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Nasdaq and Candlesticks (Part I)

01/26/01 03:39:01 PM
by Dennis D. Peterson

Candlestick patterns are well documented, but how useful are they for trading?

Security:   $compq
Position:   N/A

Greg Morris in his book "Candlepower" gathered impressive statistics about candlesticks and I undertook what I thought would be a simple task -- validating a trading system using candlestick patterns. Most candlestick patterns are reversal patterns as opposed to continuation patterns; six patterns dominate the reversal patterns. The six are harami (for either an uptrend or downtrend reversal), engulfing (for either an uptrend or downtrend reversal), hammer (for a downtrend reversal), and hanging man (for an uptrend reversal).

I wrote no indicators, only trading rules. Two of Morris' comments caught my attention when considering these rules: (1) candle patterns require that the trend be identified, and (2) candle pattern predictions are a short-term forecast, that is, they only work for one to seven days in the future as opposed to weeks. I also decided to simplify the trading rules and only take long positions.

To resolve the first comment, I reasoned that using R-squared should be an improvement over the techniques used by Morris to identify the trend. For the second comment I would allow the system to either go long or exit based on very small changes in trend. I first created a system using harami patterns and then one for engulfing. I then combined the two and finally added hanging man.

My first problem was with the data source which didn't allow trades. When I looked carefully I found that all the candles I was using were spinning tops. The vendor had made the opens equal to the closes for the period of time I wanted to perform the initial optimization. On the positive side the fact that the trading system didn't try to trade with spinning tops was gratifying. I shifted to a later period in time, and found that I needed to modify the rules slightly to take into account the position of the adjacent candle bodies. While I found that the rule to have today's body greater than yesterday's, or vice versa (today's body less than yesterday's) is not an issue, I had to allow today's body to be slightly above yesterday's in the case of an engulfing downtrend reversal and just the opposite for an uptrend reversal. In other words, a downtrend reversal is better identified when today's body is above yesterday's body for engulfing. I did just the opposite for an uptrend reversal for both harami and engulfing. I call these the modified engulfing and harami rules. These changes increased equity performance significantly.

Using modified harami, engulfing, an unmodified hanging man and R-squared for trend detection, $1000 (invested in 1989) grew to $22,000 in 11 years using the Nasdaq as a tradable item (Figure 1: top chart). There are problems however.

Figure 1: Candlestick trading system performance (top chart) of $1000 invested in 1989, and entry and exit conditions for Nasdaq (bottom chart).
Graphic provided by: MetaStock.
One of the most difficult trading periods for this system occurred in February and March 2000 (Figure 1:bottom chart- entry is denoted with green up arrows and exit with red exit sign) when the equity had a severe downturn at the beginning of April. What happened (each numbered circle is discussed below) illustrates the best and the worst for this kind of approach, and is:

1. The system sees a reversal before the actual bottom occurs - this is an infrequent event but nevertheless making the system highly sensitive to trends has its faults as well as merits.

2. The system ignores a harami reversal because it is already long.

3. Between 2 and 3 there is a nice profit and the system exits on cue - this kind of performance is typical for bull market upswings and when I first saw it, it was very encouraging - then a very small downtrend is detected with an engulfing pattern and the system is long again.

4. This point clearly shows the one day delay for entry misses a large move up. I am once again long towards the end of the area.

5. Equity has been building without disastrous drawdowns prior to this point, although it has been hit with 5% once and then a severe hit - in fact the worst the trading system will see.

What happened? If you look at circle 5 and the two candlesticks to the left of the green arrow, what you see is the following: (1) a filled red candle body before an open green candle body. The filled candle body is bigger than the open one, meaning it is a harami pattern (2) a definite downtrend. A harami reversal!!! And some lower shadows.

Part 2 follows and is a short summary of what happened using other data vendors.

Dennis D. Peterson

Market index trading on a daily basis.

Title: Staff Writer
Company: Technical Analysis, Inc.
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