Nasdaq and Candlesticks (Part II)

02/02/01 01:32:09 PM

by Dennis D. Peterson

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

Security: $compq
Position: N/A

The apparent harami reversal at the beginning of April 2000, may have been a data vendor problem. It is easy for me to switch and use alternate sources. I did and got a second surprise.

Using two other data vendors I found equity growth to be significantly less (Figure 1:bottom two charts). It is clear that vendor data differs and can have a significant impact on your trading system. Nevertheless, I had to attempt to solve the drawdown problem. I chose data vendor A to apply stop-losses because I could see it had the most serious drawdowns in the equity curve. Somewhat to my surprise, I found that stop-losses provided nearly the same equity growth performance because when a stop-loss takes you out of the market, the entry condition to get back in and make up the loss is sometimes missing. In other words, the market would dive the next day and then almost immediately recover. Delaying entry by two days instead of one produced even worse results.

Figure 1: Equity curves for $1000 invested in 1989 using Nasdaq values to trade from three different data vendors and using stop-losses.

Graphic provided by: MetaStock.

By examining the equity curves it is easy to see that in a bull market candlesticks do no worse than a buy and hold strategy and can even do better. One of the serious performance aspects is the inability to see a top. I added hanging man as an exit condition for a top and this helped significantly. But the large drawdowns remain a serious problem. I tried some other variations such as applying breadth indicators and trading only when the market was not overly bearish. For an 11-year investment this strategy performed poorly.

I concluded the following:

1. Trading systems using open and close need to pay attention to the quality of the data vendor.

2. On a potential downtrend reversal in a bear market, you need to have fairly tight stop-losses (3%). The trading system simulation allowed me to set end-of-day stops and not intraday ones. Therefore, I got hit with the entire day's loss. Minimizing a few day's losses would make a big difference. Use tight stop-losses.

3. The number of winning trades was about 64% (221 out of 344 for data Vendor A), which does a bit better than Gregory's Morris' data (from his book "Candlepower") for enguling patterns (50% reliability) and harami reversals (30% reliability). I found that when using only engulfing patterns I had an equity growth with tolerable drawdrawns, but less overall equity growth. Using harami in a bull market provided additional equity growth over and above just using engulfing. On the other side of the coin the 'not so reliable' harami reversals produced major drawdowns. I attribute the better performance to trend detection using R-squared and modifying the rules to allow today's body to be a bit above yesterday's on a downtrend reversal for engulfing. The opposite holds for an uptrend reversal for engulfing and harami since I had a significant gain in equity performance using the modified rules.

4. This method of applying market breadth momentum limits the number of winning trades and results in poorer overall equity performance. It's clear from the equity curves that performance is best in a bull market and this is probably an area that would profit from additional analysis.

5. Equity growth was strong in the latter half of 1999 when the market was very bullish. The system was not in a buy and hold trading strategy during 1999, executing about 33 trades at a fairly constant rate (two to three per month). At the risk of being a bit repetitious use either engulfing or harami reversals in a bull market. Shift to engulfing only in a bear market if placing stop-losses is something you aren't comfortable with quite yet.

Dennis D. Peterson

Market index trading on a daily basis.

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CANDLESTICK CHARTING

Nasdaq and Candlesticks (Part II)

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