Do Hammer and Shooting Star Candlestick Formations Work in Forex?
Some of the most popular trading strategies in forex markets involve the use of Japanese Candlestick charts. Given a specific pattern in candlestick formations, traders look to buy and sell currencies in anticipation of reversal or continuations in price. Yet testing the profitability of such concepts is easier said than done.
Given that many of these formations are inherently qualitative in nature, it is difficult to develop a reliable quantitative approach with which to test the viability of such strategies. That being said, we will attempt to quantitatively identify specific candlestick patterns and backtest the profitability of trading on such candlestick signals. In the second installment of our candlestick series, we will take a look at the popular Hammer and Shooting Star formations
Candlestick Formations: Which do we choose?
Given a great number of candlestick formations, it is nearly impossible to gauge the profitability of each trading signal in a single study. Instead we will examine pairs of similar buy/sell signals within the same backtest to gauge the effectiveness of each individual formation. Though not without its limitations, we feel that this method represents one of the most objective measures on the profitability of these buy/sell signals.
To that end, we would like to examine the effectiveness of two popular trend reversal candlestick patterns: the Hammer and Shooting Star formations.
A Hammer forms when price is in a downtrend and price trades sharply lower from the open, but a subsequent reversal leaves price marginally unchanged through the close. The candlestick formation is distinct for its long wick to the downside, small candle body, and little or no wick to the topside—signaling that price finished near the top of its intra-candle range. It is a decidedly bullish formation, as it tells us that bulls have overpowered an initial bearish tumble.
A Shooting Star formation is effectively the exact opposite of the Hammer. Price remains in an uptrend when it opens and trades sharply higher within a given candle, but a subsequent reversal leaves it near or below its candle open. The Shooting Star is distinctive for its very long upward wick, small candle body, and little to no wick to the downside. The formation signals that a bullish run was initially enough to push price to new heights, but exhaustion has allowed bears to push price significantly lower before the candle close.
