Candlestick charts are popular amongst all kind of traders although they originally come from ancient Japan and were first used to trade rice. Nowadays, they are considered a "common knowledge" and there are plenty resources about them on the Internet. Despite everybody agreeing about meaning of some of the patterns it seems like nobody performed actual tests on historical market quotes to measure actual performance.
I have back tested some of the most popular candlestick patterns on American Stock Market. I used daily data of 400+ most liquid stocks spanning last 20+ years. Some patterns were confirmed and some turned out to be complete failures. Before diving into test's results let's talk about different types of patterns:
Reversal patterns -- patterns after which market (or a stock) usually reverses. Important for trading as they enable traders to exit before the trend changes its direction.
Continuation pattern -- patterns after which market usually continues. Can be useful for moving stop loss order closer to the market (as breaking a continuation pattern is usually a bad sign) and entering additional position.
I have back tested the following patterns:
Evening Star -- Reversal pattern in an up trend, although quite weak and short term. Exhibits a bearish edge over the next few days. Average change in 5 days after the pattern is -0.2%, after 20 days+0.3%.
Falling Three Methods -- Reversal pattern in a down trend. Shows strong bullish edge -- average stock's change is +0.7% in 5 days and +2.0% in 20 days.
Bullish Kicking -- Reversal pattern in a down trend. Not as strong as "Falling Three Methods" but good for trading: average market's change is +1.5% after 20 days.
Morning Star -- Very popular amongst traders but rare reversal pattern in a down trend. Very strong bullish edge -- average change is +4.5% after 20 days.
Bullish Piercing Line -- Very common reversal pattern in a down trend. Average change after 20 days is +1.4%
Three White Soldiers -- Pattern that is in fact a confirmation of "Bullish Piercing Line". Average change in 20 days is +1.7%
Dark Cloud Cover -- Continuation pattern in an up trend. Very common (over 12000 occurrences) with average change +1.4% in 20 days.
Three Black Soldiers -- Looks like a confirmed "Dark Cloud Cover" but is in fact a continuation pattern. Average market's change is +1.6% in 20 days after the pattern.
Rising Three Methods -- Very strong, and quite common, continuation pattern in an up trend. Average market change equals +2.2% in 20 days.
As can be seen, some patterns provide a significant market edge and can be used for trading purposes. Obviously any trading method has to be back tested before committing any money and this is what I've tried to show in this article. Using back tested candlestick patterns you can expect returns of about 2% a month which compounds to 26% a year -- much more than broad market's average. If you want to read more about this subject or my tests, please download my candlestick patterns research e-book.
About the Author
Lukasz Wojtow is a stock market trader and investor. He uses technical analysis and quantifiable methods for finding market's edges.
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