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International Journal of Finance and Managerial Accounting, Vol.4, No.15, Autumn 2019
Analyzing the Effectiveness of Candlestick Technical
Trading Strategies in Foreign Exchange Market
Seyyed Behshad Yassini
Ph.D. Student, Department of Financial Management, Science and Research Branch, Islamic Azad University, Tehran, Iran
Fereydoon Rahnamay Roodposhti
Professor and Faculty Member, Department of Financial Management, Science and Research Branch, Islamic Azad University,
Tehran, Iran.
(Corresponding Author)
f-rahnamayroudposhti@srbiau.ac.ir
Mir Feiz Fallahshams
Assistant Professor and Faculty Member, Department of Management, Central Tehran Branch, Islamic Azad University,
Tehran, Iran.
ABSTRACT
Candlestick charts are a type of financial chart for tracking the movement of securities. Some of the earliest
technical trading analysis was used to track prices of rice in the 18th century. Some investors find them more
visually appealing than the standard bar charts and the price actions easier to interpret. In technical analysis,
a candlestick pattern is a movement in prices shown graphically on a candlestick chart that some believe can
predict a particular market movement.
In this paper it is analyzed whether various candlestick patterns can predict trends in Foreign Exchange
Market. The first group of minor hypotheses include whether a candle with an inverted color proceed by these
patterns. The second group analyze whether the profit of trading after various patterns is significantly profitable.
Three “open” prices of first candles are considered as different possible stop points. These three different
points have different results, hence I’ve categorized them in three various scenarios and discussed about them
separately.
At the end on the basis of minor hypotheses, it is concluded that there is not any evidence on predicting
power of candlestick patterns in trend recognition. Although the rates of correct prediction of the next candle after
a confirmed pattern is almost insignificant in all cases, the trading profit of confirmed patterns are significant
Keywords: Technical Analysis, Major currency-pairs, Forex, Candlestick Charts, Candlestick Patterns.
With Cooperation of Islamic Azad University – UAE Branch 25
26 / Analyzing the Effectiveness of Candlestick Technical Trading Strategies in …
1. Introduction fiscal data from previous quarters and years to
The Foreign Exchange Market (FOREX) — most determine future growth.
often called the Forex market, or simply the FX market As I searched, there are very few researches those
— is the most traded financial market in the world focus on candlesticks. These researches just discussed
(Rhoads, 2008). This market is the crossroads for about very popular forms of patterns. There are many
international capital, the intersection through which patterns of candlesticks that are not analyzed.
global commercial and investment flows have to move Moreover I didn’t find any research that focuses on
(Rhoads, 2008). applying candlesticks in Foreign Exchange Market.
Technical analysis and fundamental analysis are There were few researches about applying western
the two main schools of thought in the financial instruments such as trend lines, resistance and
markets. While technical analysis concentrates on the persistence levels, various indicators, head and
study of market action, fundamental analysis focuses shoulder pattern, etc. But I didn’t find any research
on the economic forces of supply and demand that about the profitability of candlesticks in Forex.
cause prices to move higher, lower, or stay the same.
In 1750 a wealthy Japanese merchant, Munehisa The keywords are defined as below:
Homma, began trading at his local rice exchange in Forex:
Sakata using his own personal candlestick analysis. The foreign exchange market (forex, FX,
Homma became a legendary rice trader and amassed a or currency market) is a global decentralized
huge fortune. Today’s Japanese candlestick market for the trading of currencies.
Currency pair
methodology is credited to Homma’s trading A currency pair is the quotation of the relative
principles as he applied them to the rice markets value of a currency unit against the unit of another
(Marshal at al., 2007). currency in the foreign exchange market. The
There are some ways to classification of
candlesticks. From one perspective they can be divided currency that is used as the reference is called
into two types of ‘Reversal Patterns’, and the counter currency or quote currency and the
currency that is quoted in relation is called the base
‘Continuation Patterns’ (Nison, 1991) There is another currency or transaction currency
perspective that divides candlesticks to three distinct
types: ‘Single-Stick Patterns’, ‘Double-Stick Patterns’, Major currency-pairs
and ‘Three-Stick Patterns’ (Rhoads, 2008). Currencies are traded in pairs and exchanged one
against the other. The majority of currencies are
Traders use technical studies to establish target traded against the US dollar (USD). The four
points for buy and sell financial assets, whether to currencies traded most frequently after the US
open or close trading positions. These traders include dollar are the euro (EUR), Japanese yen (JPY), the
banks, hedge funds, equity and bond fund managers, British pound sterling (GBP), and the Swiss franc
multinational corporations, brokers, central banks, (CHF). Some sources also include the Australian
government agencies, and individuals. According to dollar (AUD) and the Canadian dollar (CAD)
the Bank for International Settlements, as of April within the group of major currencies.
2010, average daily turnover in global foreign Candlestick Patterns
exchange markets is estimated at $3.98 trillion, a In technical analysis, a Candlestick pattern is a
growth of approximately 20% over the $3.21 trillion movement in prices shown graphically on
daily volume as of April 2007. a candlestick chart that some believe can predict a
Technical analysis has become popular over the particular market movement. The patterns
past several years, as more and more people believe analyzed in this paper are hammer, hanging man,
that the historical performance of a stock is a strong dragonfly doji, gravestone doji, long-leged doji,
indication of future performance. The use of past bearish and bullish engulfing, piercing pattern, and
performance should not come as a big surprise. In dark cloud cover.
contrast, people using fundamental analysis have
always looked at the past performance by comparing
Vol.4 / No.15 / Autumn 2019
International Journal of Finance and Managerial Accounting / 27
2. Literature Review towards understanding the behavioral patterns of price
2.1. Background Research from a trader’s perspective. The project extensively
Marshal (2005) in his paper “Candlesticks used secondary data and inferred certain logical
Technical Trading Strategies: Can They Create Value conclusions based on the behavior shown by the data.
In end it concluded that the project does accomplish its
for Investors?” examines the profitability of technical aim to understand the reasoning behind price moves
analysis, candlestick trading strategies. The literature and lends a credible insightful eye to any trader who
review is divided into three major sections. In the first wishes to trade successfully in the Foreign Exchange
the extensive literature that covers the random walk markets.
and efficient market hypothesis, two of the most Ramadhani and Mashaushi (2006) in their paper
important concepts in modern finance are considered.
In section Two, the finance literature in which “An Analysis of Technical Trading Strategies” extends
attempts are made to explain financial phenomena the literature on the efficacy of technical analysis in
using psychology literature is discussed. This the direction of the `risk premium view' as an
emerging area, known as behavioral finance, suggest explanation for excess trading rule returns. The
that seemingly irrational financial market behavior can empirical analysis is based mainly on a sample of
be explained by looking at the psychological make-up stocks drawn from the London Stock Exchange,
of market participants. The extensive literature in (LSE), portfolios constructed from three US markets;
which the profitability of technical trading strategies is the New York Stock Exchange, (NYSE), the American
considered is then discussed. In this section the Stock Exchange, (ASE), and the National Association
empirical literature is divided into two categories: that of Securities Dealers Automated Quotation market,
which finds that technical trading strategies are not (NASDAQ). Data from ten small emerging markets of
profitable once transaction costs and risk are taken into Africa is also used in empirical analyses. Focusing on
account, and that which finds that profitability of these documented evidence of differences in risk levels
strategies is robust to those adjustments. The former among several markets or market segments, the
findings are consistent with market efficiency while empirical analyses examined whether these risk
the latter is not. differentials can explain excess trading rule profits as
Varun Juneja (2011) in his essay “Price Behaviour compensation for bearing risk.
Analysis of Major Forex Pairs” which include 2.2. Theoretical Framework
EURUSD, GBPUSD, USDCHF and USDJPY, aimed The Forex market is the biggest and fastest
to study the four major factors - Fundamental Factors, growing market on the earth. The participants in this
Technical Factors, Time Factors and Correlation market are central and commercial banks,
Factors which affect the movement of the price. The corporations, industrial investors, hedge funds, and
study covered these four factors and how each of them private individuals. Average daily turnover in global
contributed to the movement of the price of the above foreign exchange markets has more than trebled over
mentioned four Forex pairs. This study has analyzed the past decade, reaching around $4 trillion in 2010,
the daily and 4H prices of the four major pairs according to the 2010 BIS Triennial Central Bank
(EURUSD, GBPUSD, USDCHF and USDJPY) over a Survey (O’Connor, 2011).
period of 8years and 6 years respectively, up until 30th Technical analysis and fundamental analysis are
April, 2011. It has analyzed two different candlestick the two main schools of thought in the financial
patterns and one general technical pattern. Candlestick markets. While technical analysis concentrates on the
patterns analyzed include the pin bar and the study of market action, fundamental analysis focuses
bearish/bullish engulfing patterns whereas the on the economic forces of supply and demand that
technical pattern analyzed includes number of cause prices to move higher, lower, or stay the same.
successive up moves or down moves. It has analyzed The fundamental approach examines all of the relevant
the said patterns on two time frames i.e. on a daily factors affecting the price of a market in order to
chart and on a 4 hourly chart. This study determine the intrinsic value of that market. The
acknowledged that there is no 100% accurate method intrinsic value is what the fundamentals indicate
of trading the Forex markets. The study was aimed something is actually worth based on the law of supply
Vol.4 / No.15 / Autumn 2019
28 / Analyzing the Effectiveness of Candlestick Technical Trading Strategies in …
and demand. If this intrinsic value is under the current man has a black real body, it shows that the close
market price, then the market is overpriced and should could not get back to the opening price level. This
be sold. If market price is below the intrinsic value, could have potentially bearish implications. (Nison,
then the market is undervalued and should be bought 1991)
(Murphy, 1999). Technical analysis is the study of The Doji is one of the most important signals in
market action, primarily through the use of charts, for Candlestick analysis. It is formed when the open and
the purpose of forecasting future price trends. The the close are the same or nearly the same. The lengths
term "market action" includes the three principal of the shadows can vary. The longer the shadows are,
sources of information available to the technician- the more significance the Doji becomes. The
price, volume, and open interest (Murphy, 1999). Dragonfly Doji occurs when trading opens, trades
With advancements in technology and the growing lower, and then closes at the open price that is the high
availability of trading and investing resources of the day. At the top of the market, it becomes a
available to traders, many options exist for the charting variation of the Hanging Man. At the bottom of a
of securities. There are several different types of charts trend, it becomes a specific Hammer. An extensively
and dozens of variations and features to be configured long shadow on a Dragonfly Doji at the bottom of a
on each type (Rhoads, 2008). trend is very bullish.
In 1750 a wealthy Japanese merchant, Munehisa The Long Legged Doji is comprised of long upper
Homma, began trading at his local rice exchange in and lower shadows. The price opened and closed in the
Sakata using his own personal candlestick analysis. middle of the trading range. Throughout the day, the
Homma became a legendary rice trader and amassed a price moved up and down dramatically before it closed
huge fortune. Today’s Japanese candlestick at or near the opening price. This reflects the great
methodology is credited to Homma’s trading indecision that exists between the bulls and the bears.
principles as he applied them to the rice markets (Bigalow, 2002)
(Marshal at al., 2007). There are three criteria for an engulfing pattern:
In this paper 9 different candlestick patters are 1) The market has to be in a clearly definable
analyzed. They include hammer, hanging man, doji uptrend or downtrend, even if the trend is
gravestone, doji dragonfly, doji long-lagged, bearish short term.
and bullish engulfing, piercing pattern, and dark cloud 2) Two candlesticks comprise the engulfing
cover. pattern. The second real body must engulf
The hammer and hanging man can be recognized by the prior real body (it need not engulf the
three criteria: shadows).
1) The real body is at the upper end of the 3) The second real body of the engulfing
trading range. The color of the real body is pattern should be the opposite color of the
not important. first real body. (The exception to this rule
2) A long lower shadow should be twice the is if the first real body of the engulfing
height of the real body pattern is so small it is almost a doji (or is
3) It should have no, or a very short, upper a doji). Thus, after an extended downtrend,
shadow. a tiny white real body engulfed by a very
The longer the lower shadow, the shorter the upper large white real body could be a bottom
shadow and the smaller the real body the more reversal. In an uptrend, a minute black real
meaningful the bullish hammer or bearish hanging body enveloped by a very large black real
man. Although the real body of the hammer or hanging body could be a bearish reversal pattern)
man can be white or black, it is slightly more bullish if (Nison, 1991).
the real body of the hammer is white, and slightly
more bearish if the real body of the hanging man is The following is a list of some factors that intensify
black. If a hammer has a white real body it means the the importance of dark-cloud covers:
market sold off sharply during the session and then 1) The greater the degree of penetration of the
bounced back to close at, or near, the session's high. black real body's close into the prior white
This could have bullish ramifications. If a hanging real body, the greater the chance for a top.
Vol.4 / No.15 / Autumn 2019
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