Types of Evening Star : Explained with Detail

MOD1 EVENING STAR

Removing the third day white space gap requirement and leaving the other changes to the initial pattern definition results in looking for evening stars in uptrending stocks with: a white body on day one of the pattern that is larger than the body size of the previous day; a gap up on the second day of the pattern with a body less than 30% of the first day’s body; and a black body on the third day of the pattern that closes in the bottom half of the first day’s range. We will refer to this evening star definition as the “Mod1” evening star. This definition results in a 3% annualized ROI during the 01/03/ 06 to 05/01/07 test period when using a four day holding period, as shown in Figure 7.13.

FIGURE 7.13: TEST RESULTS FOR MODI EVENING STAR DURING JAN. 2006 TO MAY 2007

Since the “white space on day three” parameter change resulted in too few trades, we will now look at other parameter changes and filters for the mod1 evening star to see if we can find a pattern with better results. The mod1 evening star is not a tradable system because it yields an annualized ROI less than buy and hold. We need to find a modification that shows better trading results or use a different pattern for trading. 

RECENT HIGH REQUIREMENT

After looking at a number of evening star patterns, it seemed they worked well when the second day of the pattern was the recent high. In these cases, the middle day of the evening star was the peak of the run up, which makes sense since the evening star is a reversal pattern. An example of this type of pattern is shown in Figure 7.14.

FIGURE 7.14: EVENING STAR IS RECENT HIGH IN HSOA ON 05/24/06

One of the issues with trading is it is easy to look at a number of charts and be convinced there is a pattern. The advantage of backtesting is you can look at thousands of charts and patterns and determine how often something actually happens. Testing the mod1 evening star with the additional requirement that the pattern occur at a recent high, as shown in Figure 7.14, actually reduced the results slightly and resulted in an annualized ROI under 2% during the 01/03/06 to 05/01/07 test period.

Knowing What Works and What Doesn’t

At this point you may be thinking, “Just show me what works.” But remember, not all patterns can be made to work; and, it is important to thoroughly understand a pattern before trading it. It is just as important to know which parameters don’t maximize results as the ones that do because some days you will see more patterns than you can trade and you will have to prioritize the opportunities. This is where this information becomes vital. The more you understand how a trading pattern works, what affects results and what does not, then the easier it will be to make trades with confidence.

RECENT RUN REQUIREMENT

Another filter that looked promising was to look for evening stars in stocks that were not just in an uptrend, but had shown a strong recent run. The idea is that after a rapid run, many stocks reverse and the evening star would mark the reversal. I looked at all the evening stars using the mod1 definition plus a requirement that the stock had to have run up at least 20% in the last 10 days. An example of this behavior is shown in Figure 7.15. 

FIGURE 7.15: EVENING STAR PATTERN IN MAMA ON 12/22/06

Taking evening star trades after at least a 20% run up in 10 days sounds like a great idea. It makes sense that after a fast movement a stock would retrace. However, traders need to be careful about a few examples and a logical explanation. It is not what sounds good that matters; it’s what works. This filter actually reduced results and moved the annualized ROI back into negative territory. 

I tried a number of other parameter changes and filters, and most did not turn the evening star pattern into a tradable system. In many cases, the pattern is more susceptible to the market conditions than it is to parameter changes and filters. Because of this discovery, I used a volume filter that helps locate stocks that might be running out of steam.

CREATING MOD2 USING A VOLUME REQUIREMENT

I added the requirement to the mod1 evening star that the short term average volume be declining and it improved results. The way I calculated the volume decline was to require that the average volume of the five days before the evening star pattern be less than 80% of the average volume of the last 25 days. An example of this declining volume pattern is shown in Figure 7.16, in which the low volume days preceding the formation of the evening star pattern are marked by down arrows in the volume portion of the chart.

FIGURE 7.16: DECLINING AVERAGE VOLUME EVENING STAR IN ARD ON 02/27/07

Test results for declining volume patterns with the mod1 evening star resulted in promising results as shown in Figure 7.17. During the 01/03/06 to 05/01/07 test period, this new filter resulted in the most interesting results seen so far. The 27% annualized ROI is about double buy and hold and the pattern shows winning trades more than 53% of the time while producing a respectable 243 trades. Amazing how one simple filter can make quite a difference; the issue of course is whether we also see positive results in other time frames.

FIGURE 7.17: TEST RESULTS FOR DECLINING VOLUME PATTERNS WITH MODI

Testing the mod1 evening star with declining volume, which we will now call the mod2 evening star, in six different time periods yielded the results shown in Table 7.4. The mod2 pattern only showed a loss in one period, a period that included the worst NASDAQ bear market in history. In the other five time periods, the results beat buy and hold by 2-to-1 in four of the periods and were about the same in the other. This represents a significant improvement over the results of Table 7.3, while at the same time producing more trades.

These results are the beginning of an interesting trading pattern that may be useful in the trader’s toolbox. I would not trade the basic evening star as first defined, since the results were less than buy and hold and showed losing trades most of the time. Adding the parameter changes and filters discussed above turned the original pattern from something I would pass on into something worth considering.

TABLE 7.4 MOD2 PATTERN TEST RESULTS IN DIFFERENT TIME PERIODS