Engulfing Candlesticks: The Limitations of Technical Analysis and the Value of Experience

ppearlman

I am a huge proponent of pattern recognition as a core trading competency.  I have been influenced in this regard by my own experience over time as well as the work of Brett Steenbarger who writes:

Much of trading expertise consists of seeing so many variations of these patterns that they become internalized, creating a “feel for the market”… Traders need to see enough examples of patterns to create what psychologists call “implicit learning”.  This is the learning that characterizes athletes, fighter pilots, chess masters and other trained professionals.  A hallmark of implicit learning is that the performer’s knowledge cannot be verbalized and yet can result in expert performance.

Dr. Steenbarger is making a critical distinction in this paper. There is a big difference between simply recognizing classic technical patterns as they appear in books and that have become over time a part of the traditional canon among technicians.

It is the difference between simply recognizing the pattern as it is plainly exemplified in the literature and having seen that pattern numerous times and, importantly, within the context of a mutlitude of other dynamic variables occuring simultaneaously as the market plays out in the moment.

I thought of Steenbarger’s paper while reading CXO Advisory Group’s study entitled Testing Engulfing Patterns in which they test the validity of bullish and bearish engulfing candles over one and 30 days.  They find that while there is evidence suggesting bullish and bearish engulfing candlesticks are predictive over the one day period (and not the one month period), the significance is not practically tradeable.  In addition, the significance is dependent upon a second variable, namely the 200 day SMA.

In summary, they write:

… given the fairly small size of any abnormalities, standard deviations of daily returns that are much larger than any abnormalities and the rareness of signals, it seems unlikely that a trader could materially exploit these results on a net basis.

Learning to recognize  common technical patterns from the work of others is only a small first step towards proftability.  Much will remain misleading to the novice who steps in with only a template of these patterns and a trading account.  The real value of this wealthy tradition of documented chart patterns comes only with experience – having seen the pattern repeatedly within the context of intense focus as well as the broader and more complex behavioral environment.


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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