Trading Candle Stick Patterns

Introduction :

Candlestick is a very popular charting technique to visually display Open, High, Low and Close prices of any instruments which are traded in markets that occurred during a predefined time-frame. There are basically two types of candles :

Illustration 1 : Types of candles.

Key Note : The colour of volume bar does not depend on colour of Candles. It depends on the close price. If the close is higher than previous candle close, the colour is green and vice versa.

A Brief History of Candlesticks :

Candlesticks originated in Japan more than 200 years age. Munehisa Homma, a rice trader from Japan is considered as the father of candlesticks. Before candlesticks, bar charts were popular in the West. Steve Nison discovered candlesticks while travelling to Japan and introduced it to the western world through his book ‘Japanese Candlestick Charting Techniques.’

Illustration 2 : Types of candlestick patterns. Simple patterns are single candle patters while complex patterns consist of multiple candles.

Simple Candlestick Patterns :

Table 1 : Examples of simple candlestick patterns.

Complex Candlestick Patterns :

Table 2 : Examples of complex candlestick patterns.

Important Points to keep in mind while trading candlestick patterns :

Reversal patterns must occur after a trend. Eg. A bearish reversal pattern is significant only if it has occurred after an uptrend. If it appears near a resistance zone, the probability of success increases.

Less frequently occurring patterns have a higher probability of success. Traders must look for other confirmations too before entering the trade to increase the chances of being profitable. Simple patterns are very short term patterns while complex patterns are short to medium term patterns.

Backtesting some of the candlestick patterns to evaluate their validity :

Let’s check if candlestick patterns have any predictive value by backtesting it on some of the stocks traded on the NYSE. We will be using Streak Platform to carry out the backtest as the platform offers an easy to use interface and the backtests are done on the cloud within no time.

The backtesting has been carried out using bullish engulfing pattern on 1 hour chart for a period of 1 year with the following entry and exit conditions :

Entry : Bullish Engulfing Pattern is formed

Exit : 1% Stop-loss is hit or 2% Target is hit (Risk:Reward of 1:2)

Illustration 3 : Backtest results for Bullish Engulfing Pattern on Streak

During the period of backtest i.e 25th Jan 2019 to 24th Jan 2020, The buy and hold would have given 26.49% while the strategy gave returns of 37.39%. The strategy performed good enough on other stocks as well.

Conclusion :

Candlesticks are the most basic things to learn when one beings learning technical analysis. Certain patterns have been identified which have some predictive value as patterns basically represent market reactions and the market is moved by the reactions of the participants.

Not all the patterns have similar kind of predictive advantage hence it is paramount to carryout backtests to evaluate their performance and carryout optimizations to improve the strategy. Streak provides one of the simplest and fastest platforms to carry out all these analysis without the need to code or buy and manage data.

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