DETERMINING PATTERN EFFECTIVENESS

In order to understand how often the bullish engulfing candlestick pattern works, we could look at 100 charts during the last year and count the number of patterns that worked and the number that failed. This would give us a better understanding of how effective the pattern was during the last year. However, the manual approach quickly becomes impractical when, after looking at the data, we ask questions such as:

• Do the results change when looking at several hundred or 1,000 stocks?
• Do the results change when looking at a one-, two- or five-year test period?
• What is the win/loss ratio when the market is in bullish periods?
• Does the win/loss ratio change when the market is in bearish or trading range periods?
• Does it help to combine this candlestick pattern with other indicators?
• Does it make a difference if the stock is above or below a key moving average?
• Does it matter how much the second day’s body overlaps the first day’s body?
• Does the size of the body on either the first or second day of the pattern affect results?
• How long do I hold the position after entering?
• Does it matter if the volume on the second day of the pattern is higher or lower than the first day’s volume?
• Does it matter if the volume is above or below average?
• Does the price of the stock affect the trading results?
• Does the average volume of the stock affect trading results?

In order to answer these questions, we would need to examine and record thousands of patterns in thousands of stocks, which could result in years of rather boring and methodical work. For a long time, this was a barrier to all but the most serious traders because of the extensive and repetitive work involved. Many traders would just trade patterns and hope for the best, but hope is not a trading strategy.

Fortunately, much of this work can be done easily on a good desktop computer with an investment of a few days’ worth of time to learn how to use one of the backtesting software packages available to individual investors. The investment in, and the use of, this software is well worth it and can drastically reduce the effort required to answer trading questions like those outlined previously.