|As you read material and try out different trading systems a recurring theme is the use of candlesticks. An underlying premise is that candlestick patterns can predict turning points in price action. Some argue that it is not whether the body of the candlestick is filled (price closes down) or not filled (prices close up) that matters, but the length of the shadow. A candlestick has two prominent features: the body and the wick. The body is a rectangle and denotes the difference between the open and closing prices for the day. The wick extends above or below the body and denotes the high and low prices for the day. It is also referred to as lines, hairs or shadows.|
Chande and Kroll, in the New Technical Trader, suggest that major turning points may occur when the shadows are long. Long shadows represent uncertainty. The length of the shadow and the times when stock shadow lengths seem to coincide with major turning points are what matters. So you must find the right length of the shadow at the turning points. For calculating the shadow length they suggest using the following formulas:
upper shadow = high-close (if close>open) or upper shadow =high-open (if close<open),
lower shadow=open-low (if close >open) or lower shadow=close-low (if close<open).
I created two Metastock formulas for Chande and Kroll's shadow formulas and they are
|I next plotted these two indicators with the Nasdaq (Figure 1). Chande and Kroll suggest using averages and studying the trend of the averages to determine if the market is becoming more certain or uncertain. Again, uncertainty corresponds to long shadows. When I applied this to the Nasdaq the two indicators did not appear to be particularly useful. I then created a trading system built around the two shadow types. I reasoned that if I could build a simple trading system using these indicators and make money they would have some validity.|
An upper shadow is bearish and a lower shadow is bullish. I built the system to enter long on a lower shadow value and to exit on an upper shadow value. I did not short because part of this effort is to see if these indicators can tell us if we have hit a Nasdaq bottom. When I initially ran the system I noticed that many buys and exits were in close proximity. I had to allow for a delay on my exits. So I optimized around the exit criteria incorporating a delay of one to five days, incrementing one day at a time.
|Figure 1: Nasdaq with buy and exit signals (upper chart), the result of $1000 investment (second chart from top), upper shadow values (second chart from bottom) and lower shadow values (bottom chart).|
|Graphic provided by: MetaStock.|
|Graphic provided by: Data vendor: eSignal<.|
|The annualized yearly return was 74% and a $1000 investment in 1997 would now be $4419 for a percentage gain of 341%. There were thirteen trades, nine of which were successful. The investment chart (second from the top) shows straight lines at times because there are points when I exited and did not re-enter. In late May you can see one of the entry points. The system optimized on using 84 as the threshold for entering, that is, a lower shadow equal to 84 triggering the enter signal, and exiting when the upper shadow was at 59. The system chose a five-day delay before exiting.|
What does this tell you? It says that if you put money on this idea you would be ahead by starting in '97. However, this is not enough to validate a trading system. Twelve of the thirteen trades were completed in 2000 and only the first trade was in '97. Most of the gain was the result of entering in '97 and exiting at the beginning of 2000. When you optimize for profit the system goes through all the combinations you specify and lists the results for each combination. The volatility of 2000 drove the selection of parameters I wanted to optimize on. These were: length of upper shadow, length of lower shadow and the number days to delay the exit. It does however suggest there is some merit to the notion of shadows. The entry points are reasonable. The exits need more work. What you want to see is the ratio
new highs /(new highs + new lows)
start to turn up (see October 13 posting). If you also saw along the way a bullish candle with a lower shadow of about 84 (be careful because bearish signals can immediately follow bullish ones) or greater, you would start to think there we are finally through beating up on the tech stocks. Otherwise just wait for the eventual upturn. We are clearly close to the bottom, unless we have a recession.
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