Morning Star Patterns in Money Making

MORNING STAR PATTERNS

In previous chapters, we have examined the hammer and hanging man candlestick patterns that form in a single bar, and the bullish and bearish engulfing patterns that form in two bars. Now it’s time to examine the next level of candlestick patterns.

The morning star pattern is a three bar pattern that marks the end, or reversal, of a downtrend. The first bar is a long black body that indicates a continuation of the downtrend. The second bar features a small body that can be either black or white and gaps lower. The third day of the pattern shows a white body that closes well within the area of the first day’s black body.

Figure 6.1 shows an example of a morning star pattern that occurred in LVS on 06/28/07. The first day of the pattern is a large black-bodied candlestick and is marked by the down arrow. The second day of the pattern is a white body that gaps down. The third day completes the morning star pattern by forming a white body that moves well into the area of the first day of the pattern. This morning star pattern marks the end of the LVS downtrend, and the stock bounces 8% in a few days. 

FIGURE 6.1 MORNING STAR PATTERN IN LVS ON 06/28/07

The second day of the pattern can be either a black or white body. The requirements that the second day gap down and that the body of the candlestick be small are important. Figure 6.2 shows a morning star that formed in SYMM on 03/19/07. The stock was in a downtrend and the first day of the three day pattern was a large black body as marked by the up arrow. On the following day, SYMM gapped down and formed a black body. The pattern was completed on the third day, marked by the down arrow, when the stock moved up and formed a white body that closed well into the area of the first day of the pattern. Following the formation of the morning star pattern, SYMM moved up more than 6% in the next few days.

FIGURE 6.2: MORNING STAR PATTREN IN SYMM ON 03/19/07

Morning star patterns are fairly easy to recognize, but the basic definition leaves several parameters open to interpretation. Without a clear definition of what constitutes a “large black body” for the first day of the pattern, or a “small body” for the second day of the pattern, or how far into the first day’s range the final day of the pattern most close, different traders will pick different patterns. If changes in these parameters do not yield different results, then it does not matter. If slight changes in the parameters affect the trading results, then traders using the morning star should be aware of them.

STANDARD DEFINITION ASSUMPTIONS

Backtesting provides a way for traders to better understand how variations in the definition of the morning star pattern affect trading results. As a starting place for this analysis, I tested the morning star pattern in the period between 01/03/06 and 05/01/07 using the following definitions:

• The first day’s “big black bar” must have a body greater than 50% of the day’s range.
• The second day’s gap down is defined as the opening value on the second day being less than the close of the first day.
• The second day’s body must be less than half the day’s range.
• The third day’s white body must close in the upper half of the first day’s range.

The positions were entered at the open on the day following the formation of the morning star pattern, held for five days, then closed. Using these parameters resulted in more than 51% winning trades and a fractional annualized ROI for the 1,476 trades during the period, as shown in Figure 6.3.

FIGURE 6.3: INITIAL MORNING STAR TEST RESULTS FOR 01/03/06 TO 05/01/07

Table 6.1 shows the results of investigating the effects of variations in the relationship of the first day’s black body to the day’s range. The first column shows the minimum percentage of the day’s range the body must be on the first day of the morning star pattern. The second and third columns show the test results for annualized ROI and percentage of winning trades.

TABLE 6.1 EFFECT OF FIRST DAY BODY SIZE ON 01/ 03/06 TO 05/01/07 TEST RESULTS

The results shown in Table 6.1 are interesting in that they show improving annualized ROI numbers as smaller and smaller body sizes are allowed when the body size is measured as a percentage of the day’s range. In fact, when the requirement of the first day’s black body is changed to require it to be less than 30% of the day’s trading range, the test results for the period improve significantly, as shown in Figure 6.4. The 23% annualized ROI beats the 14% buy and hold and the percentage of winning trades increases to more than 54%.

FIGURE 6.4: TEST RESULTS WHEN FIRST DAY BLACK BODY IS <30% OF THE DAY’S RANGE

An example of the morning star pattern using this small body requirement of the first day of the formation is shown in Figure 6.5. HEB was in a clear downtrend when it formed a black candlestick on 07/20/06 whose body was less than 30% of the day’s range. The next day, HEB gapped down and formed a small-bodied candlestick. The third day completed the morning star pattern by moving up well into the range of the first day of the pattern.

FIGURE 6.5: SMALL FIRST DAY BLACK BODY MORNING STAR IN HEB ON 07/20/06

Another example of the small first day morning star pattern is shown in Figure 6.6 in which GMR is in a downtrend and forms a black-bodied candlestick with a body less than 30% of the day’s range on 06/12/06, which is followed by a candlestick that gaps down and forms a small body. On the third day of the pattern, GMR moves up and closes well into the range of the first day of the pattern, which completed the morning star.

FIGURE 6.6: SMALL FIRST DAY BLACK BODY MORNING STAR IN GMR ON 06/14/06

The small body morning star results outlined above are interesting. Backtesting often leads traders in new and sometimes unexpected directions, which is another reason for going through the process. These results are something worth looking into further, but they also deviate from the typical morning star pattern with which most traders are familiar. That means it’s time to investigate other ways to improve the trading results of the more typical pattern.