I show in the blog that the candlestick pattern known as bearish engulfing is no more than a random formation even when it occurs near 52-week highs. Although this and a host of other related patterns are useless for making trading/investing decisions, the financial news industry continues to frame them as important.
This particular candlestick formation when formed near all-time highs has been called an “ominous pattern”. It basically involves a reversal candlestick pattern known as bearish engulfing. An article on April 28 of this year in a major financial news website used this pattern that was formed in S&P 500 index to argue for a high probability of a top in stocks. As it may be seen from the chart below, the index made new all-time highs in May, ignoring any calls based on this random pattern formation.
It is known that many traders and investors look for signals that confirm their bias about market direction while ignoring many other signals that do not confirm it. In the above case, some thought that the top in stocks would form in April and handpicked this random pattern to offer a “rational” explanation for their bias.
What is amazing is that the accuracy of these claims can be verified. However, these financial websites count on the fact that the majority of investors do not follow quant blogs but solely rely on biased information.
The chart below shows the latest call of an ominous bearish engulfing pattern in XLF by the same financial website that now calls for a selloff in bank stocks by, surprisingly enough, referring to the failed formation in S&P 500 last April. This is quite interesting…
The 2-day pattern formed in XLF on Wednesday and Thursday of last week is shown on the above chart. I have no idea if bank stocks will plunge or not. What I know for sure is that this random bearish engulfing pattern does not provide any signals worth following. I show that below after first defining the system to backtest.
ETFs with data since inception: XLF, SPY, TLT
Indexes with data since inception: FTSE (UK), S&P/ASX 200 (Australia)
Starting capital: $100,000
Fully invested equity (hypothetical in the case of indexes)
Commission: $0.01 per share
IF A 250-day high close as of the close of yesterday
AND Close of yesterday > open of yesterday
AND Open > close of yesterday
AND Close < open of yesterday
THEN Sell short at the open of next day
Case 1: 5% profit target and 5% stop-loss
Case 2: 20-day time exit
The system is backtested with two different exit conditions, 5% profit target and stop-loss and 20-day time-based exit. Although I do not like time-based exits I include them here because they are still popular.
Case 1: 5% profit target and stop-loss
The table below shows the compound annual return performance for all markets tested along with the number of trades:
It may be seen from the above table that performance is negative across all markets tested.
Case 2: 2-day time-based exit
It may be seen from the above table that performance is negative in all tested markets except in the case of TLT.
One could possibly find several markets where this pattern worked and several where it did not but nevertheless this is the point because this pattern is random.
Journalists are under pressure of writing articles for a living but they should keep in mind that nowadays one can check their claims much more easily than it was in the past. Therefore, it may be a good idea contacting quants before making claims that do not pass scrutiny. As far as the ominous bearish engulfing pattern, it is a random one as the majority of candle patterns. Most use such and related patterns, such as the classical patterns of technical analysis, in an effort to confirm their bias about market direction. But when tests are performed, it is easily shown that these patterns do not have any economic value and their use leads to noise trading.
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Charting program: Amibroker
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