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Some of the most popular trading strategies in forex markets involve the use of Japanese Candlestick charts. Given a specific pattern in candlestick formations, traders look to buy and sell currencies in anticipation of reversal or continuations in price. Yet testing the profitability of such concepts is easier said than done.
Given that many of these formations are inherently qualitative in nature, it is difficult to develop a reliable quantitative approach with which to test the viability of such strategies. That being said, we will attempt to quantitatively identify specific candlestick patterns and backtest the profitability of trading on such candlestick signals. In the second installment of our candlestick series, we will take a look at the popular Hammer and Shooting Star formations.
To see our first candlesticks article, see How Profitable Are Candlestick Formations in Currency Trading?
Candlestick Formations: Which do we choose?
Given a great number of candlestick formations, it is nearly impossible to gauge the profitability of each trading signal in a single study. Instead we will examine pairs of similar buy/sell signals within the same backtest to gauge the effectiveness of each individual formation. Though not without its limitations, we feel that this method represents one of the most objective measures on the profitability of these buy/sell signals.
To that end, we would like to examine the effectiveness of two popular trend reversal candlestick patterns: the Hammer and Shooting Star formations.
A Hammer forms when price is in a downtrend and price trades sharply lower from the open, but a subsequent reversal leaves price marginally unchanged through the close. The candlestick formation is distinct for its long wick to the downside, small candle body, and little or no wick to the topside—signaling that price finished near the top of its intra-candle range. It is a decidedly bullish formation, as it tells us that bulls have overpowered an initial bearish tumble.
A Shooting Star formation is effectively the exact opposite of the Hammer. Price remains in an uptrend when it opens and trades sharply higher within a given candle, but a subsequent reversal leaves it near or below its candle open. The Shooting Star is distinctive for its very long upward wick, small candle body, and little to no wick to the downside. The formation signals that a bullish run was initially enough to push price to new heights, but exhaustion has allowed bears to push price significantly lower before the candle close.
Backtesting our Candlestick Formations
Using TradeStation’s EasyLanguage, we translate our Candlestick rules into quantitative code in order to test their performance on a historical basis. In doing so, we can easily test our concepts across the spectrum of currencies and time frames. We take special care in not adding arbitrary elements to our code that may lead us to over-optimize our results, as our aim is to judge the raw profitability of the simple candlestick formation.
In terms of actual trading rules, we tell our strategy to buy a standard lot of the given currency pair when a Hammer formation materializes and short sell the currency on an Shooting Star. Our initial results do not include stop-loss orders or profit limits. Instead, gains and losses are realized when positioning flips on the subsequent Morning or Evening Star formations. Trading is done on a daily chart in the three years ending on the publication date (December 4, 2007).
Our initial 3-year backtest on the strategy has given us very little in the way of positive news, with two of our five chosen currency pairs showing fairly sizeable losses from the buy-sell signals. Perhaps interestingly, the Commodity Bloc AUDUSD and USDCAD are the most profitable pairs of the five. Yet this seems to be almost an aberration given the fact that our most liquid currencies do not produce worthwhile profits on said strategies.
Our Strategy Does Not Make Money – What Gives?
Our trading results suggest that we must make substantial improvements to our strategy before we may even consider trading live with Hammer and Shooting Star formations. A cursory glance at the trading signals generated by our strategy suggests that these coded candlestick formations produce accurate timing signals at market turns. Yet we clearly see that there are numerous false buy/sell orders, and it likewise remains clear that our simple strategy of just buying when we see a hammer and selling when we see a shooting star does a very poor job of capturing profits.
How do we Improve our Strategy?
An examination of the trading signals provided by our raw candlestick code shows promise, and we believe that certain changes may be enough to make our candlestick strategy profitable. In our last FX Candlesticks report, we showed that adding things like simple take-profit and stop-loss orders vastly improved the performance of Morning Star and Evening Star buy/sell signals.
In immediately setting out to establish the “ideal” profit target and risk limit, however, we run the risk of over-optimizing our results and coming to misleading conclusions. Thus we look to our actual trading results to examine instances in which our strategy clearly failed, looking to build on instances in which our trading is successful.
In the above chart we see that our strategy produces several inaccurate buy/sell signals in a row, with our largest single trading loss highlighted in red. Our simple code triggered a buy on a Hammer candlestick formation, but we subsequently see that price breaks through key trendline support in the trading that follows. From a discretionary standpoint, it stands to reason that we would exit our trade when we see price break through a clear support level. In doing so, we could have avoided this tremendous 615 pip drawdown and clearly improved the results of our strategy. By quick estimates, this would have boosted our total net-profit to $9,330 and reduced our maximum drawdown accordingly.
We can also look at instances in which our candlestick strategies gave accurate trading signals to learn when it is most appropriate to use candlesticks in our forex trading.
When do FX Candlestick signals work best?
The following example shows us an instance in which a Shooting Star formation very accurately predicted a 450+ point reversal in the EURUSD—a solid profit opportunity by any standard. In this particular instance we see that the Shooting Star candle forms at the very top of the currency pair’s previous resistance mark. The single candle clearly shows us that EURUSD bulls showed willingness to push the currency pair beyond previous heights, but a daily close clearly suggested that bears had taken the reins.
In this case we would have seen the Shooting Star formation and confluence of substantive resistance to sell the EURUSD. Though our candlestick strategy does not produce a timely exit signal since there was no hammer, we could have improved our candlestick trading by exiting the short positions when the EURUSD fails to break below support.
Final Conclusion and Caveats
Our study of Hammer and Shooting Star candlestick formations suggest that they do not work especially well as trading signals onto themselves, but using other filters for potential trades improves the accuracy of these FX Candlestick strategies. Indeed, we see that a simple discretionary examination of currency support and resistance levels would have prevented a significant loss on a EURUSD buy signal, while the confluence of candlestick and other technical signals provided an excellent opportunity on a EURUSD sell signal.
Thus our initially discouraging results do not rule out the effectiveness of these particular candlestick formations. Instead, we see that it is important to combine a number of technical tools to maximize the effectiveness of our trading strategies. Thus our Hammer and Shooting Star technical formations may prove valuable as additional confirmation of potential buy/sell entries.
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