Candlestick Formations: Which do we choose?

Given a great number of different candlestick formations, it would be nearly impossible to gauge the overall profitability of all candlestick strategies in a single study. Instead, we will focus on specific reversal signals that we believe have intuitive value as it relates to market sentiment. In this particular case we will look at both the Morning Star and Evening Star formations as buy-and-sell signals.

Candlesticks_Morning_Evening_body_Picture_21.png, Forex Strategy Corner: Using Candlestick Formations in Trading

A Morning Star formation is a bullish reversal signal for an overall downtrend. Given fairly consistent losses, we see a strongly negative full-bodied first candle. The second candle opens at or below the previous close, trading within a relatively narrow range with the high staying below the midpoint of the first candle. The third candle is strongly positive and closes above the midpoint of the first candle. This tells us that bearish sentiment is unable to push price below previous lows, and risks remain for a reversal in price trends.

Candlesticks_Morning_Evening_body_Picture_24.png, Forex Strategy Corner: Using Candlestick Formations in Trading

The Evening Star is effectively the opposite of a Morning Star, as price starts in an uptrend and the first candle is strongly positive. The second candle opens above or at the previous close, trading within a fairly narrow range and with its low above the previous bar’s midpoint. The third candle is strongly negative and closes below the first candle’s midpoint. This gives warning that bulls are unable to push price to new heights, and a strongly bearish candle hints at further downside potential through subsequent trade.

Backtesting our Candlestick Formations

Using FXCM’s Strategy Tradersoftware, we will code a strategy based on these two popular candlestick formations and see their historical results. In doing so, we can easily test our concepts across the spectrum of currencies and time frames. We take special care in not adding arbitrary elements to our code that may lead us to over-optimize our results, as our aim is to judge the raw profitability of the simple candlestick formation.

View a video guide on strategy backtesting and optimization in Strategy Trader here:

https://admin.na6.acrobat.com/_a205571165/p83928216/

Forex Candlestick Morning Star and Evening Star Strategy

Entry Rule:If there is an Evening Star formation (as defined by our strategy code), we place a market order to go short on the open of the next daily bar. If there is a Morning Star, we place a market order to buy on the next bar.

Stop Loss:None

Take Profit: None

Exit Rule:The trade is taken out by the opposite signal. Thus if we are long due to a Morning Star formation, a subsequent Evening Star would close the existing long and establish a short position.

Using Strategy Trader, this is relatively easy to accomplish in code. Thus we are left to load the strategy onto our chart and see the results.

Download and install the Strategy Trader platform, then import the following code example from the DailyFX forex forum. Download and unzip the attached .zip file. Open Morning_Evening.fxd and click “OK” when prompted on whether you would like to import the Strategy Advisor into your platform.

Subsequently open the Morning_Evening.fxw file to load the workspace that will load the strategy onto the British Pound/US Dollar and Euro/US Dollar currency pairs.

Forex Candlestick Strategy Results

If we run this strategy on the often-volatile and fast-trending British Pound/US Dollar pair, with a daily chart going back to January 2001, the results are quite impressive.

Candlesticks_Morning_Evening_body_Picture_4.png, Forex Strategy Corner: Using Candlestick Formations in Trading

To be absolutely fair, this strategy does not perform nearly as consistently well on any other currency pair. This author is quite frankly at a loss to explain why the Morning Star and Evening Star formations (as defined by the strategy code) have done so clearly well on the GBPUSD and few other currency pairs. The same strategy did a particularly good job in catching the EURUSD uptrend through late 2008 but has been unable to profit on subsequent moves.

Candlesticks_Morning_Evening_body_Picture_7.png, Forex Strategy Corner: Using Candlestick Formations in Trading

We invite you to test the strategy on different currency pairs and across specific time frames. Using the attached code, you may also test different stop loss and profit target levels to your trades—learning the different characteristics of potential money management techniques for the Evening Star and Morning Star formation strategies.

Applying it to Existing Forex Strategies

Though we have achieved mixed results with the Morning Star and Evening Star formations, there does seem to be some use for said strategy in trading the British Pound/US Dollar currency pair. Past results are never a guarantee of future performance, and as such a great deal of caution is urged. Yet we have seen such remarkable consistency in said technique’s ability to pick GBPUSD reversals that it is difficult to ignore the backtest data.

In future articles we hope to delve further into these and other Candlestick formations—combining them with other analysis techniques to put together attractive trading strategies.

If you would like to suggest ideas for this topic or any other forex strategy you would like to see in this series, feel free to e-mail author David Rodríguez at drodriguez@dailyfx.com.

View previous articles in this series:

Using Seasonality Strategies in Your Trading

Forex Trading Strategy Analysis: Trade with Market Conditions

How do we use Money Management for Moving Average Forex Strategies?

How do we set stops for the Range Trading Strategies?

Written by David Rodríguez, Quantitative Strategist for DailyFX.com

To be added to this author’s distribution list, e-mail drodriguez@dailyfx.com with subject line “distribution list”