TESTING CANDLESTICK PATTERNS
Candlestick
patterns can be effective tools for the trader’s toolbox; however, like any
other tool, the user needs to understand exactly what it is designed for and
how to use it effectively. Carpenters can make beautiful things with a table
saw, but they have to know how to use it and when another tool might be more
appropriate for the task at hand. They also need to know the safety rules, how
to avoid kickback, and the importance of using a push tool. At least the
carpenters that still have all their fingers do.
The
analogy holds for trading patterns. There are times when a particular
candlestick pattern is effective, and times when another candlestick pattern
should be used to do the job. Trading any pattern, candlesticks or some other
technique, without a clear understanding of what it is and what to expect in
different situations is like using a power tool without an understanding of its
use and safety precautions. To protect your fingers and your money, it is a
good idea to have a clear understanding of how the tools you are using work.
It
is not unusual for trading patterns to have undefined or unclear parameters.
Some patterns, such as the hammer, have specifications that may be interpreted
differently by different traders. The same is true for Western patterns such as
flags and the head and shoulders pattern. The hammer pattern requires, “little or no upper shadow.” The definition of
“little” will be interpreted differently by individual traders. This is one
reason that several traders using the “same” pattern may see different results.
One way to address this is to study the results of many trades using different
lengths of upper shadows and then to compare the results. This process results
in a clear definition of what constitutes “little
upper shadow” and has the added benefit of giving the trader an
indication of the type of results the pattern may produce.
Some
traders gain a better understanding of trading patterns, and the environments
in which to use them, though experience. After trading for a number of years,
they begin to understand which variations of a particular trading pattern work
best, and which ones are more prone to failure. Experience often produces good
results when we are listening closely; however, it can be costly.
The Tidal Force of the Market
The
overall market has a strong effect on how well trading patterns perform.
Focusing solely on the patterns or setups in the individual stocks that you are
trading can diminish results or make them highly variable. This is another
reason why traders using the same patterns may experience different results.
Trading patterns are like waves at the beach; they all are affected by the
tide.
Even
when the tide is going out, there are waves coming in, just as there is usually
something moving up even in bearish market conditions. Like conditions at high
tide, when the market is bullish, we are likely to see more stocks moving up.
Using different trading tools designed for specific market conditions is a
process I call market adaptive trading (MAT), which we will cover in the last
chapter.
In
order to develop the tools and techniques for market adaptive trading, one has
to be able to analyze a number of different trading tools in various market
conditions and determine which are the most effective in specific market
environments. After doing this, a trader can look at the market to determine
the current environment, then open the trading toolbox and select the
appropriate tools. Without this knowledge, the trader may be using the wrong
tool, which could lead to significant drawdowns and wide account swings.
I
believe a less expensive way to develop an in-depth understanding of how
trading patterns work is by backtesting the pattern. Backtesting allows us to
test how simple variations or changes in the trading pattern affect results.
Backtesting can be done during a variety of time periods and even in specific
market conditions.
You
do not have to become a software engineer to backtest candlestick patterns; there
are several good products available that provide backtesting tools traders can
use. In fact, most of the available choices provide excellent results and
probably more statistics than the average trader may care about. All of my
backtesting results shown in the subsequent chapters were produced using AIQ
Systems’ Trading Expert Pro. The analysis can also be done with other
backtesting tools; the important thing is to make sure to do the analysis
before trading a system with hard-earned money.
WHY BACKTEST?
Backtesting
allows traders to see how a system has performed in the past, to evaluate
different filters and parameters, and to evaluate a system in different market
conditions. Backtesting is not a guarantee of future performance. Successful
backtesting requires an ability to describe the trading pattern in a
backtesting language, knowledge of appropriate testing periods, an
understanding of how to interpret the results, and an ability to add and test
different filters or parameters to the original test description.
HOW DOES
BACKTESTING WORK?
The
process of describing the trading pattern in a backtesting language varies
depending on which program is being used. Each software package has its
advantages and disadvantages. The key is to select one that is easy to
understand and use. More power and features are a waste if you cannot figure
them out.
Backtesting
results are typically presented in a format similar to that shown in Figure 1.12. The results in Figure 1.12 provide a lot of information,
including the number of winning and losing trades, maximum profit and loss,
average drawdown, the probability of winning and losing trades, annualized ROI,
and other factors. It is usually not necessary to absorb all these
numbers there are really just four things that matter. The rest is interesting
but not vital.
FIGURE 1.12: TYPICAL BACKTESTING RESULTS
The
four key things to look for in backtesting results are:
- The number of trades in the test
period.
- The annualized ROI.
- The percentage of winning trades.
- The percentage profit/loss of the
average winning/ losing trade.
The
number of trades in the test period gives you an idea of how valid the test
results might be, and whether it is worth trading. A trading pattern that only
produces a few trades a year may be due to seasonal or news factors and not the
pattern itself. A trading pattern that produces 100 trades a year is more
likely to be due to the characteristics of the pattern itself, and, therefore,
has a better chance of recurring in the future.
The
annualized ROI provides an indication of how well the trading pattern performs.
Since the number is usually calculated by taking the percentage gain for a
trade during the holding period and then annualizing the result, it can
exaggerate the returns of patterns with short holding periods that do not occur
very often. This is rarely the percentage return traders will see in their
account because many traders cannot take all the trades generated by a trading
pattern, and the calculation does not include slippage and transaction fees.
The ROI number is best used as a figure of merit; more is generally better.
Annualized ROI is like the gas mileage numbers posted in a car dealership you
know you will not get that exact mileage, but bigger numbers are generally
better than smaller ones.
The
percentage of winning trades for a trading pattern is important. If the average
profit on a winning trade is larger than the average loss on a losing trade,
then, in general, the more often the pattern produces a winning trade, the
better the results. Imagine we are going to flip a coin 100 times, and every
time it comes up heads, you give me $1.50; and, when it comes up tails, I give
you $1.20. Over the long run, I expect the outcome to be profitable for me, and
frankly hope you will continue to play.
The
odds for each coin flip are 50/50 for heads. I do not know if any particular
coin flip will be profitable for me; but, since I expect to win about half the
time, and since I get paid more when I win than I have to pay when I lose, I
should make a profit in the long run. Trading patterns are similar in that you
do not know the outcome of any particular trade; but, if your odds of a winning
trade are better than 50/50, and you make more on the average winner than you
lose on the average loser, you would expect to make money in the long run.
Trading
patterns should have an advantage over coin flipping; they should provide
winning trades more than half the time. This stacks the odds in the trader’s
favor. If a trading pattern wins more than 50% of the time, and the average
winning trade gains more than the average losing trade loses, then trading is a
better game than the coin flip example. The stock pattern trader still does not
know if any given trade will be profitable, but over the long run, the odds are
favorable for the net result to be profitable. Traders do not focus on the
results of any one trade, they focus on whether or not the account balance is
going up over the long run.
WHAT TIME FRAME DO
I USE?
While
backtesting can yield great insight into how candlestick patterns perform and
the risks associated with particular trading patterns, they need to be run over
a specific time frame. Choosing that time frame can be confusing. Many people
initially feel that the longer the time frame of the backtest, the better the
results. Figure 1.13 illustrates why there
is a better way to select time frames for backtesting.
FIGURE 1.13: NASDAQ MONTHLY CHART 1994 TO 2007
Figure 1.13 shows the NASDAQ market over a
14-year period. If backtesting is done over a specific time period, then one is
assuming that the next period of similar length will be just like the previous
period. If one tests a trading pattern over the 2004 to 2007 period and uses
the results to trade in 2007 to 2010, the trader is expecting the 2007 through
2010 period to look similar to the 2004 through 2007 period. This may at first
seem reasonable, but further examination of Figure 1.13 reveals that it is hard
to find two four-year periods that look just like each other.
The
market is always changing; we do not know what it will look like in the future.
There is one constant though: Each market time frame is made from a collection
of bullish, bearish, and trading range periods. The market is either going up,
down, or sideways. It is impossible for it to do anything else. This indicates
that trading patterns should be tested in each of the three conditions, and
then traders should select the patterns that they have found to be most
effective during the current conditions. Yes, testing a trading pattern over a
calendar time frame is also good. But use more than one time period and also
look at performance in each of the three types of market conditions to gain a
better understanding of how a potential trading system performs and when to use
it.