Market Technician No 49

As this journal goes to press, stock markets are cautiously marking the
first anniversary of the nadir of the bear market. At the March monthly
meeting Nicola Merrell was relatively upbeat about the long term
outlook for equities, although she did note that many indices (such as the
Russell 2000) were approaching significant resistant levels.
The emphasis of this issue is on candlestick charts and this seems to
reflect a growing interest in the technique generally amongst traders.
For example, STA chairman Adam Sorab is a recent convert to
candlesticks having found them particularly effective in predicting the
recent gyrations in the euro/dollar rate.
The Barbican Library has also reported a growing interest in candlestick
charts and that books on the subject are always out on loan, with waiting
lists starting to appear. Our librarian, Michael Feeny, has therefore
stocked up on this subject with another two or three copies of the
following titles:
Japanese Candlestick Charting Techniques A Contemporary Guide
to the Ancient Investment Techniques of the Far East
by Steve Nison published by NYIF ISBN: 0735201811, 2001
Beyond Candlesticks, New Charting Methods Revealed
by Steve Nison published by John Wiley & Sons ISBN: 047100720X, 1994
The Candlestick Course
by Steve Nison published by Marketplace Books (Wiley)
ISBN: 0471227285, 2003
Candlestick Charting Explained, Timeless Techniques for Trading
Stocks and Futures
by Gregory Morris published by Probus Publishing ISBN: 1557388911
Candlesticks Explained
by Martin Pring published by McGraw-Hill ISBN: 0071384014, 2002
Profitable Candlestick Trading Pinpointing Market Opportunities
to Maximise Profits
by Stephen Bigalow published by John Wiley & Sons ISBN: 047102466X, 2002
The two Nison books (1994 and 2001) are considered the core textbooks
on Candlesticks and he brought out a new one last year (2003). Morris
(1995) is popular and, according to the Global Investor Bookshop, it is the
most popular of the candle books.
Pring (2002) and Bigalow (2002) are perhaps a little less well-known so far.
STA Members who visit the Barbican Library may like to know that our
liaison man there, Mr Jonathan Gibbs, is taking over systems
development within the Library and our new contact person is Miss
Sibhe Lynch. (Her first name rhymes with jive). Members will find her
very helpful. Her telephone number is 020 7638 0569, e-mail
s.lynch@corpoflondon.gov.uk. We would remind Members that you can
reserve and renew books by telephone or e-mail, and can even receive
books by mail, in which case the library pays the postage to you and you
pay the postage back to the Library.
Membership of the library is renewable every three years: the simplest
way to re-register is to e-mail Miss Lynch to confirm your details.
If you have any requests for books to be added to our library, please
contact Michael Feeny.
It is good to see to see some new names amongst the contributors to
this issue and we would like to encourage other members to think about
writing an article for the Journal. Articles should be double-spaced with
wide margins and should initially be submitted in hard copy format.
Once they have been accepted for publication, they will be processed
electronically.
The STA website (www.sta-uk.org) saw over 15,000 hits in February, a
continued pickup in interest and in a short month as well. We had
requests from over 120 different linked sites, many of them from sister
IFTA societies as well as search engines and trading software sites. On a
Google search the STA website is quite far down the list when searching
for technical analysis, but is the third technical analysis society listed after
the Australian and Canadian societies. There are a lot of sites out there
peddling books, tip sheets and trading models as well as courses around
the world. However, the STA website comes in 1st in a Google search of
technical analysis UK which is helpful (ignoring sponsored links) for us in
trying to increase our exposure in the investment community in the UK.
COPY DEADLINE FOR THE NEXT ISSUE
31st May 2004
PUBLICATION OF THE NEXT ISSUE
July 2004
IN THIS ISSUE
D. Watts Bytes and Pieces . . . . . . . . . . . . . . . . . 2
D. Watts Software Review . . . . . . . . . . . . . . . . . 3
G. Rowe Trading the Bearish
Engulfing Pattern . . . . . . . . . . . . . . . . . 4
A. Whitby The Euro a Top or the Top? . . . . . . 9
C. Lambert Candlestick Reversals . . . . . . . . . . . . 10
E. Miller The Case for a Base in
Coffee Futures . . . . . . . . . . . . . . . . . . . 11
M. Gunn Integrating Technical Analysis
into an Investment Process . . . . . . 12
D. Valcu Trending with Heikin-Ashi . . . . . . . 14
H. Calder The Resurgence of China and
South East Asian Stock Markets . . . 16
April 2004 The Journal of the STA
Issue No. 49 www.sta-uk.org
MARKET TECHNICIAN
FOR YOUR DIARY
14th April Optimisation From a
Technical Analysts Point of View
J. du Plessis FSTA, Head of Technical Analysis, Updata
12th May Swing Trading
Marc Rivalland
N.B. The monthly meetings will take place at the
Institute of Marine Engineering, Science and Technology
80 Coleman Street, London EC2 at 6.00 p.m.
MARKET TECHNICIAN Issue 49 April 2004 2
A number of new programs have been released since the last journal.
Some of these are from smaller developers but they are worthy of
consideration as often they are designed to meet a specific need. As
always you should ensure that the program meets your needs and the
level of support required. Most have free trials but smaller independent
companies normally only supply web-based support, so it often takes
some time to get an answer. However often they are more responsive to
requests by users for improvements to their products.
Another Chart Pattern Finder
Patterns Ascending triangles, symmetrical triangles, descending
triangles, pennants, head-and-shoulders, flags, wedges, double tops and
double bottoms and more can all be found via a new software release
called Chart Pattern Finder. With an EOD product released and a real-
time product under development those Edwards & Magee addicts may
find it of interest. A windows program, its someway to go for support as it
was developed in Australia, priced at $279.
See http://www.cpFinder.com
For the Quants
QuantStudio is a new release from the UK based company a .NET
framework for building trading systems. If you are looking to develop a
quantitative trading strategy for a Fund then its worthy of consideration.
There is a non-time limited demo available for those able to wait for a
40mb download. Suitable for Quants, Programmers, Math wizards, etc. the
range of frames includes portfolio and risk management. Support in this
case is only a walk away at Cannon Street for London-based traders.
http://www.smartquant.com
World-wide Stock Data
I have become increasing impressed by the range and quality of the free
service Yahoo provide for EOD stock data. Most world stock exchanges
are now covered, with the data being released midnight local time for
the exchange concerned. Yahoo data is adjusted for scripts and dividends
and, for the most part, appears reasonably clean. There are a number of
download interface programs available, but few have the ability of
MLdownloader with an excellent directory structure set-up for easy
downloading.
See MLdownloader at http://www.trading-tools.com/mld.htm for a
free trial.
Trendline Trader?
For fans of trendlines a new program called Ramp released by
Newdawn can provide hours of fun. One of the few independent
programs that can scan a database for trendline breaks, its ideal for the
Fund Manager/Technical Trader. The free stock trader videos provide a
structured approach to trendline trading. The cost is $350.
See http://www.nebadawn.com/
SpySweeper
The Trojans and Spy wear war appears to be increasingly dangerous with
numerous new viruses being released and web pages often able to load
new bugs via Java and other browser based languages. One new
program that I have found to be particularly effective and worthy of the
free trial is Spysweeper from webroot. Their website offers a free security
check, worth ten minutes of your time the results may surprise you.
See http://www.webroot.com
David Watts
CHAIRMAN
Adam Sorab,
Deutsche Asset Management,
1 Appold Street, London EC2A 2UU
TREASURER
Simon Warren. Tel: 020-7656 2212
PROGRAMME ORGANISATION
Mark Tennyson d'Eyncourt.
Tel: 020-8995 5998 (eves)
LIBRARY AND LIAISON
Michael Feeny. Tel: 020-7786 1322
The Barbican library contains our collection. Michael buys new books for it
where appropriate. Any suggestions for new books should be made to him.
EDUCATION
John Cameron. Tel: 01981-510210
George Maclean. Tel: 020-7312 7000
EXTERNAL RELATIONS
Axel Rudolph. Tel: 020-7842 9494
IFTA
Anne Whitby. Tel: 020-7636 6533
MARKETING
Gerry Celaya. Tel: 01561 340358
Kevan Conlon. Tel: 020-7329 6333
Barry Tarr. Tel: 020-7522 3626
Richard Raymar. Tel: 07890 821619
MEMBERSHIP
REGIONAL CHAPTERS
Robert Newgrosh. Tel: 0161- 428 1069
Murray Gunn. Tel: 0131-245 7885
SECRETARY
Mark Tennyson dEyncourt. Tel: 020-8995 5998 (eves)
STA JOURNAL
Editor, Deborah Owen. Tel: 020-7278 4605
WEBSITE
Gerry Celaya. Tel: 01561 340358
Deborah Owen. Tel: 020-7278 4605
Please keep the articles coming in the success of the Journal depends
on its authors, and we would like to thank all those who have supported
us with their high standard of work. The aim is to make the Journal a
valuable showcase for members research as well as to inform and
entertain readers.
The Society is not responsible for any material published in The Market
Technician and publication of any material or expression of opinions
does not necessarily imply that the Society agrees with them. The
Society is not authorised to conduct investment business and does not
provide investment advice or recommendations.
Articles are published without responsibility on the part of the Society,
the editor or authors for loss occasioned by any person acting or
refraining from action as a result of any view expressed therein.
Networking
WHO TO CONTACT ON YOUR COMMITTEE
Bytes and Pieces
Issue 49 April 2004 MARKET TECHNICIAN 3
Updata Technical Analyst
Version 2.13.
Summary: A fully featured TA charting
program for Windows, great P&F charts.
Data: EOD and Real-time
Support: UK phone or Web based.
Website: http://www.update.co.uk
Telephone: 0845 129 4884
Updatas Technical Analyst program (TA) is a comprehensive technical
toolbox for the discerning technical analyst. TA offers the promise of
Indexias proven technology with reliable accurate charting. Now with
version two released, the program appear robust, but does it deliver?
This is a substantial program that installs within some 76 MB of disc space.
A ten-minute install gets the program running with a further call needed
to the web to verify the installation key and update the database. What is
immediately apparent is the taskbar icon that acts as the quick access
route to the programs main features. Right clicking the icon gives you a
menu from Run Technical Analyst to Real-time feeds. Its a unique
feature that makes the program easy to access.
Data handling is another strength of TA; the web acts as an interactive
source of data, so if in need of more data one click and you have
extended the history of any chart under analysis. This I found to be a really
handy feature but it points to one vital thing to get the most of this
program, fast Internet access is a must you need broadband or better.
Waiting around for data on download speeds of 56k would not be my
idea of fun and, unless you are in need of plenty of tea breaks, I would not
run this program with anything less than broadband.
Real-time and EOD data is available via the web and with excellent data
handling there were no data issues. Seamless integration with the
database was apparent. An extensive international database is available
via Updatas database which is a re-packaged Xpressfeed supplied by
Standard & Poors Comstock. The LSE database appeared clean and
without the data errors so often apparent with UK data. What also
impressed me was the flexibility of the program to read either Metastock
or CSI data, a vital addition for the commodity trader. This is ideal for the
commodity trader/analyst as the CSI is an extensive and accurate
commodity database. For the equity analyst the standard datafeed will
prove adequate with the worldwide stock markets listed.
TA may front end a professional data feed via the Dynamic Data Exchange
(DDE) link. Professional-looking charts can quickly and easily be copied for
inclusion into text, allowing images to be captured for sending to a client.
The front end interface window is chock full of toolbars, and upon
opening presents a number of standard charts. In the right hand corner
are four templates that allow you to run through some standard analysis
which has been previously set-up. Clicking the indicator windows gives a
long list of the standard indicators and shows
how many tools are supplied. This is not a
program that you are going to master in a
couple of days, but within a few weeks you
should become a competent TA operator.
In many respects this program is a
comprehensive toolbox with a wide range of
standard chart types and technical indicators.
Chart types include line, bar, candle,
equivolume, candle volume and wave.
Extensive technical indicators are available and
there are some that deserve special mention
Indexias moving averages, the market tracker
and noise filters that are unique. I particularly
liked the chart inversion tool and biorhythm
charts! Then there is the market scanner here
named Highlighter for quickly finding stocks
that meet certain criteria such as head and
shoulders tops and bottoms and P&F breakouts. A moving average and
indicator optimiser is available for finding best fit values but beware,
without walk forward testing, optimisation can be a trap for the unwary.
Add the portfolio manager and the quote screen and its a pretty
crammed-full top menu. The only thing that TA lacks is the extensive self-
programming system testing apparent amongst some of its competitors.
It is evident that this program has been given the user-friendly treatment
with one click trend-lines, right click undo and the easy click toolbars. I
particularly liked the easy to use scroll bar beneath the charts, the
templates, the easy to use data handling and the clear and accurate charts
provided. This all goes to make standard analysis fast and effective, just
what I like. The program has the best P&F charts, I have seen for some
time, making this one of the best programs for those who use P&F.
Another special feature is that a P&F count ruler is provided for quickly
measuring counts.
The program comes with an extensive manual and help is available on
line. Updata provides online support, via the web and the forum. Updates
to the program are also available, with pdf files of the manual and support
information. The example Historical Charts of the Day and emailed alerts
are a useful addition which will help the novice analyst/trader. The user
also gets access to the newsletter and training sessions (at extra cost) on
the program and TA in general. Comprehensive UK support is available,
which is rare given the many imported programs. Cost details can be
found via the web site.
Yes, Updatas TA does deliver. I found TA to be an accurate and
comprehensive product you can trust, I particularly liked the clear P&F
charts. Verdict: An effective choice for the discerning TA professional or
amateur User. Why not give it a whirl?
Software Review
By David Watts
Feature: Rating:
Flexibility * * * * *
Features/Charts * * * *
Accuracy * * * * *
Support * * * * *
Overall * * * * *
Introduction
This article aims to analyse the profitability and practical application
of a trading system based upon candlestick charting. The system uses
the bearish engulfing candlestick pattern as a signal to initiate a
short sale in Microsoft Corporation (MSFT). Following the
appearance of the bearish engulfing pattern, the stock price is
expected to decline enabling the short seller to profit from the short
sale. The system is tested on MSFTs daily historical share price data
for the five-year period 2nd January 1997 to 2nd January 2002. The
results are analysed and conclusions drawn.
The overall aim of the investigation is to: -
Determine whether the system generates positive returns that are

superior to a conventional buy and hold strategy on MSFT shares.
Determine whether any trading system return exceeds the buy and
hold return on MSFT shares, which is over and above the average
risk free rate for the five-year period studied.
The main objective of this investigation is to: -
Determine whether the system has any practical application for the
individual buy and hold investor.
A brief history of candlestick charting
Technical analysis evolved in the 18th century when a Japanese rice
trader by the name of Homma developed the principles of Japanese
candlestick analysis (Nison 1991). In candlestick analysis or
candlestick charting, as it is more commonly known, price movements
for a particular financial instrument (e.g. a share) are plotted on a
chart where the y-axis represents price and the x-axis represents time.
Figure 1 shows a candlestick chart with the daily price movements for
MSFT shares.
In Figure 1, one candle represents the price movements for a given
time period. The price movements shown are for one trading day.
Therefore each candle represents the full range of one days price
movement.
A candle is constructed by plotting the opening price, the highest
price, the lowest price and the closing price for the trading day. This is
shown in Figure 2.
A white candle illustrates that the closing price was higher than the
opening price for the day. Conversely, a black candle shows that the
closing price for the session was lower than the opening price.
The Japanese place great emphasis on the relationship between the
opening and closing prices. Elder (1993) explains this relationship by
describing how the opening price usually reflects the amateurs
opinion of value for the stock. Elder also notes that closing prices
tend to reflect the actions of professional market traders. He explains
that amateur traders tend to commit funds to the market after
analysing overnight news reports. The amateur will also trade the
market open because other commitments, i.e. work duties, will
prevent him from trading during the day or at the market close.
Conversely, the professional trader will be active at the close in order
to avoid carrying positions overnight. Squaring positions at the end
of the trading session allows the professional trader to eliminate risk
from overnight price movements. If trading on margin, the trader
will also avoid paying variation margin and overnight financing
charges to his broker. Margin is a deposit, which must be paid to a
broker in order to maintain a position in a financial instrument e.g. a
share or futures contract.
In the light of these factors, the closing price is psychologically
influential on all market participants. It is the benchmark by which
margin calculations are made. It is also the price that is reported in
television and newspaper reports.
The relationship, therefore, between the opening and closing prices is
a significant principle upon which candlestick analysis is founded.
Bigalow (2002) describes the psychological importance of the
opening and closing numbers as a graphic depiction of overall
market sentiment. Thus, the candlestick chart is not only an
illustration of price movement resulting from changes in the forces of
supply and demand, but it is also a graphic illustration of changes in
market sentiment whether bullish, bearish or neutral.
Candlestick patterns and signals may be derived from the price action
for a single trading day or for a series of trading sessions. This analysis
however, will be concerned with a two-candle or two-day pattern called
the bearish engulfing. This pattern represents two successive trading
days. An illustration of the bearish engulfing is shown in Figure 3.
In order to identify a bearish engulfing, the first candle must be white
i.e. the closing price is higher than the opening price for the session.
The second candles opening price must also exceed the closing price
of the first candle. Finally, the closing price of the second candle must
be below that of the opening price of the first candle. As illustrated in
Figure 3, one observes that the second black candle is seen to envelop
or engulf the previous white candle. Once completed, this pattern is a
signal of a potential reversal in price and prices are expected to
decline thereafter (Nison 1991). Figure 4 demonstrates the effect of a
bearish engulfing on Microsoft Corporations share price.
Trading the Bearish Engulfing Pattern
By George Rowe
Figure 1 Daily Candlestick Chart of Microsoft Corporation
Figure 2 Construction of a Candle
High
Closing price
Opening price
Low
High
Opening price
Closing price
Low
Figure 3 The Bearish Engulfing Pattern
H
C
O
L
H
O
C
L
O = Opening price
H = Highest price
L = Lowest price
C = Closing price
Figure 4 shows that a bearish engulfing pattern is completed on Day
10. Following the pattern, the share price declines from
approximately $66 to a low of $63. MSFT shares lose approximately
4.5% of their value in eight trading days.
The bearish engulfing indicates that prices will decline. This article
will therefore seek to test the profitability of a trading system, which
uses the bearish engulfing as a signal to transact a short sale in the
share concerned. Edwards and McGee (1992) describe a short sale
as a transaction where the entry position is to sell a stock or
commodity first and then repurchase it (hopefully at a lower price) at
a later date. The project adopts a short selling strategy based on
empirical and authoritative evidence that stock prices tend to fall
faster than they rise (Edwards and McGee 1992). As a result of this
tendency, Edwards and McGee (1992, p.393) state that, profits can be
made faster on the downside of the market than on the upside.
The profitability of the short selling trading system is tested on
MSFTs daily historical share price data for the five-year period 2nd
January 1997 to 2nd January 2002.
The operation of the short selling system
MSFT was chosen for this investigation due to its high level of
liquidity, its wide ownership by traders, private investors and
institutions and its membership of the Dow Jones Industrial Average
(DJIA), the Standard and Poors 500 Index (S&P 500) and the Nasdaq
Composite Index.
Highly liquid stocks usually bear lower transaction costs than illiquid
stocks. The low cost associated with trading MSFT refers to its dealing
spread and not the broker commissions associated with buying and
selling. The dealing spread is the difference between the sell price
and the buy price. The typical market spread on MSFT will be around
2 cents or 0.04% of the stock price, e.g. 44.10 (sell) - 44.12 (buy). A
high level of liquidity infers a high level of price certainty i.e. the
investor knows with a degree of certainty at which price he is able to
enter and exit a trade. Given this observation, the results gathered
should have a more practical application. It should be noted
however, that the system assumes that there are no transaction costs.
For the period 2nd January 1997 to 2nd January 2002, daily historical
share price data for MSFT was downloaded to a Microsoft Excel
spreadsheet from a Bloomberg data terminal. Bloomberg is a
provider of news and data to large City institutions. The data it
supplies is therefore highly reliable and accurate.
Using the open, high, low and closing price data for MSFT, a
candlestick chart was constructed in the spreadsheet. A formula was
written in the spreadsheet to identify a bearish engulfing. For a
bearish engulfing to be identified three criteria must be met:-
1. The first candle must be white i.e. the closing price must be higher
than the opening price.
2. The opening price of the second candle must be greater than or
equal to the closing price of the first candle.
3. The closing price of the second candle must be less than the
opening price of the first white candle.
The above criteria for a bearish engulfing differ from the description
given earlier in Figure 3. Figure 5 illustrates Figure 3s definition and
the definition that will be used for this article.
In Figure 5, Definition A illustrates that the opening price of the
second candle is higher than the close of the first white candle.
Definition B shows the opening price of the second candle may be
greater than or equal to the close of the first white candle. N.B. for
clarity, the high and low prices have not been marked in Figure 5.
Nison (1994) explains that stocks tend to open relatively unchanged
from the close of the previous day and thus there should be more
flexibility in defining an engulfing pattern. It is for this reason that
Definition B is adopted.
Having identified a bearish engulfing in the spreadsheet and having
verified this on a candlestick chart of the share price, one share is sold
short at the closing price of the second candle that makes up the
bearish engulfing pattern. The buy and hold investor is assumed to
hold one share in MSFT. By selling one share short against his one share
holding, the buy and hold investor is conducting a perfect hedge.
A perfect hedge eliminates risk (Arnold 1998, p.1022). By conducting
a perfect hedge, any loss made on the short sale will be equally offset
by the gain made on the investors share holding. Similarly, any loss in
value in the share holding is equally offset by the profit made on the
short sale.
At the same time that the short sale is made, a limit order to buy the
stock back is placed at a 1% limit order level. This means that, if the
price declines and the stock loses 1% of its value, the limit order will
be triggered and a profit will be registered for the trade. The profit on
the trade is the entry price minus the exit price.
At the same time that the short sale is made, a buy stop order is
placed on any close equal to, or above the high of the second candle
that makes up the bearish engulfing. The stop order is placed to
guard against potentially unlimited losses should the share price
advance after the short sale. According to Nison (1994), the high of
the bearish engulfing is usually an area of resistance on a closing
basis, i.e. a level that acts as a ceiling to any advance in price. It is for
this reason that the stop is placed on any close equal to or above the
high of the bearish engulfing. Furthermore, with the stop at this level
the investor knows that, should the price move through this level
during the session, but fail to close above it, he will not be unduly
forced to close his position and suffer a loss. Any loss on the trade is
calculated by subtracting the exit price from the entry price.
By inspecting the stocks candlestick chart in Microsoft Excel, the
author identified whether the limit order was triggered before the
stop. If this occurred the exit price was entered in the spreadsheet
and the profit calculated. However, if the stop was triggered before
the limit order, the exit price was recorded in the spreadsheet and the
resultant loss automatically calculated. Figure 6 shows how a trade
was made in MSFT with a 5% limit order.
Figure 4 Microsoft Corporations Share Price Following the
Bearish Englufing
Figure 5 An Illustration of Bearish Engulfing Definitions
C
O
O
C
C
O
O
or O
C
O = Opening price
C = Closing price
Definition A.
Conventional definition
Also shown in Figure 3.
Definition B.
Definition used for
this report
In Figure 6, a bearish engulfing labelled BE occurs on Day 13. A short
sale is entered at the close on the BE day at a price of 23.69. This is
labelled point E. A limit order to take a profit on the short position is
placed at a level 5% lower than the entry price. This level is 22.50 and
labelled point L. The 5% limit order price is calculated by multiplying
the entry price, 23.69, by 0.95. The buy stop order, point S, is placed on
any close equal to or above this level of 24.94. The buy stop order at
point S to close out the short position is an arbitrary level. It is only
triggered if the price settles above point S at the market close. Also
note that if the buy stop is triggered, the limit order is cancelled and
vice versa. One observes that following the bearish engulfing; the stock
fails to decline in value leaving the limit order unfilled. Instead, the
share price advances and closes above point S at point S*. The trade is
exited at point S* at a price of 25.28 and a loss of $1.59 is recorded.
Ten different limit orders were tested for MSFT ranging from 1% to
10% inclusive. This was carried out to analyse the effect of moving
the level of the limit order downwards, thereby increasing the
potential profit on the short sale. The hypothesis derived from this is
that the higher the limit order percentage, the further the share must
decline in order for the limit order to be triggered and a profit made.
Thus, the greater the profit made on each successful trade, the greater
the overall profitability of the system.
It should be noted that the system takes account of price gaps. A
gap is a price area between one days closing price and the
following days opening price where no trades take place. Gaps occur
when prices move sharply in response to a sudden imbalance of buy
or sell orders (Elder 1993, p.95). An example of a gap and its effect on
the execution of the limit order is shown in Figure 7.
In Figure 7, one sees that the bearish engulfing, BE, is completed on
Day 3. The entry level for the short position, E, is made at the market
closing price of 57.25. A buy stop order to close the short position is
placed on any close above 60.50, which is point S. The 6% limit order
to buy at 53.81 marked L, is not triggered because MSFT did not trade
at this price. As a result, the limit order is filled at 51.05, marked L*.
This is the opening price of the stock for the following trading day. If
the stock had traded at the limit order of 53.81, a profit of $3.44 would
have been registered. Due to the formation of the gap, the order was
filled at a lower and more favourable price. As a result, a profit of $6.20
was recorded. Thus, an extra $2.76 was made on the trade.
As Figure 7 demonstrates, a gap changes the level at which the limit
order is executed, which in turn leads to a greater profit on the short
sale than had previously been anticipated. Gaps are a natural
phenomenon in the stock market and they have been incorporated into
this study to ensure the results generated are as realistic as possible.
Having carried out the trading method described earlier, the
profitability of the system using each limit order from 1% to 10% was
analysed and comparisons made. Profitability was measured by
multiplying the buy and hold dollar return on MSFT by the average
risk free rate. This was carried out to observe whether any short
selling returns exceeded the return that could be earned without
assuming any risk. The average risk free rate adopted was 5.19%. This
figure represents the average Fed funds rate published by the US
Federal Reserve Bank during the period studied.
The author would have preferred to have tested the profitability of
the system over a ten-year period, however due to time constraints
and the large volume of data created, this would have been infeasible.
Results and analysis
The profitability of the short selling strategy on MSFT is analysed by
comparing the risk free adjusted percentage return (RFA%R) to the
conventional buy and hold return over the five-year period. The
author also analyses the changes in profitability for each limit order.
Figure 6 A Trade in MSFT with a 5% Limit Order Figure 7 Example of a Gap in MSFT with a 6% Limit Order
Figure 8 Histogram Showing the Risk Free Adjusted Percentage
Return (RFA%R) over a Buy and Hold Strategy on MSFT
The overall buy and hold return on MSFT for the period studied was
$46.26 per share as the share price rose from $20.78 to $67.04. 58
short sales were initiated. Figure 8 shows the percentage return of
the strategy over and above the average risk free rate. One observes
from Figure 8 that the system is only profitable over the period
studied when a limit order of 6% to 10% is applied. Limit orders 1%
to 5% show negative returns. This indicates that when these limit
orders are employed; the losses on each trade exceed the profit made
on each trade. Figure 8 shows that as the limit order percentage
increases, the RFA%R over the buy and hold strategy also increases.
This is most apparent when comparing the 6% and 10% limit orders.
The 10% limit order, for example, generates around 3.5 times the
return of the 6% limit order whilst the difference between the two
limit order percentages is only 4%. By allowing the price to fall by
10% after each bearish engulfing, the RFA%R over the buy and hold
strategy is an impressive 65%. On the other hand, by allowing the
price to fall 6% after the bearish engulfing, the return is a much lower
22%. To understand the difference in return between the limit orders,
one should observe Figure 9. Figure 9 shows the percentage of
winning trades for each limit order.
Figure 9 illustrates that 1% to 5% limit orders display negative returns,
however the percentage of winning trades remains relatively high
compared to the 6% to 10% limit orders. This is most apparent in the
1% and 2% limit orders where there is a negative RFA%R of -35% and
-42% respectively. Winning trades for these limit orders are 71% and
59%. This indicates that for the 1% and 2% limit orders, although the
percentage of winning trades was high, the profits made on winning
trades were not great enough to offset losses made on losing
positions. Thus the general observation made from Figure 9 is that
the percentage of winning trades declines as the limit order
percentage increases. One may infer from this observation that the
further the limit order is from the entry price, the greater the
probability that the limit order will not be executed and, as a direct
result, the greater the probability that the stop will be hit instead.
However, the further the limit order is from the entry price, the
greater the profit generated on winning trades compared to losing
trades. In the case of the positive return bars in Figure 9, it can be
concluded, that as the limit order increases, fewer winning trades are
accounting for a large proportion of profits.
Given this analysis, one must decipher whether the combination of a
low winning trade percentage and a substantial RFA%R is desirable
for the buy and hold investor. By analysing the maximum dollar
drawdown and the overall dollar return for each limit order, one may
find a solution to this question. Drawdown is defined as the
maximum dollar loss that the system records during the period
studied. Figure 10 shows the drawdown for the 6% to 10% limit
orders. Limit orders 1% to 5% have been ruled out of this analysis as
their RFA%Rs compared to a buy and hold strategy are negative.
The limit orders 6% to 10% marked on the right hand side in Figure
10 all show positive dollar returns for the period studied. However,
these returns are generated with a certain degree of risk or
drawdown. Clayburg (2001) recommends that for a system to be
considered, return should be at least 3 to 1 over drawdown. In Figure
10, the return to drawdown ratio for the 6% limit order for MSFT is
0.78. This means that the overall dollar return is actually less than the
drawdown of the system during the five-year period. In this instance,
the trade-off between drawdown and return is undesirable as the
amount of drawdown exceeds overall return. However, the
drawdown to return ratio is more favourable for the 9% and 7% limit
orders. The ratios for these limit orders are 1.63 and 1.96 respectively
and represent the two greatest return to drawdown ratios for the
limit orders studied. However, these ratios are significantly less than
Clayburgs (2001) minimum desired return to drawdown ratio of 3 to
1. Even though the 9% and 7% limit orders do not meet the desired
ratio, the likelihood of the system generating profitable returns over
time can be analysed by observing the equity curves. Equity curves
show the change in profit and loss for each limit order and are shown
in Figure 11.
Figure 9 Histogram Showing the Risk Free Adjusted Percentage
Return (RFA%R) over a Buy and Hold Strategy on MSFT
Shares and the Percentage of Winning Trades for Each
Limit Order
Figure 10 Graph Showing the Dollar Drawdown and Return for MSFT
Figure 11 Equity Curves for MSFT with 7% and 9% Limit Orders
Figure 11 illustrates that the 7% limit order has less volatility around
the zero line on the drawdown and return axis. The 9% limit order
produces more erratic price movements between positive and
negative territory. Clayburg (2001) advises that the equity curves
should exhibit a steady progression from the beginning to the end
of the test period. Given this advice, it may be considered that the
7% limit order is most suitable even though its dollar return is
slightly less than the 9% limit order. However, it should be noted
that for both limit orders, the majority of the systems returns are
generated from day 758 onwards where the share price of MSFT
made its all-time high. As one would suspect, this demonstrates that
short selling following a bearish engulfing is most profitable when a
share is declining in value for a prolonged period. The advantages of
the 7% limit order are that the dollar returns on MSFT are positive
and the RFA%R over the buy and hold strategy is an impressive 52%.
However, the combination of a poor return to drawdown ratio, a low
percentage of winning trades and the observation of erratic equity
curves make the long-term application of the short selling system on
MSFT shares difficult to justify. Should MSFT shares reverse their
current downtrend and begin a prolonged advance, the current level
of profitability performance for the 7% limit order as well as the
other limit orders is at risk. A study of the system for a 5-year period
from when the test period ended would enable the buy and hold
investor to observe the systems performance in both bull and bear
market phases.
Conclusions
With MSFT, there is evidence to suggest that increasing the limit order
percentage reduces the percentage of winning trades. It is also clear
that setting a low limit order, perhaps 1%, does not necessarily equate
to long term system profitability. This is because, because the fact
that there are numerous small profit trades, the resultant losing
trades although few in number are big enough loss makers to more
than wipe out any profit. One may deduce, therefore, that the current
stop loss rule is not an adequate risk management tool.
With the exception of MSFTs 1% to 5% limit orders, it may be stated
that short selling following a bearish engulfing is a profitable
hedging strategy for the buy and hold investor. However, the period
studied was only five years, where the last two years of the study saw
a bear market in MSFT shares. By studying a longer time frame e.g.
10 years, a greater degree of accuracy in the results could be
obtained. In turn, this would give a better indication of the long-
term viability of the system. This is important as it may be
considered that most rational investors will only consider a system
that performs over the long term.
Considering the analysis of the short selling strategy on MSFT, does
the strategy have any practical application for the buy and hold
investor? There is a possibility that the system could be used for MSFT
with a 7% limit order but, given the fact that the system performed
poorly for the first three years, there is no guarantee that positive
dollar returns would be sustainable. This may be especially true if
MSFT ended its current bear phase and began a new bull market leg.
Moreover, if an investor had followed the system, would he be able to
execute the trades with trying to second guess the signals?
In light of the positive returns obtained on MSFT for varying limit
orders, the question arises, what is the implication of a profitable
system based on technical analysis on the weak form of the efficient
market hypothesis? The bearish engulfing pattern has been shown to
repeat itself over time and using certain filter rules does produce a
superior return to the conventional buy and hold strategy. This
implies that to a certain extent and certainly for MSFT, that the
application of a form of technical analysis does work in practice. On
the other hand of course, the returns may be put down to chance. In
order to prove this point a more comprehensive study would be
warranted. This study would have to include at least ten years of daily
historical price data on a variety of financial instruments and not just
US stocks. This would ensure that the system is robust and can be
applied to any financial instrument.
There are some apparent limitations with the system. The exit rule for
stops does appear, in hindsight, to be flawed somewhat. This is
discussed further in the recommendations section.
Recommendations
Before exploring the practicalities of using this system, a discussion
should be made on the flaws of the system and the changes that can
be made to improve overall performance.
Although the criterion for closing a trade at a loss is adequately
defined, the rationale behind placing the buy stop order is flawed
somewhat. Under the systems rules, the buy stop is triggered and the
position is closed if the closing price of the stock is equal to or above
the high of the second candle of the bearish engulfing pattern. The
drawback of this exit rule is that the closing price can be significantly
higher than the high of the second candle that makes up the bearish
engulfing. The stop order is designed to limit risk. However, when the
short sale is initiated it is impossible to define the risk level assumed
for the trade. This is because the stop may be executed at any price
higher than the minimum stop level. By employing this exit rule, risk
is technically unlimited. This rule is therefore undesirable for risk
management purposes. The benefit of the exit rule however, is that it
provides clear confirmation that the price has completed a reaction
and is resuming an advance. The investor knows that he should
therefore accept a loss. A possible solution to this problem may be to
set the stop level at a pre-defined distance above the high of the
second candle of the bearish engulfing. This stop would be a trading
stop, meaning it could be triggered during the trading session and
not just at the market close. If the stop was triggered during the
session and the price continued higher, a smaller loss would be made
compared to the market on close exit rule.
One other flaw of the system is the market on close rule for both trade
entry and trade exit by being stopped out. The assumption is that the
last traded price equates to the entry or exit price. In reality, it may be
difficult to achieve this price, as the investor has to decide whether a
bearish engulfing has occurred. He then has to make sure that he
initiates his short position and places his stop and limit orders before
the market closes. In reality therefore, the entry or exit price may be
slightly different from the closing price on the bearish engulfing day.
One final drawback is that the system is not fully automated. As
Schwager (1996) emphasises, the benefit of a mechanical trading
system is to eliminate emotional decision-making from trading. The
investor must follow the rules of the system in order to maintain a
consistent approach. Because of the human decision making
involved in making trades, there is a risk that in reality, the investor
may decide to ignore the systems trade signals. Given this risk, the
investor may decide to pass up certain trades as he considers that his
judgement is superior to that of the system. Granting the freedom to
make trading decisions to a nave or inexperienced investor could be
detrimental to the financial standing of the individual.
In order for the system to be implemented in a practical sense, the
investor must consider which financial instruments to employ so that
transaction costs are minimised and returns are maximised. One
option is physical stock trading on the stock exchange. There are
noticeable transaction costs however. Broker commissions, the size of
the bid offer spread and the potential for slippage would contribute to
a reduction in overall returns. Furthermore, there are certain exchange
rules which apply to short sales. On US stock exchanges, short selling is
only allowed on an uptick (SEC 1934). This means that the short sale is
only allowed if the last price traded higher (on an uptick) than the
previous price. Because of this rule, short selling at the market close
may be difficult, especially if the price continues to trade on a downtick.
These rules can be avoided by trading a contract for difference (CFD).
Trading a CFD equates exactly to trading the underlying stock, the
only difference being that the investor is not conducting a deal on an
exchange. By trading a CFD, the investor is able to trade on a
downtick. CFDs are also margined trading instruments, which enables
the investor to benefit from gearing. Any returns made on capital will
be augmented by the gearing effect. Furthermore, the CFD price will
have the same bid offer spread as the underlying stock. CFD trading
houses also accept market or close orders. Finally, there are minimal
transaction costs when trading a CFD.
Having considered these factors, short selling using CFDs is a serious
consideration for any investor willing to adopt this trading system. Of
course, further research is required before this strategy can be
There is no doubt that the February peak in the Euro showed some
worrying technical action. Firstly, we saw key reversals on both the daily
and weekly charts. Secondly, momentum indicators were high or
overbought, and divergent, in daily, weekly and monthly time frames.
Thirdly, the currency had already seen an approximate 50% rise against
the US Dollar. Finally, as if any more were needed, we were bumping into
heavy historic resistance (though based on synthetic rates) in the 1.30
area. All quite alarming stuff, and certainly enough to inspire the thought
that perhaps the Euro bull run was at an end.
While that may indeed prove to be the case, there are reasons for viewing
the activity so far this year as another consolidation rather than the final
top. An aging bull almost certainly, but probably not quite a dead one
yet. What supports this argument?
Apart from its second half 2002 consolidation of the break up from its
base, the Euro had only seen one major pause in its rise until this year.
From that point of view, and given the overhead congestion resistance, it
was likely that gains would slow overall and become subject to another
longer reaction and consolidation phase. To date, there is no indication
that the January/April action is any different in character from that of
May/September 2003, and on that basis a further downside move, which
I would expect, would not alter the conclusion that the current pause is
temporary. The June to early September drop was about 9% and if we
see a similar reaction from the February peak, it could bring us back to
1.17/16. This is an area of congestion and a retracement of some 61.8%
of the September/February rise. Such a further decline should act to fully
correct the overbought position of weekly indicators, and bring monthly
ones back to a more positive level. Daily indicators have already been on
the low side of the spectrum for over a month.
In addition the large 2000/02 base, together with the second half of 2002
extension of that formation, looks capable of supporting some further
advance for the Euro against the US Dollar. The overall range from May to
November last year offers further support for some additional gains. Both
these areas give higher counts on the point and figure chart. Also, looking
at the weekly bar chart, it can be seen that on the bigger swings up in
April/May 2003, down in May/September 2003, up in September 2003 to
January 2003, down in February/March 2003 the angles of ascent are
steeper than the angles of descent. In other words, the Euro moves with
more dynamism in its up phases than it does in its down phases.
Clearly there is at present a large area of resistance up to about 1.25.
Later clearance of this is expected and would signal that demand was
increasing again. A retest of the 1.29 peak area would be expected to
follow. Once this and 1.30 are decisively broken, higher targets will
open up at 1.3310/35, 1.3460 and 1.3610. (These mark, respectively,
a projection and the midpoint of the 1995 top, a second projection, and
the October 1995 high.) Beyond is the 1.40 area, which looks harder to
reach, let alone clear. The early 1995 synthetic peak is around 1.45.
In conclusion, I would argue that the overall pattern remains consistent
with an ongoing, though mature, bull market, which is undergoing a
multi-week reaction and consolidation prior to what will probably be its
final run up before a top really does start to develop.
Anne Whitby is Vice Chairman of the Society
implemented. The author also tested the system using Genaral
Electric (GE) and 3M. Results varied between all three stocks with 3M
performing better than MSFT. In fact, 9 of the 10 limit orders for 3M
generated positive returns with 6 limit orders producing risk free
adjusted returns of 70% or more. This is of course compared to a
conventional buy and hold strategy. By contrast, GEs results were
extremely poor with negative returns across all limit orders except
the 6% order. Without a more detailed analysis of GE it is diffcult to
account for the huge discrepancy in results. However, it is clear that
with this stock the systems rules were not suitable and too much risk
was borne. As it stands, the system certainly has some promise with
3M and to a lesser extent with MSFT. It is the authors view that there
is considerable scope for the buy and hold investor in 3M stock to
earn abnormal returns.
References
ARNOLD, G., 1998. Corporate Financial Management. London:
Financial Times Prentice Hall.
BIGALOW, S.W., 2002. Profitable Candlestick Trading: Pinpointing Market
Opportunities to Maximise Profits. New York: John Wiley & Sons.
CLAYBURG, J. F., 2001. Four steps to trading success: using everyday
indicators to achieve extraordinary profits. New York: John Wiley
& Sons.
ELDER, A., 1993. Trading for a living: psychology, trading tactics, money
management. New York: John Wiley & Sons.
NISON, S., 1991. Japanese candlestick charting techniques: a contemporary
guide to the ancient investment techniques of the Far East. New York:
New York Institute of Finance.
NISON, S., 1994. Beyond candlesticks: new Japanese charting
techniques revealed. New York: John Wiley & Sons.
SCHWAGER, J. D., 1996. Schwager on futures: technical analysis. New
York: John Wiley & Sons.
SECURITIES AND EXCHANGE COMMISSION. (1934) Rule 10a-1 - Short
Sales [online]. Cincinnati, University of Cincinnati. Available from:
http://www.law.uc.edu/CCL/34ActRls/rule10a-1.html [Accessed 8
August 2002]
The Euro a Top or the Top?
By Anne Whitby
On February 11th 2004 I presented a talk entitled Candlestick Reversals
Patterns and Applications for Long Term to Intra-day Charts. In the wake
of this I received a number of e-mails and I thought I could answer the
points raised in an article as a kind of open forum. At the meeting I
went through some of the more common candlestick patterns,
highlighting the psychology behind the patterns by talking through the
price action that led to their formation. For the benefit of those who
couldnt make it to the meeting I have given a brief prcis of the patterns.
Bullish Engulfing Pattern A two-day pattern. The first day
is bearish in line with the trend. On the second day we
open below the previous days close, but then rally sharply
to close above the first days open: Quite a change over a
two-day period!
Bullish Engulfing Patterns. Do you require confirmation before
placing a trade on an engulfing pattern? I find doing so reduces
whipsaws but also causes one to sometimes enter too far into the
move because engulfing patterns can foretell immediate and
significant reversals?
The Bullish Engulfing Pattern is one of the strongest and most reliable
patterns in the book so acting upon one should give you extra
conviction for your trade. One rule I like on trading candle patterns on a
daily chart is to wait for the pattern to form (rather than pre-empting its
possible formation), then look at where the market opens the next day. If
we open higher then the chances are the late buying from the previous
day is not merely a fluke. Often a stronger open the next day would also
leave a gap/window which could be a good place to put a stop below.
So you get extra confirmation plus a solid price level to get out. But with
any candle pattern I always look for confirmation from another form of
analysis. I do not recommend using one form of analysis in isolation,
whatever it is. If you have a candle pattern, as well as a trend break, and a
divergence on a commonly used indicator, then your conviction will be
strong (and therefore your target may be higher, which in turn should
allow you a bigger stop in line with basic risk/reward ratio theory. This is
something I am very keen on).
Exiting. Once in a trade, what do you do if after one, two or a few
more bars you get a reversal pattern? Do you exit, move your stop to
the low of the reversal bar or continue with the trade? For example,
you go long on a bullish engulfing pattern and two bars later a
shooting star appears. The shooting star is not at the top of a long
trend but it may be foretelling an imminent change in sentiment
and, therefore, time to exit.
Again confirmation is the key here and the next days open would give a
good idea as to whether, using the example you cited, the Shooting Star
was a reversal, albeit reversing a very short term move, or merely the
result of a bit of closing shenanigans.
Shooting Star: A single candle pattern, which suggests a
reversal when seen in an uptrend. It has a large upper
shadow. To get the long upper shadow the market has to
rally strongly then fail and give back all of the earlier gains
to close pretty much back where it started, near the low of
the day. So the bears took hold of the baton at some point
over the session.
Stop Placement. Where do you place your stop-loss upon entering
on a candlestick pattern?
The text-book answer is to put a stop below the lower shadow of the
reversal candle/candles, but in practice this could present large draw-
downs. This is one of the toughest conundrums for me and something
that I have to admit I have always had trouble with when trading the
markets using candle patterns. Moving a stop higher in line with a rising
market is still, for me, the best way to go on this one, plus always being
prepared to re-enter the trade if you feel youve been stopped out too
early, as long as the reversal characteristics are still in place. This is why
the textbook definition is useful and sensible. For example with a
Hammer pattern: If the market goes on to make a new low then the
Hammer is effectively negated.
Hammer: The opposite to a Shooting Star; therefore
appears in a downtrend. This is a session where the early
price action is bearish but we bounce from a low and the
buying continues to the end of the session where we close
strongly, suggesting a surge of buying that may well have
spelt the end of the downtrend
Diminishment of the Edge. Do you think that too many people do, or
in the future will, use candlestick patterns on US markets to the
point where the significant edge they provide will disappear?
There is no doubt that the more and more people that look at a
particular study, or the study of technical analysis as a whole, the more
effect it will have on the market. But whether this is bad for the
technician or not is I think arguable. The NASDAQ, for me, is one of the
best-behaved markets from a technical point of view (you only have to
look at how many days highs or lows are gap fills to realise this), and this
can only be because of the number of people looking at it that are using
technical analysis. The Bund Futures is one of my old favourites. In this
market the locals look for the stops below a gap but, as long as you are
aware of this, you can adjust your trading style accordingly.
In saying this Ive always said that the market is way too big for one
particular type of analysis (or sub-group thereof ) to have an absolute
effect on its direction.
Defining Small Shadows. For the hammer, shooting stars and similar
patterns, the body is supposed to have a long shadow for a tail and
the other end of the body has no shadow or a small shadow. How
large can the small shadow be? One book I read recommended no
more than 10% of the total range of the price bar but that can cause
one to miss some good trades.
I dont subscribe to putting a percentage value on this. Textbooks
probably feel the need to adopt a quantative approach so that the
academics dont give them a hard time, but I think a commonsense
approach is more effective. Once youve been looking at candle patterns
for some time you will make the decision that something may not qualify
to be a Hammer in the true text-book definition but, as a trader youre
not going to ignore a small bodied candle at a bottom, especially if the
lower shadow is long. It may not be a Hammer per-se, but itd probably
bang a nail in if need be!
Candlestick Patterns in stocks. Do you find that you can trade candle
patterns on stocks and disregard the effect of the trend of the
overall market (i.e. taking long positions when the market trend is
down or vice-a-versa)? If not, what do you use to determine the
trend of the overall market for trading candlestick patterns on
stocks in the direction of such trend?
I prefer to use candle patterns in cahoots with the overall trend of the
market. The Trend is your Friend may be the oldest adage in the book, but
my experience is that its also the most relevant! I like using candle
patterns to buy stocks when the market is in an uptrend. One of the best
times to buy is on a pullback/retracement. One of the best times to buy
during a retracement is if the market has got to key support levels, either
old highs or lows, trend support lines, a reliable moving average, or a
Fibonacci retracement level (long or short term), and if at the same time
you get a bullish candle pattern.
Doji: A single candlestick that signals a reversal if seen in an
uptrend or a downtrend. It has one simple rule: No real body.
This means we open and close at the same level, the
psychology behind this being that if you have been in a solid
trend then suddenly post a day where the market opened
and closed at the same level this means the buyers and
sellers were perfectly matched over the session as a whole.
Continues on page 13
Candlestick Reversals
By Clive Lambert
Background and market fundamentals:
Coffee is traded on the futures markets at both LIFFE and at the Coffee
Sugar Cocoa Exchange (CSCE, now part of the NYBOT). While the contract
specifications are different between LIFFE and the CSCE, the broad
market trends are the same. We will concentrate on the US market.
CSCE Coffee futures have been trending lower since May 1997, from a
peak of $3.18/lb to a trough of 41.90c/lb in December 2001 on futures
continuation charts. The decline was due for the most part to the
establishment of new plantations in the worlds leading coffee supplier
Brazil and runner-up Vietnam, in the face of fairly steady demand.
However, since the end of 2001, the market has been shuffling higher as
production has eased and producers have shifted from arabica to robusta
production (moving up the quality scale). The market should find some
additional support this year as the Brazilian
crop shrinks due to the biennial nature of the
coffee crop. (Coffee harvests tend to be heavy
in one year and not so high in the next). The
International Coffee Organisation (ICO)
estimates that total production in the 2003/04
crop year will be 101.31 million 60-kg bags, a
fall of 15.3% compared to the 2002/03 crop
year and total production of arabica beans is
expected to fall 22%.
Technical outlook
While the long term trend is bearish, the
market has been correcting higher since the
41.90c/lb trough at the end of 2001. Bear in
mind that the market has only probed below
50c three times, once in April 1975, once in
August 1992 and the somewhat lengthier
September 2001-August 2002 period. The
market does not seem comfortable on probes
below 50c and a correction back towards
more normal levels looks underway. The
recovery through the old support line from
the January 1996 and September 1999 lows,
which had marked the neckline of a large and
sloppy top, helped trigger a supportive cup
and handle pattern breakout on weekly
charts a bullish pattern. That move has seen
the 13-week (quarterly) moving average
regained, confirming a bullish crossover in the
13- and 60-week moving averages
Daily charts show a large triangle continuation
pattern, which in turn seems to be part of a
bull flag on weekly charts. The triangle
parameters on the front month CSCE May 04
contract are noted at 70.95c and 79.05c
currently. The weekly moving averages have
seen a bullish crossover in the 13-week
(quarterly) and 50-week (annual) moving
averages and the price rebound through the
13-week moving average is encouraging. The
250-week moving average (5-year average)
offers strong support now near 69c and is key
to hold to keep the overall bias on gains. For
choice, a push towards the 79.05c triangle
resistance line looks on the cards. Ability to
clear that line, then the key 80.60/81.00c zone
(late January 2004 peak and 38.2%
retracement of the decline from the March
1999 $1.45 peak to the 41.50c December 2001
low) would trigger the large bull flag for a
target to $1.07 over the coming weeks. Along
the way, the 93.25c level marks the 50%
retracement of the same move, while the 61.8% retracement comes in
near $1.055.
The 70.95c and 69c levels offer key support on daily charts. The latter is
key to hold to not only retain the bullish patterns currently apparent on
the charts but also to retain bullish Elliott wave counts as a breach there
would invalidate a potential wave 4 correction unfolding here. If seen,
such a break would leave the 61.75c contract low vulnerable to approach
again (tested last November, as well as the previous August in thin
trading). While the long term trend is bearish, the basing pattern that has
been building since the end of 2001 dominates the charts and an
extension higher is favoured over the coming months through the
80.60/81c region towards the 93.25c retracement initially.
Elizabeth Miller, Head of Research, Redtower Research
The Case for a Base in Coffee Futures
By Elizabeth Miller
CSCE May 04 Coffee futures daily chart , with 20-day and 60-day moving averages and a triangle
pattern.
CSCE Coffee futures weekly chart, with 13-week and 50-week moving averages.
To buy and hold blindly on the basis that it is a great company, or a strong
industry, or the economys general health is, to me, the equivalent of stock-
market suicide.
Jesse Livermore
As most market practitioners believe, be they fundamentally or technically
biased, price trends exist due to the inefficiency of financial markets to
digest information in a timely manner. This is due to the fact that price
sensitive information is used in different ways, over different time scales
by many different market players thus confining the efficient market
hypothesis to the ivory towers of academia. A logical extension from this
is that a mix of diversified investment processes are required in order to
make markets inefficient and for trends to exist.
An investment process will be dictated by the bias of the practitioner (a
macro economist will be biased towards using a fundamental investment
process) and by the relevant customer base (a retail oriented fund will
generally find it easier to talk in the language that they believe their retail
customers understand). Also, different markets will require different
investment processes. A small companies investor/trader will be better
following a fundamental investment process whereas a currency
investor/trader would be more suited to a process mixed between
fundamental and technical analysis.
Technical analysis really only works and has any theoretical credibility in
deep, liquid markets because there has to be a reasonable crowd in order
for there to be crowd psychology at work. However, technical market
analysis is the oldest form of market analysis. It pre-dates modern
fundamental analysis by decades if not centuries yet the modern
assumption is that fundamental analysis is the most appropriate method
on which to base investment decisions. This is due to the natural human
desire to understand and explain WHY events happen or WHY markets
move. Lets face it, what fund manager you know would want to be honest
enough to tell you that he doesnt know why prices are moving or why
some trends exist?
So why integrate technical analysis into an investment process? Well, for
technical analysts the why markets move is not important, they are only
interested in the HOWmarkets move. Also, fundamental analysis is
broadly subjective whereas technical analysis is broadly objective.
Therefore, integrating technical analysis into an investment process allows
it to act as a REALITY CHECK on subjective decisions.
Technical analysis acts as a tremendous risk management tool as it tells
the trader or fund manager when they are wrong. This acts as a great
defence against a fund managers worst enemy their EGO and as such
it prevents crippling losses occurring from a badly positioned portfolio. As
the old market adage says the market is never wrong: opinions often are.
By integrating technical analysis, losing positions will never be held on to
for too long and indeed by using trend following techniques the market
practitioner can be guaranteed to be on the right side (or, at least, not on
the wrong side) of a large sustained market move. This is a huge benefit in
preservation of capital.
The elements of good trading are: 1. Cutting losses, 2. Cutting losses, and 3.
Cutting losses. If you can follow these three rules, you may have a chance.
Ed Seykota
So what form of technical analysis should be integrated into a process?
Although technical analysis is broadly split between trend following and
contrary thinking both can be used together. However, generally one form
will dominate the other depending on the bias of the practitioner. For
most practitioners trend identification is the bedrock of what technical
analysis is all about and is certainly the area of technical analysis most
suited to limiting the risk of holding on to losing positions for too long.
There are three broad methods of integrating technical analysis into an
investment process.
1. Full Integration
2. Position Management
3. Style Diversification
The objective of each method is to reach overweight (buy), underweight
(sell) or neutral (stand aside) decisions. The examples used here are based
on Currency Management (Overlay) but the methodology can easily be
transferred to other liquid asset classes. Fundamental drivers will differ
between asset classes and the technical analysis may have to be tweaked
slightly trend following works in most asset classes over the long term
but some asset classes (or sub sectors) may be more suited to oscillators
or contrary opinion. As always, flexibility is the key.
Full integration
In this method we include technical analysis as part of the overall process in
order to reach one single decision (i.e: overweight, underweight or neutral).
The spreadsheet shows various drivers of currencies each with a
hypothetical score ranging from -5 to +5. A score of -3 in the Growth
Expectations field for EUR/USD means that this driver is negative for
EUR/USD and a score of +4 in the trend field indicates that this driver (the
trend) is positive for EUR/USD. The overall decision is reached by simply
adding the scores of each driver together. Thus we get a small
underweight position in EUR/USD. Note that we are assuming an equal
weight given to each driver here but they could be weighted according to
their importance for the currency pair.
The advantages of full integration are that it can be seen to take all
relevant drivers into account to reach one simple decision and that it
controls risk (limits the downside) by having a weighting given to
technical analysis.
The disadvantages are that positions taken away from the benchmark (or
neutral) may be very infrequent due to the often conflicting messages
from fundamental and technical analysis. The technicals could be a
screaming buy but if the fundamentals are poor then only a neutral
position would result. There is therefore a very high risk of opportunity
loss using the full integration method.
Position management
In this method we include technical analysis as a filter in order to decide
the size of the position that will be taken.
Integrating Technical Analysis into an
Investment Process
By Murray Gunn
Vs USD Value Growth Money Sentiment Trend Position
(PPP, FEERS) Expectations Supply Growth
EUR 1 -3 0 -3 4 Underweight
JPY 0 -4 -1 2 3 neutral
STRATEGIC PROCESS
PRICE
ACTION
FILTER
Neutral
Smallest o/w
Overweight
Currency
Underweight
Currency
Neutral
Smallest u/w
The method makes use of two processes. A Strategic Process
(fundamental analysis) decides the direction of the position whilst a Price
Action Filter (technical analysis) decides the size and timing of the
position.
The diagram shows how the strategic process (the fundamentals)
interacts with the price action filter (the technical analysis). If the
fundamentals are positive and the technicals are positive then an
overweight currency position will exist. If the fundamentals are negative
but the technicals are positive then we have a neutral or very small
underweight position.
The advantages of using technical analysis as part of a process in this
way is that it combines fundamental and technical analysis but for
separate purposes. The technical analysis is acting as a controller of how
much risk to place on a given fundamental view. It therefore contains risk
and limits the downside.
The disadvantage of this method is that a very high risk of opportunity
loss still exists. The Yen could be on a strong upward trend but if the
fundamental view was for Yen weakness then only a neutral position (or
even the smallest underweight position) would exist. A large move in the
market in the opposite direction of the strategic process would NOT be
captured.
Perhaps a better way to use this process would be to flip it around so
that the technical analysis decides the direction and timing of the
position and the fundamentals decide the size of the position. This would
avoid the opportunity loss problem as trend following (if that is the
technical analysis utilised) is guaranteed to be the right side of a large,
sustained market move.
Style diversification
In this method we include technical analysis as part of a diversified
portfolio of management styles. We take the maximum position (or risk)
that can be taken and divide it up into sub-positions with each one
managing a portion of risk according to a separate management style.
For example, suppose we are managing the Japanese Yen risk in a
portfolio. Assume that the benchmark weighting is 20% for Yen but we,
as the managers, are allowed to vary the exposure between 10% and
30%. The 10% differential from the index is the maximum position size.
If we were to utilise the style diversification method here then we may
have something that looks like this.
The spreadsheet shows that we are employing four separate styles of
management, fundamentals, cost of carry, contrary opinion and trend
following. We have allocated a percentage to each one and this refers to
the amount of risk that each style will manage. For example, we have
allocated 40% to trend following which means that 4% (40% of 10%) of
the portfolio will trade the Yen based on trend following techniques.
Assuming a portfolio value of USD100m then the trend following position
can go up to USD4m long of Yen or USD4m short of Yen. In the above
example the trend following style is showing an overweight position in
Yen so the position would be USD4m long of Yen.
Each sub-position should not be heavily correlated with any other and
each will have its own independent designation for performance
attribution purposes. The size of the sub-positions will vary according to
what is working well and what is not. This is process known as risk
budgeting and means that more risk can be allocated to the styles that
are working well and less risk can be allocated to the styles that are not
working well.
Note also that the sub-positions could be further sub-divided. For
instance, the USD4m allocated to trend following could be further split
into USD1m for a moving average crossover system, USD1m for a MACD
system, USD1m for a breakout system and USD1m for discretionary
pattern recognition.
The main advantage of using the style diversification method as a way of
integrating technical analysis in to an investment process is that it reduces
risk, especially of opportunity loss. It also optimises returns, it is
transparent and very flexible.
The disadvantage is that it can be administratively cumbersome
depending on how many different styles will be used.
Conclusion
Technical analysis should be an integral part of an investment process, if
only for risk control purposes. There are various methods of integration
but the danger of opportunity loss exists in most. However, style
diversification is probably the best method as it goes a long way to
eliminating the opportunity loss and it is extremely transparent.
Few, if any, have the ability to view their portfolios as a whole and even fewer
are able to optimise capital usage. Traders and investors must move from a
defensive or reactive view of risk in which they measure risk to avoid losses, to
an offensive or proactive posture in which risks are actively managed for a
more efficient use of capital.
Turtle Trader
Continued from page 10
Candlestick Reversals
Defining Doji. How large can the body of a bar be before it goes
from a Doji to a Spinning Top? The book referenced above says the
body can be up to 3% of the entire range of the price-bar?
The 3% rule is most likely derived from a computerised study of these
sorts of patterns in a wide range of different markets where the
computer plays around with different percentages and finds the most
optimal. But there are so many different markets and so many different
time frames that can be applied to each market, that this sort of figure is
too much of a generalisation, admirable though its intent may be.
Hard work is the only answer to this conundrum; knowing your market
and your time frame, combined with knowing your risk profile. The
market is a bunch of individuals acting as a whole. No one person has all
the answers. To be a successful trader or analyst you need to work out
what works best for your market and time frame and this is a long hard
slog. There is no other way.
But if it came down to whats the difference between a Doji and
Spinning Top I would say theres not too much to choose between them
if the next day confirms. Whats in a name?!
Defining Long Candles. How long must it be? The books tend to
suggest that long candle should be at least 130% of the average
body size of the prior 10 trading sessions
Again I wouldnt put a figure on it but prefer to think of it this way: If
the prior 10 sessions had seen the market posting a range of 100 points,
all with red/filled candles, then the market posts a Hammer with a 100
point lower shadow, then the market has actually moved over 200
points that day. The first 100 points were much the same as the
previous sessions, but the second 100 points, i.e. the subsequent intra-
day rally, was quite different to anything seen previously. This is the key
to this pattern.
As you may have gathered Im not a huge fan of quantifying patterns
with percentages that need to be stuck to rigidly. I prefer to look at
candlestick analysis as a strong guide to market psychology rather than a
set of rules that must be rigidly applied to in order to present clear cut
trading signals. Use the candles to light your way in coming to trading
decisions, not to give you outright signals.
Clive Lambert writes a subscription daily technical analysis service on
European and US Financial Futures Markets. clive@futurestechs.co.uk
Vs USD Fundamentals Cost of Carry Contrary Opinion Trend Following
20% 20% 20% 40%
EUR Underweight Overweight Underweight Overweight
JPY Underweight Underweight Neutral Overweight
ABSTRACT. The article introduces an almost unknown Japanese trend
technique, Heikin-ashi, which is based on modified open-high-low-close
values and is displayed using candlesticks. It is a visual instrument which
assesses the current trend and its strength. The Heikin-ashi technique,
also known as modified candles, takes the noise out from the price and
displays a smoother evolution of the stock price or index value. This
technique is mainly used as a visual way to assess the trend, but it can
also be quantified with indicators. It can be applied successfully to all
instruments with open-high-low-close values (stocks, options,
commodities, futures). Heikin-ashi charts and related indicators are easy
to generate by most of the technical analysis software packages available
on the market. They can also be produced using common spreadsheet
software available on all personal computers. The article will also discuss
how this technique may apply to UK stock market.
WHAT IS HEIKIN-ASHI? Last summer, while researching for Ichimoku
charts material, I came across a very rare way to look at trends: Heikin-
ashi or modified candlesticks. At that time there was only one English-
language site which displayed charts built using this technique. Now
there are a number of sites and discussion forums which focus on this
form of analysis. However, it is still very difficult to trace its origin due to
the lack of available literature in English. I could only obtain the way the
modified OHLC values are computed from a Japanese trader. From there,
interpretation and quantification as technical indicators came as logical
steps. Lets start with the definitions of modified values and continue
with discussions about use of this technique:
COMPUTATION OF HEIKIN-ASHI VALUES
CASE STUDIES: The best way to understand Heikin-ashi is to apply it to
familiar instruments. For example, lets apply the code to display Heikin-
ashi / modified candlesticks (see box on next page) to the FTSE-100 index:
The periods associated with ascending trends are shown as sequences of
continuous white candles, while descending trends are displayed as black
filled candles. A trend may be strong, weak, or ready to change. A strong
uptrend appears as a sequence of long white candles with no lower
shadows. A strong downtrend is associated with a sequence of long
black candles with no higher shadows. The reduction in size for the
candles during a trend may signal a weakening of the current trend.
Periods of consolidations are associated with Heikin-ashi candles having
small bodies, but longer upper and lower shadows. And finally, possible
trend changes are identified by a candle with a small body having both
high upper- and lower shadow.
The table below summarizes these basic rules to identify and assess the
strength of any trend using the Heikin-ashi technique:
Taking into account the findings in the previous table and looking at the
second subchart, we can see some obvious trends.
The main advantage of Heikin-ashi technique is that the modified OHLC
values are displayed as Japanese candlesticks. This powerful
representation makes the trend clear for everybody. The original
Japanese candlesticks theory is very complex and it requires very good
skills for an accurate translation of patterns. Heikin-ashi charts eliminate
the need for a sophisticated understanding of Japanese candlesticks
theory and their related patterns.
Since this technique is simple and easy to understand, lets use and
discuss it for another example from the UK stock market, LogicaCMG.
Figure 2 shows three different subcharts: regular candles, modified
candles, and Heikin-ashi indicator HaDiffCO together with its 3-day
moving average.
As mentioned before, Heikin-ashi is a visual technique and as a result,
there is a certain degree of subjectivism when we try to translate what
we see. To avoid this and make the process more mechanical, I have
created an indicator, HaDiffCO, which is simply the difference between
HaClose and HaOpen:
HaDiffCO = HaClose HaOpen
HaDiffCO is nothing more than the value of the modified candles body.
When this indicator is positive, the Heikin-ashi candle is white. Negative
Trending with Heikin-Ashi
By Dan Valcu
Modified Mnemonic Definition Comments
OHLC
Modified HaClose (O+H+L+C)/4 O-H-L-C values are for
Close the current bar
Modified HaOpen (HaOpen(prev.bar) +
Open HaClose(prev.bar))/2
Modified HaHigh Max(H,HaOpen,HaClose) H value is for current bar
High
Modified HaLow Min(L,HaOpen,HaClose) L value is for current bar
Low
FIGURE 1: FTSE-100 Candle chart vs. Heikin-ashi chart.
Uptrends and downtrends are easier to identify on Heikin-ashi chart.
Rule # Rule description Area on Chart Comments
1 Uptrend A-B, C-D, E-F, G-H, K-L, M-N White candles
O-P, R-S
2 Downtrend B-C, D-E, F-G, J-K, L-M, P-R, S-T Black candles
3 Strong Uptrend A-B, G-H, O-P, R-S white candles with
no lower shadows
4 Strong Downtrend F-G, J-K Black candles with
no high shadows
5 Consolidation C, E, I between N-O, T Candles with small
bodies (white or
black) and with
upper and lower
shadows
6 Change of Trend C, I, F, first white candle Similar to #5, but
after R only one
occurrence. Not
always reliable as
it may also be part
of a consolidation
sequence
values for HaDiffCO are equivalent with black-filled Heikin-ashi candles. If
we look simultaneously at subcharts #2 and #3, we see the equivalence I
just mentioned. There are two immediate advantages of having this
simple indicator: (a) for those who use software with no built-in
capability to display modified candles and (b) possibility to apply moving
averages or other indicators.
The indicator is smoothed with its 3-bar moving average and the resulting
crossovers suggest entry and exit points. Going one step further (not
shown in this article), we may apply another moving average to the
moving average and the intersections suggest another set of entries and
exists (the lag introduced by moving averages will delay these signals).
CONCLUSIONS. Heikin-ashi trend charting technique is simple to
implement either as candlesticks or as traditional technical analysis
indicator(s). This can be done with most of the software packages
available on the market. It is a visual way to look at the trend and assess
its strength. It works with all timeframes and there are a small number of
simple rules required to understand in order to make an easy and correct
judgment of any trend. It fits well in the category of visual Japanese
techniques, such as Kagi, Renko, and three-line break charts. Heikin-ashi
charts are not the solution for instant success in the markets, but they
help to enter and remain on the right side of a trend for a great deal of
its duration. It is highly recommended to use modified candles together
with other independent indicators, patterns, or techniques.
FURTHER REFERENCE:
(1) Valcu, Dan Using the Heikin-Ashi Technique Technical Analysis of
Stocks and Commodities: February 2004
(2) Traders Tips Technical Analysis of Stocks and Commodities: February
2004
(3) http://www.educofin.com
(4) http://plaza4.mbn.or.jp/~skoike/heikin.htm
How to build and display Heikin-ashi charts using
technical analysis software
For this article, all formulae and charts have been generated using
AmiBroker v4.50 and are described below as implemented for the
article (1).
Code to display Heikin-ashi (modified) candlesticks:
HaClose = (O+H+L+C)/4;
HaOpen = AMA( Ref( HaClose, -1 ), 0.5 );
HaHigh = Max( H, Max( HaClose, HaOpen ) );
HaLow = Min( L, Min( HaClose, HaOpen ) );
PlotOHLC( HaOpen, HaHigh, HaLow, HaClose, Modified + Name(),
colorBlack, styleCandle );
Code to generate Heikin-ashi indicators HaOpen, HaClose, and
HADiffCO with its average:
HaClose = (O+H+L+C)/4;
HaOpen = AMA( Ref( HaClose, -1 ), 0.5 );
HaHigh = Max( H, Max( HaClose, HaOpen ) );
HaLow = Min( L, Min( HaClose, HaOpen ) );
HaDiffCO = HaClose HaOpen;
per = Param(MA Periods, 3, 3, 50, 1 );
Plot( HaDiffCo, HaDiffCO, colorRed );
Plot( MA( HaDiffCo, per ), MA(+per+), colorBlue );
Daily data from Yahoo Finance UK&Ireland: http://uk.finance.yahoo.com/
Dan Valcu is a Swedish private investor and IT consultant. His website,
www.educofin.com focuses on trends and trading using Heikin-ashi and
trend-based proprietary systems. He may be reached via email at
ta@educofin.com
FIGURE 2: LogicaCMG Quantifying Heikin-ashi candles
Led by the Chinese dragon, the South Eastern Asian tiger markets have
been roaring again. Overall, the chart patterns continue to look
constructive although some of the markets (such as Korea and Taiwan)
are at or near their 2002 highs which may prompt some consolidation.
This chart shows the completion of the base area which has been in
formation since the fall in mid 2000. This is the best signal of an Asian
bull market and suggests a minimum gain of 22% from here. Only an
unlikely relapse back below 290, would weaken the chart.
This US Dollar based relative chart details the gradual outperformance
since the base completion in October. The minimum target is for a 26%
relative gain by the CFE against World equities. Support is at the base
ceiling, and has been confirmed.
Previous breakouts of the key 12,000 level have eventually resulted in
new highs. Previously the 12,000 mark was retested several months after
the initial breakthrough. Therefore it is a very positive scenario, but with
a chance of a pullback, before a quantum move to much higher levels.
Some neckline resistance is shown at 14,000 to 14,500.
Thailand has been leading the regional indices higher with base
completion at 550. On a measure, the minimum target has been met,
and so the easy part of the advance is over. There is trendline support
about 690. Resistance is at 1,000 (big figure) and 1140 (neckline).
There has been an orderly advance since early last year, underpinned by
a trendline providing support at about 820. Prominent resistance is at
940 and 977.
The Composite recently confirmed support at 5760 to provide the
momentum to test the 2002 high at 6460. The minimum target from the
base completion at 5000 has been achieved, so there is more chance of a
light consolidation, which fits in with the staircasing character of the
advance.
Hamish Calder works for South China Securities (UK) Ltd
The Resurgence of China and South East
Asian Stock Markets
This article is a summary of the talk given to the Society on 3rd December, 2003 By Hamish Calder
MS COMBINED FAR EAST ex JAPAN
MS COMBINED FAR EAST ex JAPAN vs MS WORLD (Weekly)
HANG SENG INDEX (Weekly)
THAILAND SET INDEX (Monthly)
KOREA COMPOSITE (Daily)
TAIWAN COMPOSITE (Daily)

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As this journal goes to press, stock markets are cautiously marking the

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