Candlestick Trading: The Basic of Bearish Engulfing Patterns, Part 2
In the first part of this series on market analysis, Steve Palmquist discuss trading styles and techniques for matching different market conditions. You can read part 1 of “Trading Bearish Engulfing Patterns” by clicking here.
Effect of Market Environment on Bearish Engulfing Pattern Results:
Many trading patterns show specific market environments in which they perform well; and others where they are best avoided. One of the keys to trading involves knowing which is which. Unless the trader studies the results of large numbers of trades in different market conditions they will not know when to use each pattern in their trading tool box. Using the same pattern in all market conditions may just churn the account. Selecting the right pattern for the current conditions may improve results.
During the period of 12/31/04 to 04/28/05 the market was in a down trend and dropped about 200 points or about ten percent. Testing the basic bearish engulfing pattern with a three day holding period during this period resulted in 1859 trades; a 31% annualized ROI which is quite favorable as compared to the approximate 10% loss in the NASDAQ. Fifty eight percent of the trades were profitable and only forty percent resulted in losses. This is a significant improvement over the previous results.
During the period of 11/17/05 to 03/13/06 the market moved mostly sideways within a one hundred point range. Testing the basic bearish engulfing pattern during this period when the market was stuck in a trading range resulted in 2880 trades and a forty five percent loss. Less than forty five percent of the trades were winners and more than fifty four percent were losers. It would appear that at least in these two cases the basic bearish engulfing pattern performs better when the market is in a downtrend than when it is moving sideways in a range.
The third market condition is an up trend, such as the market experienced during the period of 08/11/06 to 11/17/06. Running the basic bearish engulfing pattern with a three day holding period during this bullish market period resulted in 2627 trades that showed an annualized ROI of negative sixty nine percent. Less than thirty seven percent of the trades were profitable and the trading pattern lost money on more than sixty two percent of the trades. This was the worst result so far.
The test results are interesting and show that in these cases the bearish engulfing pattern works best in a down trending market and should be avoided in sideways or up trending markets. Testing the basic bearish engulfing pattern in another market down trend, the period between 07/28/05 and 10/17/05, confirms the previous results by showing a thirty eight percent annualized ROI for the 1451 trades made. More than fifty four percent of the trades were profitable.
After testing the bearish engulfing trading pattern in two different timeframes and all three types of market conditions we find that the only times it has shown profitable annualized ROI’s are the two times it was tested in bearish markets. Additional testing bears out the results that this trading pattern works best in declining markets and provides poor results in trading range or bullish markets.
Instead of relying on a few examples of trading patterns that work, the backtesting process allows us to examine the results of thousands of trades and even look at how the bearish engulfing pattern performs in different market conditions. Traders who did not perform this type of analysis would get different results depending on the type of market conditions in which they started using the pattern.
A trader who started using the pattern in a declining market might think it was a good technique and tell one of his friends about it. The friend might try it a few months later when the market was in an up trend and find that he loses money and thus concludes that his friend is ‘just better at picking stocks’. The professional trader analyzes trading ideas in various market conditions and knows when to use the bearish engulfing pattern and when to use something else. He also knows that because different market conditions favor different tools he needs a well stocked trading tool box of different tools for each market condition.
Effect of Holding Time on Bearish Engulfing Pattern Results:
Money management techniques have a strong impact on trading results and are one reason that different traders will sometimes see different results when using the same trading patterns. If you enter the same pattern at the same time as someone else you may not see similar results, unless you have the same exit strategies and position sizing. There is a lot more to trading than just learning a pattern and entering a position.
Table One, shows the effect of varying the holding period for the basic bearish engulfing pattern when running the test during the market down trend of 12/31/04 to 04/28/05. The best results are obtained using a four day holding period and the annualized ROI drops off consistently for longer holding times. The bearish engulfing pattern is a short term trading pattern and the longer the position is held the lower the results. Each trading pattern seems to have timeframes that it likes best, it is a good idea to check this information for every pattern you intend to use.
Table One. Test Results for 12/31/04 to 04/28/05 with Different Holding Periods
Effect of Volume on Bearish Engulfing Pattern Results:
Another filter that often affects trading patterns is volume. Volume measures the interest in a stock. Stocks that are moving up on increasing volume are showing that more people are willing to pay more money for the stock every day, just the kind of thing you want to own. Stocks that are moving up on less volume every day indicate that fewer people are willing to pay more money for the stock and perhaps it is time to take profits.
Traders using the bearish engulfing pattern are looking to short an up trending stock, after a down day occurs that has a body whose range completely covers or engulfs the previous day’s range. One would think that taking trades when this down day occurs on large volume would be good, since the large volume might also indicate that the down day (the second day of the pattern) was more important.
Table Two shows the results of testing the bearish engulfing pattern during the period of 12/31/04 to 04/28/05. The difference between each line in Table Two is that the ratio of the volume on the second day of the pattern to the 21 day simple average volume is changes. In the first line of Table Two only bearish engulfing patterns during the test period whose day two volume is at least 60% of the average volume is considered in the test results. The second line only looks at the results for bearish engulfing patterns whose day two volume is at least 80% of the average volume.
There are many ideas that seem logical for trading patterns. Some of these work, many do not. This is why testing trading patterns before using them is important. It is much better to find out what really works instead of trading on beliefs and assumptions. The data in Table Two indicates that, in general, above average volume on the second day of a bearish engulfing pattern hurts rather than helps results.
Table Two. Test Results for 12/31/04 to 04/28/05 with Different Day Two Volume Ratios
If instead of looking for a volume increase compared to the average daily volume, we simply look for larger volume on the second day of the bearish engulfing pattern than we had on the first day of the pattern the results are much more promising. The data in Table Three shows the results of running the back test seven times during the period of 12/31/04 to 04/28/05 using a constant three day holding period for each test.
The first line in Table Three shows the results of the standard bearish engulfing pattern during this test period. The second line adds a requirement to the standard pattern that the volume on the second day of the pattern be at least 70% of the volume that occurred on the first day of the pattern. The third line in Table Three shows the test results for the standard pattern with the additional requirement that the second day’s volume be at least ninety percent of the first day’s volume.
It is interesting to note that when the second days volume is at least one hundred and thirty percent of the volume on the first day of the pattern that the annualized ROI in the tests doubles over that found when using the basic pattern. The relationship between the first day’s volume (the volume on the white bar up day) and the volume on the second day of the pattern (the black bar down day) is clearly important to results.
Table Three. Test Results for 12/31/04 to 04/28/05 with Day 2 volume larger than Day 1 volume
Summary:
Candlestick patterns can be effective tools for the trader’s tool box. However, like any other tool the user needs to understand exactly what it is designed for, and how to use it effectively. Carpenters can make beautiful things with a table saw; however they need to understand how to use it, and also know when another tool might be more appropriate for the task at hand. They also need to know the safety rules, how to avoid kickback, and the importance of using a push tool. At least the carpenters that still have all their fingers do.
The analogy holds for trading patterns. There are times when a particular Candlestick pattern is effective, and times when another Candlestick pattern should be used to do the job. Trading any pattern, Candlesticks or some other technique, without a clear understanding of what it is, and what to expect in different situations, is like using power tools without an understanding of what they are for and the appropriate safety precautions. To protect your fingers and your money it is a good idea to have a clear understanding of how the tools you are using work.
In this brief article we have shown how backtesting can be used to determine the most favorable market conditions in which to use the bearish engulfing pattern, how holding times affect trading results, and how returns may be improved by selecting bearish engulfing patterns that have significantly stronger volume on the second day of the pattern than the first. The test data in this article came from the research for the book, ‘Money Making Candlestick Patterns, Backtested for Proven Results’. The book examines a half dozen popular candlestick patterns in depth using backtesting techniques to determine when each pattern should be used and the best filters for improving performance.
Steve Palmquist is a full time trader who invests his own money in the market every day. He has shared trading techniques and systems at seminars across the country; presented at the Traders Expo, and published articles in Stocks & Commodities, Active Trader, The Opening Bell, and Working Money. Steve provides additional information for traders at www.daisydogger.com and is the publisher of the Timely Trades Letter.