Japanese Candlestick Sheds Little Light

This column was originally published on RealMoney on Oct. 18 at 1:32 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

Japanese candlesticks are simple charts for trading that were popularized in the book Japanese Candlestick Charting Techniques by Steve Nison.

According to supposedly ancient Japanese techniques for commodity trading, they are usually very short, visual patterns that when seen in the markets are either bullish or bearish, depending on the mythology for that pattern.

I decided to test one of the more bullish patterns: the Morning Star. It's a three-day pattern that occurs when a stock has had a large down movement, followed by a gap down open but then a higher close, followed by a large up day.

In other words, you've hit bottom and reversed, and people are excited: Time to buy.

Below is an example of a Morning Star pattern in Amazon(AMZN Quote) in a chart covering eight days in early November 2002.

The idea is to buy at the close of the third day (indicated by the first arrow in the chart), the long up day.

The result in this example was a profit of 5.53% after buying at $19.34 and selling at $20.41 (as indicated by the second arrow).

I tested the Morning Star pattern on the current Nasdaq 100 stocks using data going back seven years, covering both bull and bear markets as well as flattish periods like the one we seem to be in right now.

There were 120 occurrences of the Morning Star pattern, and exactly 60 successes and 60 failures with an average return per trade (not including commissions and slippage) of 0.25%, which is not enough to beat commissions and slippage. (I held each position for one week, figuring that if this is a bullish sign, it should at least be bullish for a week.)

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Charting the Morning Star The pattern appeared in an early November 2002 chart of Amazon

Source: Wealth-Lab.com

If anyone has any favorite candlestick patterns they would like me to check out, please send them along.

Aficionados of Wealth-Lab or TradeStation can click here for the code I used for the simulation.

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