Trading With Candlesticks 'Twinkle Twinkle Little Star'
AIQ Opening BellNewsletterMay 2002Vol. 11Issue 5Trading with CandlesticksIn This IssueA look at two candlestickpatterns that predict oncomingreversals in a stock’s price. 1Market Review: AIQ's markettiming signals for month of Aprilare reviewed . 5Data Maintenance . 5'Twinkle Twinkle Little Star'By Allen ThomasEditor’s note: We recommend that thoseunfamiliar with candlestick charts should firstread Allen Thomas’s introductory article oncandlestick charting in the April 2002Opening Bell.S&P 500 Changes . 5hen I first beganreading about candlestick analysis in SteveNison’s book JapaneseCandlestick Charting, Iwas overwhelmed withall the different patterns. There’s the“Hanging Man,” “Shooting Star,” “DarkCloud Cover,” “Piercing Line,” and so on.Fortunately, many of the patterns havecolorful, descriptive namesAllen Thomas is a full-time trader andto help distinpresident of A-TeamTraders.com, a websiteguish onegeared toward teaching traders how topattern fromanother. But tomomentum trade using technical analysis.the buddingHe specializes in candlestick chartingcandlestickanalysis, using TradingExpert Pro as histrader it can beprimary software package.a daunting taskto sift out whichof these candlesticks they shouldactually look for and use in their everyday trading. So, in this issue of theOpening Bell, I’m going to take an inThe Opening Bell Newsletterdepth look at two of my favorite patis a publication of AIQ Systemsterns that have proven to be consisP.O. Box 7530tently powerful in their ability toIncline Village, Nevadapredict an oncoming reversal in a89452stock’s price. These two patterns arethe “Morning Star” and the “EveningStar.” The planet Mercury is called the“Morning Star” because it appearsStep-by-step process forcreating a mechanicalscreening model based on theMoney Flow indicator . 6Wbright in theearly morning skyPlacepresagingThomas Photothe rising ofthe sun andHerethe beginning of anew day. Soit is with theAllen Thomascandlestickpattern of the same name. The “Morning Star” (Figure 1) is a bullish trendreversal pattern made up of threesuccessive candlesticks.The first candle is a long blackcandle at the end of a significantdowntrend. A long black candle impliesthat the security closed well below itsopening price. The second candle is asmall real-bodied candle (either black orwhite) whose real body gaps down fromthe previous candle’s close (remember,real body is the difference between theopen and the close). The last candle is astrong white candle which gaps up atthe open and then closes well within thereal body of the first black candle.This pattern is a graphic depiction ofa bearish trend that has exhausted itselfof sellers. On the first day, the pricesells off dramatically as panic sets in andtraders are willing to exit at all costs,allowing the stock to close at or near thelow of the day. This is followed by agap-down opening the next day, butfurther attempts by the bears to push
AIQ Opening BellMay 2002ing Star pattern.reversal to be more significant (aFirst, the longerDoji is when the open equals thethe real bodies ofclose).boththefirstandFigure 2 shows an hourly chartMarch 2002final candles, theof Emulex (EMLX) during the end ofmore powerful isFebruary and beginning of Marchthe expected2002. After trading laterally bereversal. Second,tween 36 and 37, the price took aalthough a gap-up nosedive down to the 31 area whereon the final candle it found support and formed ais not alwaysdecent looking Morning Star pattern.present, when you Note that we don’t have a true gapsee one it doesdown between the close of the firstincrease the oddslong black candle and the followingof this patternsmall white one, but the pattern isworking. Third,certainly close enough to be athe higher theMorning Star.volume on theFigure 1. Morning Star and Evening Star trend reversal patternsFollowing the formation of thefinal candle, thepattern, prices consolidated betweenprices lower stalls with a veryhigher the conviction is of the bulls 32 and 33 before breaking fromnarrow trading range. The final day to pushsignifies the coup by the bulls asprices loftierprices not only gap up in astill in“In my experience, I’ve found the best placebreakaway manner, but also push off comingto take a long position after the Morningtheir opening lows to close muchdays.Star is to wait until the security hashigher, no doubt spurred on byFourth,retraced about 30% to 50% into the lengthsome degree of short covering.when themiddleof the large white candle’s real body.”Before we take a look at somecandle is acharts, there are a few additional“Doji”criteria that will help to furtherthis small descending trendlinecandle, you can generally expect theenhance the reliability of the Morn(further confirmation of the trendchange) the following day with abreakaway gap that saw the stockrun up nearly 6 before cooling off.Notice that the decline in priceprior to the Morning Star patternwas pretty steep and rapid. Whenyou see that type of selling followedby a Morning Star formation, youcan anticipate a more significantbounce in price.Figure 2. Candlestick chart of Emulex with Morning Star trend reversal pattern2The chart in Figure 2 also callsattention to an important pointregarding where to enter after theappearance of one of these candles.In my experience, I’ve found the bestplace to take a long position after theMorning Star is to wait until thesecurity has retraced about 30% to50% into the length of the largewhite candle’s real body. Thissimply reduces your risk, as yourstop is closer than if you were toenter at the very opening of the next
AIQ Opening BellMay 2002candle. It also serves to make iteasier to get your order filled versustrying to buy as the price continuesits ascent.Figure 3 demonstrates theconcept of waiting for a retracementback into the pattern before buying.Mid February saw Compuware(CPWR) shed about 20% of its pricein the week prior to the developmentof this bullish Morning Star pattern.However, it wasn’t until four tradingsessions later that a “buy” signalfired. This occurred when the pricefinally retraced around 50% of thewhite candle’s length before findingintra-day support. The stock thenmoved rapidly upwards, addingover 2 in as many days.Note in Figure 3 the lowershadows of the first and secondcandles of our Morning Star pattern.Do you see how much longer theyare in relation to any of the lowershadows in the previous tradingsessions? This shows a general senseof support at these lower prices andfailure of the bearish camp to pushprices any lower, adding overallvalidity to the bullishness of thepattern.Figure 3. Candlestick chart of Compuware showing Morning Star trend reversal pattern followedby price retracement before rapid upturn.herald the arrival of darkness, andlower prices to come. This trio ofcandles is found at the end of an uptrend, and sometimes at the tail of alateral congestion band. As with allcandlestick reversal patterns, thelonger and steeper the trend preced-ing the pattern, the more significantis the expected reversal. An EveningStar on a 15-minute chart will havefar less impact on the overall trendthan one on a daily or weekly chart.Author Steve Nison likens thisI’ve covered where to buy butwhat about stops? Another conceptto remember with Morning Stars isthat the low of the pattern (usuallythe lower shadow of the secondcandle) will serve as a level ofsupport in future retracement. So, Iplace my stops just a tick or twobelow the low point of the MorningStar pattern. If the price falls belowthat low, then it has broken throughsupport and a new up trend isimprobable. In Figure 3, waitingfirst for the retracement in order tobuy decreases the amount of riskyou are taking due to the shortenedinterval to the stop loss just underneath the low of the pattern.The bearish counterpart to theMorning Star is, of course, called the“Evening Star” (see Figure 1). Justlike Venus in the night sky, theEvening Star can be looked upon toFigure 4. Hourly candlestick chart of COMPX showing temporary congestion channel.3
AIQ Opening BellMay 2002pattern to a traffic light. A trafficlight goes from green (bullish whitecandle), to yellow (the small bodiedcandle) to red(the blackMarch2002candleconfirming the up trend is over).Evening Stars are potent callers ofmarket tops, and often serve asresistance levels for future rallies.During the second half of January this year, the NASDAQ had beenin a steady decline (Figure 4) when alateral trading band of congestiondeveloped between the 1925 and1960 area. On two separate occasions the price had turned downward off the upper trendline. Whenthe price began moving upward offits support, this hourly chart gavelittle indication of whether the indexwas going to break free above thischannel or travel south again to testthe lower support.Figure 5 shows the final failedattempt at breaking the 1960 area ofresistance on a 15-minute timeframe. The opening three candles onJanuary 29 show a very cleanlyformed Evening Star pattern withgaps between all three candles’ realbodies. The ensuing decline thistime pushed through the 1925support and signaled a continuationAIQ Opening Bell NewsletterDavid Vomund, PublisherG.R. Barbor, EditorP.O. Box 7530Incline Village, NV 89452AIQ Opening Bell does not intend to maketrading recommendations, nor do wepublish, keep or claim any track records. Itis designed as a serious tool to aid investorsin their trading decisions through the useof AIQ software and an increasedfamiliarity with technical indicators andtrading strategies. AIQ reserves the right touse or edit submissions.While the information in this newsletter isbelieved to be reliable, accuracy cannot beguaranteed. Past performance does notguarantee future results.For subscription information, phone1-800-332-2999 or 1-775-831-2999. 1992-2002, AIQ Systems4Figure 5. Hourly COMPX candlestick chart with Evening Star pattern followed by price declineof the prior downtrend. To a candleenthusiast, the first 45 minutes of theday were all that was needed toabandon any notion of higher pricesin the immediate future.our stops.After a large intra-day gapdown, QLGC staged a rally toattempt to close the gap. A niceEvening Star pattern popped up onthe 15th. The following candleretraced upwards nicely into theAlthough the retracing candlethat followed failed to reach into the50% area of the finalblack candle, thesame principles of“Just like Venus in the night sky,waiting forthe Evening Star can be looked uponretracement andto herald the arrival of darkness,stop-loss levelsand lower prices to come.”apply to theEvening Star as theMorning Star.black real body, but rather thanThose wishing to short (or abandonselling off hard, prices simplya long) should wait until there isconsolidated around 48 through thesome upward movement of therest of the trading session.candle following an Evening Starpattern. Since an Evening StarThe following day saw morepattern sets a level of resistance, stop buying on a gap-down opening thatloss orders should be placed justpushed prices up to, but not over,above the highest upper shadow ofthe high of the Evening Star pattern.the three-candled pattern.When prices moved under 47.50, itFigure 6 is a 15-minute chart ofQlogic (QLGC) in April of this year.It shows how the high of an EveningStar pattern can serve as futureresistance to any rally. It also showswhy I use just beyond that level forgave confirmation to the EveningStar’s bearishness via a Double Top.Don’t you wish all your chartsunfolded this nicely? Had the pricebeen able to take out the high of theEvening Star, then the Evening Star
AIQ Opening BellMay 2002topping pattern would be invalidated and shorts would be covered.As with all other candlestickpatterns, the more information youhave to corroborate a trend reversal,the greater your success will be.Watch for these patterns to developat prior levels of resistance andsupport. Look for confirmation withyour favorite momentum indicators.Feel free to contact me on mywebsite and I’ll happy to answer anyquestions you might have includinginterpretation of a specific candlestick formation you’re seeing. Goodluck and happy hunting!For more details on how usingcandlestick analysis can help toimprove your trading, and forfurther examples of Morning /Evening Star patterns in action, visitthe A-TeamTraders website at:www.A-TeamTraders.com.Figure 6. Qlogic 15-min. chart with Evening Star pattern. Price retraces to resistence levelforming double top before selling off.Market ReviewSTOCK DATA MAINTENANCEThe following table shows stock splits and other changes:StockP.F. Chang’s ChinaOption Care Inc.Darden RestaurantsBest BuyFastenal Co.Maxwell ShoeTickerSplitApprox. 0205/02/0205/02/0205/13/0205/13/0205/20/02Trading Suspended:APW Ltd. (APW), Budget Group (BD), Comdisco Inc. (CD),GenTek Inc. (GK), Intimate Brands (IBI), J2 Communications (JTWO),Kaiser Aluminum (KLU), NTL Corp (NLI)Name Changes:Minnesota Mining & Manuf. (MMM) to 3M Co. (MMM)PanCanadian Energy (PCX) to EnCana Corp. (ECA)S&P 500 ChangesChanges to the S&P 500 Index and Industry Groups:IMS Health (RX) moves from the Diversified Commercial Services(SERVICED) group to Health Care Distributors & Services (HEALTHSS).Convergys Corp (CVG) moves from the Diversified Commercial Services(SERVICED) group to Data Processing Services (SERVICEP).In April, the S&P 500 index lost6.1% and the Nasdaq Composite lost8.5%. Government data signspointed to a renewing economy butthat didn’t spill over into corporateprofits.The AIQ timing model has beenineffective in this market. It registered five market timing buy signalsin April -- on April 3, 15, 16, 18, and24. Yet the market continued itsdecline. At the end of the month, theNasdaq had broken down; its chartshowed lower lows. The S&P 500,however, was at the bottom of itstrading range.All Day Seminarswith AIQ Chief AnalystDavid VomundAugust 23rd, San FranciscoOctober 23rd, New YorkFor more information visitwww.aiqsystemsor call 800-332-2999.5
AIQ Opening BellMay 2002Step-by-Step Process:March 2002 Creating a Mechanical Trading ModelBased on the Money Flow IndicatorBy David VomundDAVID VOMUNDn the April Opening Bell,we introduced an ExpertDesign Studio modeldesigned to find stockswith attractive MoneyFlow indicators. For people likemyself who place considerableimportance on this indicator, thismodel serves as a great time-saver.Each day it provides a list of stocksthat have positive divergences intheir Money Flow indicators andwhose Money Flow indicators havebeen strong for the last six months.With this list of stocks, we canperform further analysis by lookingat the chart patterns of the stocks aswell as other indicator readings.Iof trades and hopefully increase theoverall return.The first step in creating a fullymechanical Money Flow tradingmodel was to test the individualrules from the April model, makingthem more restrictive and increasingthe effectiveness of their selections.1879 and the average annual ROIincreased to 13.29% (Figure 1). Thisis the foundation of our mechanicalMoney Flow trading model.Pause ruleThe April model had a rule thatrequired the stock to pause for atleast ten days. Specifically, the rulePersistence of Money Flow rule stated that the highest close in theThe most effective rule from the last three days was less than thehighest value in the previous sevenApril model was the Persistence ofMoney Flow rule. This rule required days. Testing this rule combinedwith the Persistence of Money Flowthe Volume Accumulation Percentrule found 1785 trades with anindicator to be above zero at leastaverage annual ROI of 13.85. Com80% of the time in the previous sixparing this to Figure 1, we see thatmonths. An Expert Design Studiothe Pause rule only lowered thebacktest over the last two years ofnumber of trades by 94 trades andthe Persistence of Money Flow ruleslightly increased the overall return.showed 5056 tradeswith an averageWe tested several variations toannual return onthe Pause rule. For example, we“The process of creating ourinvestment (ROI) ofsearched for recent consolidations bymechanical Money Flow model10.08%.requiring a less than 10% differencebetween the high and low prices ofis outlined in this article. It isNote: In this andstocks. Results were worse.all other tests in thisuseful to understand the processbecause those who create theirown trading models will followthe same steps.”article, we used a fixed30-day holding periodon a database of about2100 stocks. Onlythose stocks withprices greater than 10and volumes greater than 100,000The April model was designed towere considered for purchase.provide trading ideas. This month,With 5056 trades, we could makewe will refine the model and create athe Persistence of Money Flow rulefully mechanical trading modelbased on the Money Flow indicator. more restrictive, hoping for evenbetter results. We changed the ruleSince the April model wasto require the Volume Accumulationdesigned to give trading ideas, itPercent indicator to be above zero atfound a large list of stocks. A threeleast 90% of the time in the last sixyear backtest of this model showedmonths. This corresponds to the2059 trades. With that many trades,default for the Persistence of Moneywe can tighten the technical buyFlow report. After this change, therules and thereby lower the numbernumber of trades dramatically fell to6In the end, we kept the Pauserule just as used in the April model.This rule does not play a prominentrole in the model.Money Flow ruleThe April model required theMoney Flow indicator to be hitting a120-day high. Combining this rulewith the Pause rule denotes a positive divergence in the Money Flowindicator. That is, the stock is nothitting a new high but its MoneyFlow indicator is. Running this rulecombined with the Persistence ofMoney flow rule showed 1271 tradeswith an average annual return of9.6%.We included this rule in the
AIQ Opening BellMay 2002April model because we wanted tofind stocks with very strong MoneyFlow indicators. In creating a fullymechanical model, however, thisrule needed to be changed. As is,this rule reduced the number oftrades and lowered the overallreturn.Instead of requiring the MoneyFlow indicator to be hitting a newhigh, we found the indicator’s slopeto be a better screening parameter.Requiring a positive 22-day slopehad good test results. Using a fiveday slope was better. In the end, wechanged the rule to require a positive two-day slope in the MoneyFlow indicator.Using a two-day slope combinedwith the Persistence of Money Flowrule yielded 1785 trades with anaverage annual ROI of 13.50%(compare these results to Figure 1 tosee the effectiveness of the rule).Similar to the Pause rule, this rulefilters out very few trades.Figure 1.Test results of Persistence of Money Flow trading model, first versionindicator keeps moving higher. Wedon’t want that. For that reason, theApril model had a rule that requiredthe stock to increase by at least 10%Uptrend ruleover the last 44 business days(approx. two months). TestingIndicators don’t always work.Every once in a while you see a stock found 1150 trades with an averageannual ROI of 6.7%. That could bethat continually falls month aftermonth even though its Money Flow improved. We tried requiring thestock to rise by 20% instead of 10%but overall returns fell. This changewould have improved results duringthe 1990s bull market but in the lasttwo years it didn’t work. We alsotried a 30% criterion but thoseresults were poor as well.We kept the 10% criterion butnext experimented with the timeperiod. Results were much improved by requiring the stock toincrease by at least 10% in the lastfour months (instead of twomonths). Using a six-month timeperiod worked even better. A oneyear time period found lowerresults.For the final decision, theUptrend rule required the stock torise by at least 10% over the last 132business days (approx. 6 months). Abacktest with these criteria found1561 trades with an average annualROI of 15.06% (compare this resultto Figure 1 to see the effectiveness ofthe Uptrend rule).Final ModelThe Expert Design Studioscreening model is now complete.Figure 2.Procter & Gamble chart showing history of rising price and Money FlowMoney Flow Trading Model continued on page 87
AIQ Opening BellMay 2002The rules are: Price is greater than 10 Volume is greater than 100,000shares March 2002 Persistence of Money Flow set at90% The stock is below its 10-day high Two day slope of Money Flow isgreater than zero The stock has increased by at least10% in the last 6 monthsOf these rules, the Persistence ofMoney Flow rule is by far the mostimportant.An example of a stock thatpasses the model is Procter &Gamble (PG), shown in Figure 2. PGhad increased in value over the lastsix months but on a short-term basisit was just off its high of five daysearlier. Procter & Gamble’s MoneyFlow indicator persistently rosehigher over the previous six monthsand on a short-term basis its two-dayslope was positive.An EDS backtest of this finalmodel is shown in Figure 3. Thismodel made money during the twoyear bear market. There were 1363trades with an average annual ROIof 15.79%. How did it perform overa longer time period? A four-yeartest showed an average annual ROIof 18.31%.A summary of the tests in thisarticle is found in Table 1. The firstline shows the results of testing theApril Opening Bell model. TheFigure 3.Test results of Persistence of Money Flow trading model, final versionsecond line shows the results fromrunning the model on the mostimportant rule, Persistence of MoneyFlow. The next section shows theresults of adding additional rules tothe Persistence of Money Flow rule.Finally, the backtested results of allthe rules combined are found on thelast line.The process in creating ourmechanical Money Flow model isoutlined in this article and Table 1.It is useful to understand the processbecause those who create their owntrading models will follow the samesteps.The tests in this article were runon a databaseof about 2100Table 1.stocks. Manyof the stocksEDS Testing Resultsthat wereAnnual ROI # of Tradespurchasedwere lesserApril Model2.78%1457known smallPersis. MnyFlow13.29%1879companyPersis. plus Pause13.85%1785stocks. Somepeople, includPersis. plus MnyFlow13.50%1785ing myself,Persis. plus Uptrend15.06%1561probablyFinal Model15.79%1363wouldn’t buy8stocks that they’ve never heard of.Therefore, we tested this model onStandard & Poor’s 500 stocks. Usingthe same two-year time period, therewere 366 trades with an averageannual ROI of 9.09%.The EDS Money Flow screeningmodel is now completed. The modelcan be downloaded from AIQ’s webpage at www.aiqsystems.com. Clickon Educational Products and thenOpening Bell.The screening model may befinished but the trading system isnot. We have to establish ourcapitalization rules, such as howmany stocks will be held in a fullyinvested portfolio. We also have toset the sell parameters. There was a66% loss in one of the trades. Bysetting better sell criteria, we canlessen the drawdowns and increasethe returns. Our mechanical MoneyFlow trading model will be completed next month.David Vomund publishes VIS Alert,a weekly investment newsletter. Fora sample copy of the newsletter, call775-831-1544 or go towww.visalert.com.
unfamiliar with candlestick charts should first read Allen Thomas’s introductory article on candlestick charting in the April 2002 Opening Bell . hen I first began reading about candle-stick analysis in Steve Nison’s book Japanese Candlestick Charting, I was overwhelmed with all
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