How Profitable Are Candlestick Strategies in Currency Trading?
Some of the most popular trading strategies in forex markets involve
the use of Japanese Candlestick charts. Given a specific pattern in
candlestick formations, traders look to buy and sell currencies in
anticipation of reversal or continuations in price. Yet testing the
profitability of such concepts is easier said than done. Given that
many of these formations are inherently qualitative in nature, it is
difficult to develop a reliable quantitative approach with which to
test the viability of such strategies. That being said, we will attempt
to quantitatively identify specific candlestick patterns and backtest
the profitability of trading on such candlestick signals. The first
ones that we will analyze are morning star and evening star formations.
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
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.
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 TradeStation's EasyLanguage, we translate our Candlestick
rules into quantitative code in order to test their performance on a
historical basis. (For those interested in seeing the actual
Candlestick strategy code in TradeStation's ELD format, click here. To see the same code in more widely compatible .txt format, click here.)
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
In terms of actual trading rules, we tell our strategy to buy a
standard lot of the given currency pair when a Morning Star formation
materializes and short sell the currency on an Evening Star. Our
initial results do not include stop-loss orders or profit limits.
Instead, gains and losses are realized when positioning flips on the
subsequent Morning or Evening Star formations. Trading begins on the
inception of the euro (12/31/99) and ends at publication date.
Initial Backtesting Results: Could we Improve Upon our Raw Candlestick Strategy?
Our initial backtest shows that our simple strategy remains modestly
profitable across major currency pairs. Yet with sizeable Max
Drawdowns, it remains clear that our strategy may do well with slightly
improved risk management. Indeed, it may be important to take a closer
look at individual exit and entry rules and their efficiency in
capturing strong risk-adjusted returns.
Using TradeStation, we are able to quickly assess maximum profit and
loss potential across trades with several functions. Of particular
interest in this case is to measure each individual trade's maximum
downward move before turning profitable. For simplicity's sake, we will
look at EURUSD trades. The chart below gives us an accurate depiction
of how risk/reward on overall trades.
The chart above shows us an interesting pattern in our
candlestick-based trades. Namely, our most profitable trades tend to
have very little negative incursion. In plainer terms, our best trades
are those that are strongly positive from the onset and show very
little downward extension. At the same time, some of our most negative
trades show very little profit potential from a buy-and-hold
perspective. What this tells us is that our strategy would likely
benefit from a simple stop-loss measure that protects us from large
losses yet does not keep us from making a profit on our more successful
In this particular case we see that six out of ten trades that draw
down beyond $2,000 turn out to be losers, while only one of nine that
drawdown less than this amount end as net losses. This suggests that
adding a stop loss to our strategy can dramatically improve our overall
The table above is clear evidence of this point, as our overall rate
of return improves substantially if we limit or maximum loss to a total
of $1,000 per given trade. Looking at our results, we see that our
percentage of profitable trades drops dramatically when we set a stiff
profit target on our trades. In fact, of 37 total trades, 24 produce a
loss when we set our stop to $1,000. Yet the amount in profits we
collect on each winner far surpasses the relatively modest loss on each
loser. It seems as though our Morning Star - Evening Star candlestick
strategy works best with tight stop losses and looser profit targets.
The next logical question becomes whether we can improve our strategy
with a fixed profit target.
The chart above shows us the exact opposite of our Maximum Adverse
Excursion chart, whereby we can judge the efficiency of our
profit-taking techniques on our trading strategy. The solid black line
represents a 1:1 Maximum Favorable Excursion to trading profit line. In
other words, trades closed at the line represent instances in which we
have captured the maximum possible profit in a particular trading
opportunity. Of course, we all know that this is a near-impossibility
to achieve on a regular basis. Instead we look to see if there are any
particularly extreme cases in which a set take-profit would have
dramatically improved our profitability.
Again we see interesting results when we modify money management
rules in our trading strategy. Our profitability improves and our
overall rate of return rises when we set a fixed profit target of
$12,000 per trade. Though the percentage of trades that are profitable
drops to a mere 36%, it is clear that a reward to risk ratio of $12,000
to $1,000 offers very attractive risk-adjusted returns. Below we see
the actual equity curve of our trading strategy and final conclusions
on the profitability of our Morning Star - Evening Star candlestick
Final Conclusion and Caveats
Our attractive equity curve suggests that our candlestick strategy
has been profitable in the EURUSD from inception to present. The raw
results - with no set money management rules - were slightly less
profitable, and tell us several interesting things about the nature of
our candlestick strategy. We saw that profitability improved
dramatically when we cut losses short and let our winners run
significantly longer. This tells us that our candlestick signals are
either "wrong" in their reversal signals and not worth holding, or they
are "correct" and give us ample opportunity to take profits on a turn
in trend. It is undeniable that this strategy does indeed provide many
false trading signals. Yet we see that proper management rules allow us
to capture solid profits and limit our downside on these declines.
Combined with other trading techniques and more discretionary
strategies, we would argue that these candlestick formations increase
our overall trading profitability.
David Rodríguez, Currency Analyst for DailyFX.com