Do Candlesticks Work? Are They Reliable? A Quantitative Test Of 23 Candlestick Formations

Last Updated on August 30, 2021 by Hakan Samuelsson

Candlesticks are a popular charting tool and frequently used by promoters using anecdotal evidence. We use candlesticks in our charts ourselves, but not as a predictive tool in our trading strategies.

In this article, we ask: do candlesticks really work? We test quantitatively 23 different candlestick formations with strict buy and sell signals. Perhaps surprisingly, some of the formations work pretty well. Some of the formations can highly likely be improved by adding one more variable. We provide the code for a small fee.

Candlesticks are a popular way to display quotes on a chart, something we have done since we read Gregory Morris’ Candlestick Charting Explained back in 1998. However, we have never implemented candlesticks in any of our quantified strategies.

Why do we use candlesticks in our charts? We agree with Mr. Morris, who writes this in the introduction of the book:

However, once you become accustomed to seeing Japanese candlestick charts, you will prefer them because their clarity is superior and allows a quick and accurate interpretation of the data.

Mr. Morris is right. Candlesticks are easy to digest once you get used to them. But do they have any predictive value? After all, we operate in the markets to make money, not to make nice visual graphs.

Candlesticks explained:

If you have never seen a candlestick, it might be a little confusing to start with, but once you get used to candlesticks, you get a much better visual look of the charts – for example, where the stock opened and closed.

A black candlestick means the open was higher than the close, while a white candlestick means the close is higher than the open. The difference between the open and the close is called “the body”. The “tails” on both sides are the high and low readings that day (or whatever time frame you are using):

 

Candlesticks explained.

 

Candlesticks might have an appealing and/or easy interpretation, but does it add any value?

Are candlesticks reliable?

A quick search on the internet reveals many articles touting candlesticks’ importance and what formations to look for. Endless articles explain the formations, but as usual, without any empirical evidence about their predictive power. That’s a shame because it’s relatively easy to test candlesticks. Further down in the article, we reveal some quantitative results from 23 formations.

What is the strongest (best) candlestick pattern?

In the 100% quantified test below there are some candlestick patterns that look promising:

  • Bearish engulfing
  • Piercing Line
  • Bearish Evening Doji Star
  • Three Outside Down Pattern
  • Dark Cloud Cover

How many candlesticks are there?

Exotic names like Hanging Man, Bullish Engulfing Pattern, Shooting Star, Bullish Hikkake, One White Soldier, Bearish One Black Crowe, Piercing Line, and Hammer are just a few of the candlestick formations that exist. We have no idea how many candlesticks formations there are, but if you like to know more about candlesticks, we recommend this page.

Do candlesticks work best in daily or intraday bars?

We recommend using different timeframes in your trading, but with candlesticks, they seem to work best on daily bars and not on shorter time frames (intraday). Daily bars seem to be more reliable than intraday bars. Among many, the reasons are that there are many more transactions in daily bars than intraday ones, and daily bars, in general, attract more attention.

How to quantify candlesticks:

To test candlesticks quantitatively, we need to make rules based on strict criteria. Like most things that can be labeled technical analysis, no specific or mathematical definition of the candlesticks formations exists. However, most of the formations can be fairly easily defined and is already done by many on the internet. 

A strategy is not complete until you have exit criteria. Candlestick formations only look at “bullish or bearish” setups without considering any exit criteria.

Thus we need to make our own criteria for when to close the position. If you want to know our exit criteria and have the quantified code for all the 23 formations, please click on the link further down in the article under the heading called “Amibroker code for candlesticks”.

The exit criteria are a vital part of any strategy and can, of course, change results dramatically. Even a strategy based on random entry can generate splendid results using the “correct” exit criteria. And, honestly, when testing the candlestick formations, it would probably be fairer if we had different exits based on the number of days since entry. But we leave that test to another day.

The results are in: Do candlesticks work? A 100% quantified test

Some of the formations are meant as bearish formations. Nevertheless, we test all formations by buying, not selling/shorting.

We tested the 23 formations on the S&P 500 using the ETF SPY from its inception in 1993 until the end of November 2020. The results are summarized in this table:

Some of the formations give many signals, while others produce few signals. Only one formation, Three White Soldiers, produces negative returns, perhaps not surprising because it goes long after three days when the close is higher than the opening. As most of the readers probably know, the stock market is highly mean-reverting in the short-term.

What happens if we trade only the strategies with a higher profit factor than 1.5 from the table above? That is 12 patterns in total.

The compounded result is good: 975 trades, CAGR is 12.89%, the average gain is 0.36% per trade, max drawdown is 25%, and the profit factor is 2.02. The only negative year was 1994 and the total time spent in the market is 47%. The best year was 2020, with almost 41% return from 40 trades (!). Buy and hold was 9.9% during these 25 years.

The equity curve looks like this (no commissions and slippage):

The chart is compounded, starting with 100 000 in 1993.

Do these 12 candlesticks patterns work on other ETFs (those formations with a profit factor above 1.5)? Here is a list of a random sample:

  • QQQ: 12.9% CAGR
  • TLT: 5.5% CAGR
  • XLP: 9% CAGR
  • GLD: 0.3% CAGR
  • EEM: 16% CAGR
  • GDX: 12.2 CAGR

Amibroker code for candlesticks:

We have developed code in Amibroker to test the 23 candlestick formations below. We have put in a great deal of time and effort to do this, and think it’s fair that we charge a fee for it.

If you want to have the Amibroker code for all the 23 formations, you can order it for 75 USD via this link (23 candlestick formations Strategy no. 6):

BUY NOW

When you have paid, please press the link below to access the code (PDF file):

Download 23 candlestick formations strategy no.6 by clicking here (you need to pay for access)

We also would like to give you a humble reminder about our subscription service called Trading Edges, where you get a monthly trading idea that can be used as a stand-alone strategy.

Why use Amibroker and not, for example, Tradestation?

How to trade and use candlesticks?

To improve the results, you might want to add a variable. This variable could, for example, be:

  • The direction of the long-term trend, for example, a moving average filter
  • By using an ADX filter
  • Include a short term RSI filter.

Conclusion:

Some candlestick formations show some promise, but most of the formations give few signals. However, the slightly data-mined test of using the 12 best formations beat buy and hold. This is promising considering that the time spent in the market is 47%, and the drawdown is just half of buy and hold.

As usual, you need to backtest yourself and test ideas you might have.

For free trading ideas, check out this page:

 

Disclosure: We are not financial advisors. Please do your own due diligence and investment research or consult a financial professional. All articles are our opinions – they are not suggestions to buy or sell any securities.