STATISTICS
Paper Umbrellas
The Dynamics Of Candlestick Patterns
by Shijoong Sung, PhD
Candlestick patterns have been used for centuries, but given that
they have received so much attention among technical analysts, can they
still be used in the conventional way?
If a hammer pattern appears during a bearish
trend, does that mean you should plunge into the market? If a hanging man
pattern appears during a bullish trend, does that mean you should exit
the market immediately? Little is known about the effects and dynamics
of candlestick patterns, so to find out more, I did a thorough and systematic
investigation of 351,745 candlestick patterns. My analysis seemed to suggest
that the conventional way of interpreting candlestick patterns should be
reconsidered.
MYSTERY
Typically, a hammer that occurs in a downtrend suggests a trend reversal.
Similarly, a hanging man pattern in an uptrend suggests the trend will
end and the market will reverse. It is a nice surprise to see a hammer
pattern that turns a bearish price movement into a bullish one, or a hanging
man pattern that turns a bullish movement into a bearish one. But that
doesn't mean you can make money from these patterns. From my analysis,
I found that there are many hammer patterns that give the correct bullish
signal. Unfortunately, there can be just as many -- or even more -- hammer
patterns that give the false signal. Is it really favorable to take any
action when these patterns appear?
Another important issue that is rarely addressed is the amount of time
it takes for the expected price movement to continue after a specific candlestick
pattern occurs. When should you take action? Candlestick patterns are usually
considered to have a very short-term effect. But is that really the case?
To answer these riddles, it is necessary to perform a systematic investigation
into how the market reacts to these patterns. To analyze the pattern effectiveness
and the time it takes for price movement of the patterns, I collected about
eight years of daily data from the KOSPI 200 stock index, which is listed
on the Korea Stock Exchange. There were approximately 1,758 candlesticks
for each symbol studied. In total, I investigated 351,745 candlestick patterns.
FIGURE 1: UPTRENDS, DOWNTRENDS, AND CANDLESTICKS. Here
you see the average returns depending upon the trend definition. Note that
the upward bias of the data has been corrected.
...Continued in the December issue of Technical Analysis
of STOCKS & COMMODITIES
Excerpted from an article originally published in the December 2004
issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2004, Technical Analysis, Inc.
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