Evening Star Candlestick Pattern - Explained with Examples

EVENING STAR PATTERNS

The evening star is a three bar reversal pattern that may signal the end of a stock’s uptrend. The first candlestick in the pattern has a long white body, indicating the current uptrend is continuing. The second candlestick gaps up and then forms a small body. It is as if the enthusiasm of the initial opening gap up cannot be maintained, and the distance between the open and close is not very large. The third candle is a black candle, indicating a reversal of sentiment; the black candle must close at least halfway down the range of the first day’s candlestick.

Figure 7.1 shows an evening star pattern in DIA. The stock was in an uptrend and showed a long white body on 05/09/06. The following day DIA gapped up and formed a small body, which was followed by a large black body on 05/11/06 to complete the pattern. After the formation of the evening star pattern, DIA dropped about five points during the next few days.

FIGURE 7.1: EVENING STAR PATTERN IN DIA Courtesy of AIQ

Figure 7.2 shows another evening star pattern that occurred in MDG on 02/23/07. MDG had been in an uptrend and formed a large white body on 02/21/07, which was followed by a gap up the following day and the formation of a small black body. On the third and final day of the pattern, MDG formed a large black body which marked an end to the recent uptrend, and the stock dropped nearly 11% during the next four days.

FIGURE 7.2: EVENING STAR PATTERN IN MDG ON 2/23/07

The definition of the evening star leaves some room for interpretation, and different traders may not classify some patterns as evening stars. For example, the definition of the third day of the pattern requires the candle to close at least halfway down the range of the first day. If the third day gapped down well below the low of the first day, it would still meet this definition, yet some traders would not look at the resulting pattern and call it an evening star.

Some of the literature on evening stars requires a gap between the first and second days of the pattern and also a gap between the second and third days of the pattern. As we’ve seen with the other patterns, variations among the definitions and some uncertainty of the adjectives sometimes make it difficult for new traders to understand exactly what to look for. Backtesting not only gives us an idea of what one might expect in trading the pattern, it also gives us a tool for exploring how different variations in the parameters of the pattern’s definition affect the results. Using this technique allows us to test different definitions and select the one(s) that seem to work best.

INITIAL TEST ON THE STANDARD ELEMENTS

In order to backtest the evening star pattern, I started with the definition below and used a four-day holding period. The initial test period was 01/03/06 to 05/01/07. After a pattern formed that met the definition below, a short position was entered at the open the following day and held for four days before being closed.

The stock must be in an uptrend.

• Day one requires:
• A white body.
• A body larger than the previous day’s body.

Day two requires:

• Either color body.
• A body less than 60% of the previous day’s body.
• A gap up, defined as the opening being above the previous day’s close.

Day three requires:

• A black body.
• A close below the midpoint of the range of day one.

The initial test results were a little surprising, as shown in Figure 7.3. Taking all of the evening star trades during the test period showed an annualized ROI with an 18% loss, and less than 46% of the trades were winners. Not exactly an inspiring start; but trading is about knowing what is, not about hoping what might be. Whether or not a trading pattern or a filter works, we learn something by knowing what it does, and in the trading business knowledge can make you money and keep you out of trouble.

FIGURE 7.3: EVENING STAR TEST RESULTS DURING 01/03/06 TO 05/01/07

Testing the initial evening star pattern in the longer time frame of 01/02/04 to 05/01/07 yielded about the same results, so it is possible that the poor return is due to the pattern itself and not just a function of one specific time frame. We can use backtesting techniques to investigate the affects of changing parameters of each day of the three day evening star pattern.