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 forex strategies. That being said, we will attempt to quantitatively identify specific candlestick patterns and backtest the profitability of such a forex trading strategy with candlestick signals.

Candlestick Formations for Forex Trading: Which Strategies work?

Given the large number of different candlestick formations, it would be impossible to gauge the overall profitability of all candlestick strategies in a single study. We will focus on specific reversal signals which have value as they relate to market sentiment.  We will look at both the Morning Star and Evening Star formations as buy-and-sell signals.

A Morning Star formation is a bullish reversal signal for an overall downtrend. Given fairly consistent losses, we see a strongly negative full-bodied first candle. The second candle opens at or below the previous close, trading within a relatively narrow range with the high staying below the midpoint of the first candle. The third candle is strongly positive and closes above the midpoint of the first candle. This tells us that bearish sentiment is unable to push price below previous lows, and risks remain for a reversal in price trends.

The Evening Star is effectively the opposite of a Morning Star, as price starts in an uptrend and the first candle is strongly positive. The second candle opens above or at the previous close, trading within a fairly narrow range and with its low above the previous bar's midpoint. The third candle is strongly negative and closes below the first candle's midpoint. This gives warning that bulls are unable to push price to new heights, and a strongly bearish candle hints at further downside potential through subsequent forex trade.

Backtesting our Candlestick Formations

In terms of actual trading rules, we tell our strategy to buy a standard lot of the given currency pair when a Morning Star formation materializes and short sell the currency on an Evening Star. Our initial candlestick forex strategy results do not include stop-loss orders or profit limits. Instead, gains and losses are realized when positioning flips on the subsequent Morning or Evening Star formations.

Could we Improve Upon our Raw Candlestick Strategy?

Our initial backtest shows that our simple strategy remains modestly profitable across major currency pairs. Yet with sizeable Max Drawdowns, it remains clear that our strategy may do well with slightly improved risk management. Indeed, it may be important to take a closer look at individual exit and entry rules and their efficiency in capturing strong risk-adjusted returns.

Using TradeStation, we are able to quickly assess maximum profit and loss potential across trades with several functions. Of particular interest in this case is to measure each individual forex trade's maximum downward move before turning profitable. For simplicity's sake, we will look at EURUSD trades. The chart below gives us an accurate depiction of how risk/reward on the overall forex strategy.

The chart above shows us an interesting pattern in our candlestick-based forex trades. Namely, our most profitable forex trades tend to have very little negative incursion. In plainer terms, our best forex trades are those that are strongly positive from the onset and show very little downward extension. At the same time, some of our most negative forex trades show very little profit potential from a buy-and-hold perspective. What this tells us is that our forex strategy would likely benefit from a simple stop-loss measure that protects us from large losses yet does not keep us from making a profit on our more successful trades.

Final Conclusion and Caveats as a Forex Strategy

Our attractive equity curve suggests that our candlestick forex strategy has been profitable in the EURUSD from inception to present. We saw that profitability improved dramatically when we cut losses short and let our winners run significantly longer. This tells us that our candlestick signals are either "wrong" in their reversal signals and not worth holding, or they are "correct" and give us ample opportunity to take profits on a turn in trend. It is undeniable that this forex strategy does indeed provide many false trading signals. Yet we see that proper management rules allow us to capture solid profits and limit our downside on these negative forex trades. Combined with other forex trading techniques and more discretionary forex strategies, candlestick formation strategies do increase our overall forex trading profitability.

David Rodríguez, Currency Analyst for DailyFX.com
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