those statements.
Modern day testing software enables even the most basic of coders to test a theory, and each
time that I see a statement such as “buy the hammer pattern at the 50 day moving average”
and that statement isn’t backed by any form of tested proof – I am highly sceptical that the
advice is worth following.
What we will find out in this book is exactly how often such rules have worked in the past
and whether combining candlestick patterns with modern day technical indicators seems to
have increased their efficacy.
Note that I said in the past. What you choose to do with the findings of this book is entirely
up-to you, although I do conclude the book with my own recommendations.
How this book is structured Chapter 1 briefly explains the concepts written about in the book. Included in this chapter
will be a brief primer on the difference between a candlestick chart and a line chart. I will
also present two annotated diagrams that tell you how to read the individual candlesticks.
Chapter 2 will introduce the major candlestick patterns that I will be testing. These are
broken down into either bullish or bearish patterns:
Bullish Patterns
The Bullish Engulfing Pattern. (Also known as the bullish outside bar.)
The Morning Star.
The Piercing Pattern.
The Hammer.
The Bullish kicker.
The Bullish Harami. (Also known as the bullish inside bar.)
The Inverted Hammer.
Bearish Patterns
The Bearish Engulfing Pattern. (Also known as the bearish outside bar.)
The Evening Star.
The Dark Cloud Cover.
The Hanging Man.
The Bearish Kicker.
The Bearish Harami. (Also known as the bearish inside bar.)
The Shooting Star.
Chapter 3 introduces the technical indicators that I will use in an effort to mechanize and
improve each candlestick pattern trading strategy.
The tools which I shall test alongside each of the patterns will include the historical volatility
indictor, rate of change %, Stochastics, RSI, Bollinger bands, Keltner Bands, moving
averages, ConnorsRSI and market environment filters.
Chapter 4 highlights the different rules that I will apply to each candlestick pattern and I will
also explain the period and markets that I will run the tests on.
Chapter 5 – 19 present each of the candlestick pattern test results. These chapters will be
broken down into the following order:
1) A visual reminder of the pattern being tested.
2) The exact rules for coding the candlestick pattern (using Amibroker).
3) Testing the candlestick pattern with no filters.
4) Discovering the best market environment for trading the pattern.
5) Discovering whether certain technical indicators can significantly improve the win-
rate or net-return of the pattern.
6) Discovering the optimum length of time to hold positions for and where best to put
stop-losses and profit targets.
7) The final strategy formula.
8) A Summary of all individual test observations and a final strategy equity curve.
Candlestick Chart Basics
What is a candlestick chart? A candlestick chart is simply a variation of the well-known line chart that shows us the
historical prices of a security. To calculate a standard candlestick chart you need the
following price data:
The Open
The Close
The High
The Low
The idea behind candlestick charts is that the information provided by the difference between
a candle high, low, open and close can enable us to better gauge investor sentiment during a
given period.
A quick look at a line chart and a candlestick chart will highlight the difference between the
two:
Reading individual candlesticks As I mentioned above, every candlestick chart is populated by individual candlesticks that
provide visual confirmation of the high, low, open and close of any given period.
For example, if you are looking at a 5 minute chart, each candlestick will tell you the high
price, low price, open price and close price of each 5 minute period.
If you are looking at a daily chart, each candlestick will tell you the high price, low price,
open price and close price of each daily period. And so on.
The structure of all candlesticks (irrespective of timeframe) is the same except for one
difference:
Green (some charts use white) candlesticks signify that the price has closed higher than it
opened during the timeframe period that you are viewing.
Red (some charts use black) candlesticks signify that the price has closed lower than it
opened during the timeframe period that you are viewing.
You might reasonably be wondering how a candlestick chart helps us to gauge investor
sentiment. If you take a look at the next picture of a line chart and a candlestick chart side-by-
side (daily time-frame) you will see.
The candlestick on the right of our example (highlighted in yellow) helps us gauge investor
sentiment because it provides us with visual evidence that significant selling was occurring at
the recent highs.
For example, studying the highlighted candle in the above chart we can see that the price
opened higher than it closed (indicated by the red colour of the candle), but more importantly
we see that even though buyers had pushed the price to new highs (indicated by the upper
shadow), by the end of the day sellers had caused the market to close lower than at any other
time during the past 3 days.
At its simplest, a red candlestick tells us that there are more sellers than buyers and a green
candlestick tells us that there were more buyers than sellers.
The shadows are then providing us with further information because they alert us to periods
when price has been controlled by the bulls and then taken back by the bears, or vice versa.
If there are no shadows, we know that either the bulls or the bears were in complete control
of the market during the period.
Most importantly, it is the difference between the high and low or the open and close, as well
as the lengths of the upper and lower shadows, which provide us with the different
candlestick patterns that I will test.
Candlestick Patterns
There are literally hundreds of candlestick patterns and signals available to read about online,
any of which can be incorporated into a complete trading strategy. While it would be
interesting to test each of them, I will leave that to a more studious author!
It is not my intention to focus too long on the descriptions or psychology that lies behind each
pattern either. Steve Nison’s book Japanese Candlestick Charting Techniques has covered
those topics in depth. (If you haven’t already read Steve Nison’s book, I would urge you to
do so.)
Instead of rehashing what has already been written about so eloquently, this book will focus
more on the actual results of trading the candlestick patterns.
For your information, the patterns which I decided to test were chosen by the popularity with
which they are requested on my blog.
Following is a brief description and diagram of the 14 most commonly enquired about
candlestick patterns.
Bullish Candlestick Patterns
The bullish engulfing pattern
The bullish engulfing pattern is a reversal pattern that is comprised of two candlesticks. The
first day is a down day which indicates that sellers were controlling the market.
The second day opens lower than the first day close and closes higher than the first day open.
The second day thus engulfs the first day. The precise rules are as follows:
Price must be in a down-trend.
The first day must be a down day.
The second day must open lower than the first days close.
The second day must close higher than the first days open.
As ever, a picture paints a thousand words.
The morning star pattern
The morning star pattern is a 3 day reversal pattern that is supposed to signify the bottom of a
downtrend. The rules for a morning star pattern are as follows:
Price has been in a downtrend.
The first day of the pattern is a down day (a black or red candle).
The second day of the pattern gaps down from the first day and creates a candle that
doesn’t close higher than the first day close.
The second day is also an indecision day signified by a small real body in relation to
its entire day range.
The third day of the pattern is a large up day (a white or green candle) that closes
higher than the half-way point of the first day.
The piercing pattern
The piercing pattern is a 2 day pattern that occurs during a downtrend. As with each of our
bullish candlestick patterns, the piercing pattern is supposed to signify that a change in
investor sentiment has occurred and a reversal is imminent.
The rules for a piercing pattern are as follows:
Price has been in a downtrend.
The first day of the pattern is a larger than average down-day.
The second day of the pattern opens lower than the first day low.
The second day closes at least halfway into the real body of the first day.
Note that if the second day closes higher than the first day open the pattern would
become a bullish engulfing pattern.
The hammer pattern
The hammer is a 1 day pattern that occurs during a downtrend. It is similar to the dragonfly
doji pattern because the real body of the candlestick is small in relation to the lower shadow.
The difference to the dragonfly doji is that a hammer signal does not need to close at the high
of the day nor at the same price as the open. The rules are as follows:
Price must be in a downtrend.
The hammer day must have a lower shadow at least 2 times longer than the real body.
The upper shadow must be 10% less than the entire day range.
The real body must close in the upper half of the entire day range.
The bullish kicker pattern
The bullish kicker pattern is the most powerful reversal candlestick pattern of all according to
Steven Bigalow, the author of Profitable Candlestick Trading. Without first carrying out our
own tests, I wouldn’t want to vouch for that!
However, the visual aspect of the pattern certainly suggests that a significant change of
investor sentiment has occurred.
The bullish kicker signal is a 2 day pattern that is supposed to signify a reversal in a
downtrend. The rules of the bullish kicker pattern are as follows:
Price has been in a downtrend.
The first day is a down day.
The second day opens equal to or higher than the first day’s high.
The second day low is higher than the first day high.
The bullish harami pattern
The bullish harami pattern is commonly known in the west as a bullish inside day. It is a 2
day pattern where the first day is a continuation of a downtrend and creates a large down day.
The second day creates a smaller body and the open and closing price are contained within
the open and closing price of the first day. The exact criteria are as follows:
The price must be in a downtrend.
The first day is a down day.
The second day opens lower than the first days open and closes higher than the first
days close.
The second day can either be an up day or a down day. (I shall test both rules to
determine whether one is better than the other.)
Some people require that the high and low of the second day are within the first day
range as well. (I will also test that rule too.)
The inverted hammer pattern
The inverted hammer is a 1 day pattern. It is created during a downtrend and is supposed to
signal that reversal is imminent.
The inverted hammer shows indecision because even though selling has occurred during the
day, at one stage the bulls had been able to push price higher. The exact rules for the inverted
hammer pattern are as follows:
Price has been in a downtrend.
The upper shadow must be at least 2 times larger than the real body.
The lower shadow must be less than 10% of the entire day range.
The real body must be in the lower half of the entire day range.
The real body has an open and close that are lower than the previous days open and
close. (A real body gap down)
The inverted hammer can be an up day or a down day. It is often written that the
inverted hammer as an up day has more bullish implications. (Our tests will tell us of
that is true.)
Bearish Candlestick Patterns
The bearish engulfing pattern
The bearish engulfing pattern is simply the reverse of a bullish engulfing pattern. The bearish
engulfing pattern occurs in the context of an up-trend and is supposed to signify that sellers
(bears) are taking control of the market away from the buyers (bulls).
The bearish engulfing pattern is a 2 day signal that requires the following rules:
Price must be in an up-trend.
The first day must be an up day.
The second day must open higher than the first days close.
The second day must close lower than the first days open.
The evening star pattern
The evening star pattern is a 3 day reversal pattern that is supposed to signify the bottom of a
downtrend. It is the exact opposite setup to the morning star pattern. The rules for an evening
star pattern are as follows:
Price has been in an uptrend.
The first day of the pattern is an up day.
The second day of the pattern gaps up from the first day and creates a candle that
doesn’t close lower than the first day close.
The second day is also an indecision day signified by a small real body in relation to
its entire day range.
The third day of the pattern is a large down day that closes lower than the half-way
point of the first day.
The dark cloud cover pattern
The dark cloud cover pattern is a 2 day pattern that occurs during an up-trend. As with each
of our bearish candlestick patterns, the dark cloud cover pattern is supposed to signify that a
change in investor sentiment has occurred and a reversal of the existing up-trend is imminent.
The rules for a dark cloud cover pattern are as follows:
Price has been in an up-trend.
The first day of the pattern is a larger than average up day.
The second day of the pattern opens higher than the first day.
The second day closes at least halfway into the real body of the first day.
Note that if the second day closes lower than the first day open the pattern would
become a bearish engulfing pattern.
The hanging man
The hanging man is a 1 day pattern that occurs during an up-trend. It is the exact same setup
as the hammer but because it is supposed to signify a reversal of an uptrend and not a
downtrend it has a different name.
The rules are as follows:
Price must be in an up-trend.
The hanging man day must have a lower shadow at least 2 times longer than the real
body.
The upper shadow must be 10% less than the entire day range.
The real body must close in the upper half of the entire day range.
The bearish kicker pattern
The bearish kicker pattern is a 2 day pattern that is supposed to signify a significant change of
investor sentiment and precede a reversal of an uptrend.
The rules of the bearish kicker pattern are as follows:
Price has been in an up-trend.
The first day is an up day.
The second day opens equal to or lower than the first day’s low.
The second day high is lower than the first day low.
The bearish harami pattern
The bearish harami pattern is commonly known in the west as a bearish inside day. It is a 2
day pattern where the first day is a continuation of an up-trend and creates a large up day.
The second day creates a smaller body and the open and closing price are contained within
the open and closing price of the first day. The bearish harami is exactly the same pattern as a
bullish harami pattern except that it occurs during an up-trend.
The exact criteria are as follows:
The price must be in an up-trend.
The first day is an up day.
The second day opens lower than the first days close and closes higher than the first
days open.
The second day can either be an up day or a down day. (I shall test both rules to
determine whether one is better than the other.)
Some people require that the high and low of the second day are within the first day
range as well. (As I will with the bullish harami pattern, I will also test that rule too.)
The shooting star pattern
The shooting star pattern is a 1 day pattern that is the same as the inverted hammer except
that it occurs during an up-trend.
The shooting star shows indecision because even though buying has occurred during the day,
the bears have taken control of the market to close the price in the lower half of the day’s
range. The exact rules for the shooting star pattern are as follows:
Price has been in an up-trend.
The upper shadow must be at least 2 times larger than the real body.
The lower shadow must be less than 10% of the entire day range.
The real body must be in the lower half of the entire day range.
The shooting star can be an up day or a down day. But it is often written that the
shooting star as a down day has more bearish implications. (Our tests will tell us of
that is true.)
You now know how to identify each of the major candlestick patterns that we shall be testing
in later chapters.
In the next chapter I will explain the indicators that I will be using in a bid to improve the
efficacy of each candlestick pattern.
As I mentioned in the introduction, I am a strong proponent of having specific trading rules
because without them you will often find yourself taking trades based on nothing more than a
gut feeling.
If you are guilty of trading on emotion instead of logic, the next chapter will lay out the tools
that are guaranteed to help you better improve the regularity with which you follow a trading
plan that you know to have a positive expectancy.
Technical Indicators
Introduction to Technical Indicators
Technical Indicators are based upon mathematical calculations that include price, volume and
momentum. There are literally 100’s of technical indicators at a traders disposal, each of
which offering a chance to view price from a different perspective.
It is often written that technical indicators are able to forecast price changes. I am extremely
dubious whether that is true, however, I do believe that technical indicators are a vital
component of a technical trading strategy and that’s because without them it is very hard to
quantify your rules.
To give you an example, presume that you regularly trade hammer candlestick patterns and
that you have recently noticed that when a market seems to be very strong, the pattern stops
working so well.
You’d like to know whether a very strong market is a bad time to trade hammer patterns, but
how? That’s what technical indicators are for.
In the above example, you could apply a ROC indicator to your charts and test all hammer
patterns with and without a ROC filter of your choosing.
Without using technical indicators, it can be very hard to quantify anything that you might
have noticed about the market and think might give you an edge.
Take another example, the following chart is a naked price chart.
A valid candlestick pattern at support is a classic buy signal, but how often will this set-up
produce a winning trade?
It’s hard to say because one trader might see support where I have highlighted it in the above
picture, whereas another trader might see support in a slightly different place.
Over a thousand trades, the small change in where a trader sees support can have a huge
impact on the profits or losses made.
My argument is that if you can’t follow the rules to a strategy which involves something as
simple as a binary decision (which is what you have with mechanical trading strategies), you
have even less chance of following the rules to a strategy which involves multiple areas of
subjectivity (which is what you have if trading from trend-lines or similarly subjective
patterns).
A trader will begin to question her strategy when the last ten trades in a row have been losers
because she will have no idea if it’s because she is finding support in the wrong place, or
whether it’s because the volatility of the market has changed, or perhaps it’s because the
pattern only works during a broader market up-trend.
There are 100’s of reasons for why a trader might have had 10 losing trades in a row, but
without being able to test a strategy before taking it live, it is hard to know what those
reasons might be.
Imagine that we knew only 40% of bullish engulfing patterns worked when the market was
not volatile. Would you take the trade from the above chart? If you’re not sure I understand.
After all, is the market from our image volatile or not?
Again, this is where technical indicators come in handy. The next chart is the same as the one
above, but I have added the historical volatility indicator. We have a simple rule that says
‘don’t trade bullish engulfing patterns unless the market is volatile’.
We then need to define volatile. For examples sake let’s say that a historical volatility
indicator above 40 is telling us that the market is volatile and if the indicator is below 40 the
market is not volatile.
Presume that we have tested the bullish engulfing pattern on 1000’s of different stocks and
we know that if the historical volatility indicator is below 40, the pattern has less than a 40%
chance of producing a profitable trade – and the average losses are larger than the average
gains.
My question to you now is would you buy the above stock at the current price? I hope you
said no because if you didn’t, it is 60% likely that you just took a trade that will lose you
money over the long run.
In my other book I go to great lengths explaining a trading expectancy and why the win rate
of a trading strategy is far less important than how much you win when you’re right and how
much you lose when you’re wrong.
So if we know that trading the bullish engulfing candlestick when the market is not volatile
has a negative expectancy, but trading them when the market is volatile has a positive
expectancy, I think we can both agree that only trading bullish engulfing candlesticks when a
market is volatile would be the best course of action.
Remember that it’s only by incorporating technical indicators into our strategies that we are
able to test such differences without any ambiguity creeping into our decision making
process.