A Tweaked Hammer Could Hit the Mark

The problem I always have with technical analysis is that it's hard to quantify. What does it mean when someone says "a stock is in a downtrend," or "stock XYZ broke through support"? If a downtrend is defined as when a stock breaks through its 200-day moving average, that's something that can be tested.

One area of TA that lends itself to testing is the use of Japanese candlesticks, which are simple patterns based on open-close, low-high price data. I've never traded on these patterns, but I like to test them to see if they contain the seeds of interesting systems. I've looked through Steve Nison's books on candlesticks as well as some online resources to find the most common candlesticks and the ones that supposedly lead to bullish or bearish behavior.

So far, I've tested three:

The Morning Star seemed to produce insignificant returns in either direction, despite being a bullish pattern.

The Evening Star is supposed to be bearish according to all of the online resources, but it ends up being bullish and is actually very playable as a bullish system even after slippage and commissions.

The Bullish Hammer had a 50% rate of success with a 0% average return. Very impressive.

This time, let's take a look at the Inverted Hammer. This candlestick pattern is believed to represent a possible capitulation by short-sellers and to signal that the price is about to move higher. The Inverted Hammer triggers when:

We're in a downtrend. I've defined this as a period when we are below the 20-day moving average.

The open and close are close together but the close is higher than the open (a "white body" in candlestick terminology).

The high is roughly twice as high or more as the distance between the open and the close.

This pattern can be seen in a chart of Ciena (CIEN - commentary - Cramer's Take) from 2003.

The pattern was triggered at the close on Aug. 7 (blue arrow). Ciena had suffered through several down days. On Aug. 7, it opened lower, then rallied before closing only slightly higher. Buying at the close and holding for five days resulted in a 5.77% return.

In general, however, the results are not great for the Inverted Hammer. I tested it on all Nasdaq 100 stocks plus stocks deleted from the index over the past six years.

Over the past seven years, there were 296 occurrences of the pattern among the stocks I tested, and 169 successes, for a success rate of 57%. The average return per trade was a meager 0.69%. While this is in the black, after commissions and slippage it's not enough to warrant saying that this is an unqualified success.

I simulated the system using 20% of equity per trade; the results per year can be seen on the chart below.

The Hammer Over Seven Years

Though this system showed impressively positive returns in 2000 and 2001, which were horrible down years for the Nasdaq, the results were rather meager for the past two years. I think there are probably ways to improve the system, such as further narrowing the definition of the downtrend, but then I'm not sure you would need to keep the definition of the Inverted Hammer around.

To see my WealthLab 3.0 code for the specifics of how I defined the pattern, click here.

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James Altucher is a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of Trade Like a Hedge Fund and Trade Like Warren Buffett. At the time of publication, neither Altucher nor his fund had a position in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Altucher appreciates your feedback; click here to send him an email.

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