Candlestick Analysis
Candlestick charting was first developed in Japan in the 18th century to analyse rice charts, each candlestick represents price movement over a fixed period of time. Each candlestick tells us four pieces of information – the opening price, the highest price in the time period, the lowest price in the time period, and the closing price. The part of the candle containing the opening and closing prices is often called the body and the part of the candle that shows us the price extremes (the highest price and the lowest price) is often called the shadow or the wick.
The popularity of candlestick charts has given rise to a form of technical analysis known as candlestick analysis where certain candlestick types (or patterns) are said to signal certain things.
In this short article I'm going to attempt 'analyse the analysis' in order to see if candlestick analysis is just nonsense, or if it really does provide a tradable edge. I'm going to do this by analysing the most common candlestick patterns that are used as entry signals and see if using any of these patterns provides a tradable edge on the EURUSD currency pair on daily candlestick charts. I'll do this by using the candlestick pattern as an entry signal with a suitable time-based exit. Random entries with time-based exits on the Forex market would, over the long run, provide no tradable edge and produce a winning trade to losing trade ratio of 50/50 with the wins being equal in size to the losses. Therefore, if using a certain candlestick setup as an entry signal does provide an edge, then using this edge as an entry signal with a suitable time-based exit will reveal the edge in the form of a win to loss ratio of over 50/50 and/or the size of winning trades being (on average) greater than the size of losers. See my article on the Edge Ratio and Exit Strategies for more information on measuring the size of a statistical edge and time-based exits.
Engulfing Candlestick Patterns,
One of the most commonly mentioned and traded candlestick patterns is the Bullish Engulfing Pattern and the Bearish Engulfing Pattern. These patterns are said to signal a trend's direction. A Bullish Engulfing Pattern is said to signal that the bulls are in control whilst a Bearish Engulfing Pattern is said to signal that the bears are in control. An engulfing pattern is when a candle's wick (or shadow) completely engulfs/covers the previous candle and it also closes above or below the previous candle's high (a bullish engulfing pattern) or low (a bearish engulfing pattern).
I'm going to test the validity of this pattern by entering in the direction of an engulfing candle pattern on the close with a 1 week (5-day) time-based exit. The results on the EURUSD candlestick chart from the beginning of January 2000 until the end of March 2010 where as follows –
Number Of Trades: 196
Number Of Wins: 99
Number Of Losses: 97
Winning Percentage: 50.51%
Number Of Pips Won: 13,034.6
Number Of Pips Lost: 11,524.7
Win To Loss Ratio: 1.131 to 1
To See The Full Results Right Click And Save Target As Here
The Hammer & Hanging-man Candlestick Patterns,
The Hammer and Hanging-man candlestick patterns are said to signal trend reversals. The Hammer candle is said to signal the end of a downtrend and the start of an uptrend and a Hanging-man candle is said to signal the end of an uptrend and the start of a downtrend. The theory behind this is that these candlestick patterns are showing either a significant end of day rally pushing the price back up after a downtrend, which creates a long bottom with a short body near the top of the candle (a hammer candlestick & bullish reversal signal). Or a significant end-of-day sell off after an uptrend pushing the price back down, which creates a long top with a short body near the bottom of the candle (a hanging-man candlestick & bearish trend reversal signal.
A Hammer candle is usually defined as a candle where the lower part of the wick (or shadow) is at least twice as large as the body and where the candle also has no, or almost no, upper wick.
A Hanging-man candle is usually defined as a candle where the upper part of the wick (or shadow) is at least twice as a large as the body and where the candle also has no, or almost no, lower wick.
As with the engulfing candles, I am going to mechanically test the validity of these patterns on the EURUSD daily candlestick chart from the beginning of January 2000 until the end of Match 2010. I will go long on the close of hammer candle with a 1 week (5-day) time-based exit and will go short on the close of a hanging-man candle with a 1 week time-based exit. In this mechanical test, I will define a hammer candle as the distance from the low to the lowest point of the candle's body being at least twice the length of the candle's body, and hanging-man candle as the distance from the high to the highest point of the candle's body being at least twice the length of the candle's body. The results of this test were as follows –
Number Of Trades: 720
Number Of Wins: 372
Number Of Losses: 348
Winning Percentage: 51.67%
Number Of Pips Won: 51,069.7
Number Of Pips Lost: 47,825.4
Win To Loss Ratio: 1.068 to 1
To See The Full Results Right Click And Save Target As Here
Reversal signal candles as defined as having a shadow/wick from the extreme to the nearest point in the body of at least twice the size of the body didn't provide much of a statistical edge, however, when we define a hammer candle as the distance from the low to the lowest point of the candle's body being at least three times the length of the candle's body, and hanging-man candle as the distance from the high to the highest point of the candle's body being at least three times the length of the candle's body the results were slightly better –
Number Of Trades: 530
Number Of Wins: 281
Number Of Losses: 249
Winning Percentage: 53.02%
Number Of Pips Won: 39,860.9
Number Of Pips Lost: 34,251.2
Win To Loss Ratio: 1.164 to 1
To See The Full Results Right Click And Save Target As Here
Conclusion,
The two types of candles measured in this short article appear to indeed have a statistical edge (albeit a small one) so I have to conclude that candlestick analysis does have it's use and isn't all 'mumbo jumbo' as so many of the analysts that only look at the market fundamentals claim. However, I do admit that the edge provided by these simple candles is a fairly small one. In the near future I intend to measure some of the more complex chart patterns such a flags and pennants, I expect these patterns may perform better than the patterns made by single candles but they will no doubt be far harder to define algorithmically. Nevertheless, when I do it, I'll publish the results too, good or bad, whatever they may be.
Good trading :)
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