Testing the Parameters in Morning Stars

A CLOSER EXAMINATION OF BODY SIZE

The tests above defined the “large body” of the pattern’s first day in terms of the range of that day. Another way to define large is in terms of the previous day or days. If the body on the first day of the pattern is required to be larger than the body of the previous day’s candlestick, then we will see results as shown in Figure 6.7 for the test period between 01/ 03/06 and 05/01/07.

FIGURE 6.7: TEST RESULTS FOR MORNING STAR WITH FIRST DAY BODY LARGER THAN PREVIOUS DAY’S BODY

Defining the long black body for the first day of the three-day pattern to be larger than the previous day’s body yields results that are significantly better than the initial test results. Figure 6.7 indicates that the annualized ROI moves from a fractional gain to more than 10% and the percentage of winning trades also improves.

The type of pattern found using this definition of large black body for the first day of the pattern is illustrated in Figure 6.8, in which QSII formed a morning star pattern on 07/28/06. QSII had been in a downtrend, and then on 07/26/06 formed a black-bodied candlestick where the body was larger than the body of the previous day. The next day the stock gapped down and formed a small-bodied candlestick. On the third day the morning star pattern completed when the stock moved up and closed well within the range of the pattern’s first day.

FIGURE 6.8: LARGE FIRST DAY BODY MORNING STAR IN QSII ON 07/28/06

When we first looked at the morning star pattern, the definition of “large body” and “small body” was not clearly defined. The test results have indicated that defining the first day’s large body as being bigger then the previous day’s body improves results, so we will incorporate that into the definition as we examine other ambiguous parameters of the morning star pattern. As we go through this process, we should end up with a more specific and improved definition of the morning star pattern.

TESTING THE SECOND DAY PARAMETERS

The second day of the morning star pattern has two parameters. It must have a small body, either black or white, and it must gap down. The question arises as to what does “small” mean? Our current definition defines small in terms of a percentage of the day’s range. The results of Figure 6.7 were obtained using the original definition that required the body of the second day of the morning star pattern to be less than half the day’s range.

Table 6.2 shows the results of testing variations in the maximum percentage the second day’s body can be in relation to the range of the second day. The fourth line shows the results for requiring that the body on the second day of the pattern be less than 50% of the second day’s range. This is the original definition and is the same as the results shown in Figure 6.7. Requiring smaller body sizes than this on the second day of the pattern reduces results.

TABLE 6.2 EFFECT OF SECOND DAY BODY SIZE ON 01/03/06 TO 05/01/07 TEST RESULTS

Based on this information, I would change the morning star definition to require a second day body size less than 60% of the day’s range, unless subsequent testing showed a better alternative.

I also looked at defining a small body on the second day of the morning star pattern in terms of its relationship to the previous day’s body size instead of the relationship to the second day’s range. After testing several different percentage relationships, I did not find one that significantly improved results. Based on these results, I modified the initial parameters noted above to define the small body on the second day of the pattern as being less than 60% of the second day’s range.

EXAMINING GAPS

The second parameter for the second day of the morning star pattern is the requirement that the stock gap down. Gaps are a popular topic of conversation among traders; there are lots of ideas and theories about trading gaps. There are some gap trading strategies with promising results, but there is also a lot of folklore that does not seem to pan out.

In this case, the only requirement we have for day two of the morning star pattern is that it gap down. Would the results change if we only looked at patterns in which the close on day two was also below the previous day’s close, or if the high of day two was lower than the close of the previous day? Once again testing is the way to find out.

Test results for morning star patterns during this test period that showed a close on day two below the close of the first day of the pattern indicated a slight increase in annualized ROI, but nothing dramatic or conclusive. Taking morning star trades when the close of the second day of the pattern was below the low of the first day of the pattern (the big black bar) was more interesting.

Figure 6.9 shows that during the 01/03/06 to 05/01/07 test period, adding a new requirement to the definition of the second day of the pattern (that its close be below the low of the first day of the pattern) improved the annualized ROI to more than 17%, which is more than the buy and hold annualized ROI. The percentage of winning trades also improved to nearly 57%. This is a requirement worth considering if further testing confirms the results in other time frames.

FIGURE 6.9: TEST RESULTS FOR MORNING STARS WITH SECOND DAY CLOSE BELOW THE FIRST DAY’S LOW

If we only took trades that show the high on day two of the pattern to be less than the low of the first day, we saw very interesting results, as shown in Figure 6.10. The annualized ROI jumped to more than 52% and the percentage of winning trades dropped to just more than 48%. The annualized ROI was high even with slightly less than a 50% winning trade percentage because the average winning trade returned nearly twice what the average losing trade lost.

FIGURE 6.10: TEST RESULTS FOR MORNING STARS WITH SECOND DAY HIGH BELOW THE FIRST DAY’S LOW

Since most traders focus on the annualized ROI number, let’s look closer at the results of Figure 6.10. When examining test results, the total number of trades produced during the test period is important. A small number of trades may not be statistically valid or may be caused by some unique event occurring during the test period. One way to determine if this is the case is to test the pattern in a longer period to see if similar results are produced. This leads to another issue: Some traders feel the longer the test period, the more valid the results. This also has issues, as we shall see.

Running the test in a period more than twice as long, 01/02/04 to 05/01/07, resulted in 124 trades with an annualized ROI of nearly 41% (compared to 10% for buy and hold) and 50% winning trades. This shows that even though the system does not produce hundreds of trades, it does show interesting results in two different time frames.