Money-Making Candlestick Patterns

02/01/2009 11:38 am EST

Focus: STRATEGIES

Steve Palmquist

Founder, DaisyDogger.com

Engineer turned trader Steve Palmquist has come out with an interesting new book that looks at individual stocks and candlestick formations from a mathematical standpoint. Though almost all traders are convinced of the relevance of candlesticks when looking at a chart, this is the first time, to my knowledge, that they have been rigorously tested. In the preface, Steve shares some of the lessons that he has learned in 20 years of trading, most of which you may have heard before, but regardless, are ignored by many traders. My favorites are: 1) You do not need to trade every day, 2) Never enter a position without a plan for exiting, and 3) Don’t rush in—if a trend is worth trading, you don’t have to be in on the first day.

Before starting, Steve identifies the basic candlestick formations that he will be testing and the criteria used to evaluate them. This chapter is very important to the rest of the book, because if you do not understand the statistics of trading and why it is a critical part of risk management, then the rest of the book may not be useful in your trading strategy.

Most people do not think about the mathematical formula that constitutes a specific candlestick formation, such as a “hanging man,” but after Steve’s explanation, it seems very clear as he tests six different formations in this book. He follows a similar process for each of these formations, starting with what he calls the initial test, which gives what might be thought of as a baseline value. For each pattern, he then runs a series of additional tests that build on the prior one. For example, the hammer formation has a long lower shadow and a small real body. (If you are not familiar with this terminology, refer to a basic description of candlesticks online before continuing with this review.) This pattern can mark a reversal pattern in a downtrend, and the hammer should have almost no upper shadow and the body color (higher or lower close) is traditionally thought not to be important. Steve tests both of these conditions to determine which gives superior results. Some of the other criteria that are used include the price of the stock, the size of the real body, the size of the shadow, and the volume associated with the formation. For example, with the hammer, the best results generally occur when tested on stocks under $30 and when the volume is 160% of the 21-day moving average on the day the hammer is formed. At the end of each chapter, there is a concise summary of what the tests concluded to be the best filters to use when trading each formation.

One other factor that is also tested is the market’s overall condition, or whether it is an up market, down market, or sideways market. It is logical to assume that the formation of a bearish engulfing pattern should work better in a down-trending market than in an up-trending market, and the test results confirm this. Steve also expands on the state of the market in the final chapter titled “Market Adaptive Trading Techniques,” or MAT. This is the process of analyzing “the current market conditions in order to determine appropriate risk levels and select the best patterns for trading.” This is broken down into a four-step process, and Steve goes into each of these steps in detail. This whole process is designed so that the trader can determine what the market is telling them as opposed to trading their belief about the market’s direction. The first step is a review of the test results, isolating what type of candlestick formation yields the best results in a given market environment. Though this may seem obvious on the surface, many traders, in my experience, can occasionally fall into the trap of using a strategy that is bearish in an up-trending market or a bullish strategy in a down-trending market. Steve spends quite a bit of time on this chapter and shares some of the knowledge that he has gained throughout his 20 years of trading experience.

If you use candlestick charts in your trading, this book will give you some interesting insights on additional factors that could improve your performance. Even if you are not trading individual stocks as Steve does, the filters he discusses could be applied to many different markets. More experienced traders who are attempting to develop their own trading systems should also gain valuable tips from this book. If you fall into any of these categories, then I think that this book, though a little high-priced, should be part of your trading library.

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