Premium Market Analysis

Technical Analysis, Trading Strategies

An Ominous Random Pattern

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.

SPX_20150724

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…

XLF_20150724

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.

Backtest environment

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

System

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
Exit conditions
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:

ParameterXLFSPYTLTFTSES&P/ASX 200
CAR-0.07%-2.77%-0.23%-0.51%-0.75%
Trades9246711
Ominous pattern performance for short positions and 5% profit target and stop-loss. ETF and index data since inception.

 

It may be seen from the above table that performance is negative across all markets tested.

Case 2: 2-day time-based exit

ParameterXLFSPYTLTFTSES&P/ASX 200
CAR-0.29%-1.67%+1.31%-0.51%-0.13%
Trades10266814
Ominous pattern performance for short positions and 20 days exit. ETF and Index data since inception.

 

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.

Conclusion

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.

You can subscribe here to notifications of new posts by email.

Charting program: Amibroker
Disclaimer

Detailed technical and quantitative analysis of Dow-30 stocks and popular ETFs can be found in our Weekly Premium Report.

© 2015 Michael Harris. All Rights Reserved. We grant a revocable permission to create a hyperlink to this blog subject to certain terms and conditions. Any unauthorized copy, reproduction, distribution, publication, display, modification, or transmission of any part of this blog is strictly prohibited without prior written permission. 

5 Comments

  1. Jake Yeager

    Hey Michael,

    Thanks for the response and the links. Read both posts. Very thought-provoking.

    All the best,
    Jake

  2. grey enlightenment

    After reading your blog awhile I get the impression very little works. These passive indexers are keeping a strong bid

    • Comment by post author

      There is a lot of truth in what you wrote and I have spoke of the dangers in some blogs, especially due to indiscriminate passive investing that is taking place for at least a year now. Very little always worked but that is becoming more evident now. Short-term quant signals work in some cases. Timing price series may not work in the near future due to increased choppiness, as in 2011 and 2012. Same for relative momentum. Definitively, chart patterns and things like candlesticks do not work. I also think that social trading does not work well due to noise and bluffing. Discretionary quant trading may be the future as changes in market conditions degrade mechanical systems and their temporary edge. See for example:

      https://www.priceactionlab.com/Blog/2015/03/quantitative-discretionary-trading-back-to-the-future/

  3. Jake Yeager

    You write: "Most use such and related patterns, such as the classical patterns of technical analysis, in an effort to confirm their bias about market direction."

    As you suggest, some do not use chart patterns to feed confirmation bias. I find classical chart patterns useful in my trading for 1) identifying consolidations periods prior to breakouts and trend continuation; 2) establishing price levels for stop placement; and 3) providing a rough estimate of the magnitude of the trend post-breakout, i.e., for estimating potential reward. I do not use classical chart patterns for prediction and I do not believe they have utility for such. Instead, they are part of a trading methodology that has positive expectancy given historical win rates and reward/risk ratios.

    Enjoy your articles as usual.

    Best,
    Jake

    • Comment by post author

      Hello Jake,

      True, I have mentioned in several blogs that some traders are able to benefit from classical patterns in different ways. However, most occurrences of classical patterns are artifacts of GBM. See an example here:

      In general, chartists have a lot more work to do:

      https://www.priceactionlab.com/Blog/2015/07/chartists-debunked/

      After 25+ years in the markets I cannot provide any support to claims that classical chart patterns can play a key role in a winning trading methodology although I admit that there are traders with different experiences and abilities.

      Michael