Engulfing Patterns: Winning the Battle with Western Point and Figure and Eastern Candlesticks by Dodge 0. Dorland

Introduction Japanese Candles Japanese candlestick charting techniques have only While using the same opening-high-low-closing recently been added as a weapon for Western techni- price data as bar charts, Japanese candlesticks pro- cal analysts to use on the investment battleground, vide a more vibrant, graphical presentation which where the bulls and bears are constantly fighting to lights up the investment battlefield with signals not achieve superior performance. However, as Steve given by bar charts. Nison pointed out in the first definitive work in the In order to create candles, the bar created for United States on this discipline,’ candles have existed bar charts is broadened between the opening and clos- since the mid-1700s, when they were first used for ing price to give that range a rectangular shape or rice trading in Japan, and are used extensively for “real body”. Activity outside the open-close body is many foreign exchange and commodities markets depicted the same as for a bar chart (a straight line) throughout the world.2 and is referred to as the “shadow” of the candle. Steve Nison’s work and most of the existing The color of the body is determined by the direc- Western literature to date covering candles focus tion of the trading. Figure 1 is a comparison of the on the use of candles for non-equity markets. How- same price data reflected in a bar chart and candle ever, I have been using candles for equities since pattern. If, as in Example A, the closing price is higher 1991 and find they have improved my investment than the opening price, the activity is positive and performance, particularly with regard to the tim- the body remains white.3 If, as in Example B, the clos- ing of my trades. ing price is lower than the opening price, the activity My research to date has evaluated whether or is negative and the body is black. not candlestick analysis provides an invaluable tool which supplements traditional Western technical Example A Example B weaponry and improves performance on the invest- ment battlefield. As part of my ongoing research, &h Wh this paper focuses on one , the ClOS Open Engulfing Pattern (Tsutsumi) and tests whether or not, and how, it improves investment perfor- mance when used with traditional disciplines such as point and figure analysis, con- Open ClOS.¶ u II vergence/divergence (“MACD”), , LOW LOW and stochastics. Figure 1: Comparison of Bar Chart and Method Candle Pattern Using Identical Data To determine the validity of my hypothesis, I ana- lyzed equities trading on the New York Stock Exchange Candlestick analysis was developed in Japan (NYSE), American Stock Exchange (AMEX), and the in the combative environment of 1500-1750,4 a time over-the-counter market (NASDAQ). I selected peri- which reflected many similar characteristics of the ods involving bull markets, bear markets, and trendless investment environment throughout the ages. Just markets. I analyzed different timeframes via intraday, ask any portfolio manager, trader, or individual in- daily, weekly and monthly charts. I used the analysis vestor how he or she feels about the conditions of the stock’s trend and relative strength to determine under which he or she makes investment decisions the timing of the candle signal and whether it was sup- today! ported (or at least not in contravention to) the other Understanding the psychology behind specific technical disciplines. I finally reviewed the actual price candle patterns and how the pattern reflects the cur- performance after the signal was given. rent environment is critical to the analyst’s ability

MTA JOURNAL / SUMMER - FALL 1994 39 to identify the pattern and interpret its emotional psychology reflected in the engulfing pattern can and technical significance accurately. For example, be explained in terms of the ongoing battle between the engulfing pattern reflects a significant reversal bulls and bears. On the first day of the pattern, in battle psychology between the bulls and bears and, the army that has been previously winning (the consequently, can prove to be a meaningful early pre- army of the bulls if the trend is up and the army of cursor to a reversal in trend. the bears if the trend is down) continues its march forward. Typically, the body of the candle of the The Engulfing Pattern first day is relatively small and may reflect the progress of an army that is somewhat tired from A. Formation its previous advances. At the beginning of the sec- As shown in Figure 2, the engulfing pattern com- ond day, this army starts the day with its contin- prises two candles and reflects trading activity over ued advance. During the second day, however, the two periods. The first candle reflects the previous psychology of the battle shifts significantly. The trend (a white candle in an uptrend or a black candle army that has been retreating gathers its strength, in a downtrend). The second candle engulfs the first charges forward, and pushes the previously ad- candle completely and is the opposite color of the first vancing army back to a worse position than at the candle. beginning of the previous day. Thus, at the end of the second day, the previously retreating army is advancing and has adopted an aggressive attitude, having taken back all the ground Bullish Bearish I it had lost the previous day. The newly advancing army has turned its enemy back in a blaze of glory, sending a signal of strength, that analysts watching 10 the battle may not yet see when using Western tools of , to assess this battle between Figure 2: Engulfing Pattern bulls and bears. B. Criteria for the Engulfing Pattern Using The Engulfing Pattern With Point And Steve Nison has described the three criteria for a Figure And Other Technical Analysis valid engulfing patterns: There is a rather unique fit between Japanese 1. “The market has to be in a clearly definable candles and point and figure analysis. While Japa- uptrend or downtrend, even if the trend is short nese candles light the investment battleground and term.” signal entry and exit points, they do not project price objectives for the army to obtain. And while point In addition to up trends and down trends, the and figure analysis locates natural areas of support market can trend sideways. Markets trending side- and resistance on the battlefield and determines price ways represent an above average opportunity for targets, it does not tell the army when best to enter engulfing patterns to provide an early warning sig- the battle. nal that a trend reversal is about to occur and the As with any single weapon, neither candlestick direction of the change. nor point and figure analysis represent an invincible 2. “The second real body of the pattern must weapon. However, when the two weapons are used engulf the prior real body (it need not engulf the together, they increase an army’s chance for invest- shadows).” ment victory 3. “The second real body of the engulfing pattern One example of how Japanese candles can work should be the opposite color of the first real body. with point and figure analysis and complement The exception to this rule is if the first real body of other Western tools can be seen with Federal the engulfing pattern is so small it is almost a National Mortgage Association (FNM), a New York (opening and closing prices are the same.). Thus, after Stock Exchange listed equity. The following charts an extended downtrend, a tiny white real body are provided to better assess the technical battle- engulfed by a very large white real body could be a field for the decisions analyzed: Figure 3 - Point bottom reversal. And in an uptrend, a minute black and Figure Chart - one point reversal; Figure 4 real body enveloped by a very large black real body - Point and Figure Chart-three point reversal; could be a bearish reversal pattern. Figure 5 - Monthly High-Low-Closing Price Activity from 1980. For the daily price activity C. The Psychology Reflected in the Pattern between 10/25/91 and 2/14/92 see: Figure 6 - Daily As with most Japanese candlestick patterns, the ; Figure 7 - Daily Stochastics;

‘it) MTA JOURNAL / SUMMER - FALL 1994 ‘Fcdctal Nalional Mlg (rwy

Figure 3: Federal National Mortgage Association Point and Figure Chart-one point reversal Source: Market Charts Inc.

Figure 4: Federal National Mortgage Association Point and Figure Chart-three point reversal Source: Market Charts Inc.

‘igure 8 - Moving Average Convergence/Diver- Decision Point 1: November 29-30, 1991 ‘ence; Figure 9 - Historical (14 Day) Relative Strength. FNM trades sideways for two weeks, between The long term “campaign” of the bulls vs. the November 15 and November 29. At the end of this ears, seen in Figure 5, reflects the ascent of the period, a bullish engulfing pattern indicates the pre- ulls dating back to 1981, which from time to time vious sideways trend is about to reverse to the upside, .as experienced pullbacks to up trendlines. Hav- a signal which is supported by a second, smaller ng exceeded $65 in 1991, FNM then proceeded to bullish engulfing pattern completed on December 6. etreat in a downtrend, as defined in a one point A buy was triggered at the open on December 3 at eversal chart (Figure 31, until it again found sup- 57 7/~ (offered price). Nort above 55. FNM then traded between 55 and At the same time, point and figure analysis would 8, with the bulls attempting a new attack but be looking for a breakout to the upside, which nable to overcome the bears. Which way will the occurred the following Monday when FNM traded at attle turn? 59. FNM having broken out, FNMA’s one point

MTA JOURNAL / SUMMER - FALL 1994 41 Figure 5: Federal National Mortgage Association Source: Long Term Values

reversal chart would establish a price objective of 65. and give a buy signal (depending on the interpreta- In this case, the engulfing pattern would send tion of stochastics) shortly after the bullish engulf- the investment decision forward at 577/a but would ing pattern. not have given a price objective. Point and figure Decision Point 2: January 8-9, 1992 would have given a buy signal at 59, where FNM broke out of its previous consolidation pattern as well Having reached 67 on December 26, 1991, FNM traded above its previous down trendline, with a price continued to fight its way to 70, reaching it on Janu- target of 65 (see Figure 3). Together, the army of the ary 7,1992. At this point, the advancing army of bulls bulls would have entered the battle at 577/~ and fails to make further progress. Fatigue has set in after remained on the field until 65 for a return of 12.08% a 15 point (27%) advance in six weeks. On January 8, (before commissions) in four weeks. Most important, the bulls move FNM from 69 ‘14 to 71 Ya but settle for the risk of the trade was 2 ‘1s points, for a reward/risk an advance to 70 l/4. On January 9, the bulls continue ratio of 2.43 to 1. This risk/reward ratio may or may the advance with an opening charge to 70 l/z (the open not be high enough for army generals to order the and high for the day), lose ground to 68 31~and fight bullish charge when using one technical tool. How- back to 69. The bulls, however, lost all the ground on ever, the generals would find a confluence of support- the 9th that they had won on the 8th and then some. ing technical weapons occurring at the same time or The army of bears, having finally turned back the shortly thereafter. bulls, are ready to take over. MACD confirmed a change in trend over the days At the same time, point and figure analysis immediately following the engulfing pattern as the would have had an insufficient area of congestion solid line crossed the dotted line from below. to enable a decision. However, once FNM broke The relative strength indicator (as defined by below 68, point and figure could have targeted 65 Bloomberg Financial MarketQ), supports FNM’s as an objective. increasing strength but does not give a clear signal In this case, the bearish engulfing pattern would as it is not low enough to indicate an oversold con- send the investment decision forward with a short at dition nor high enough to indicate an overbought 68 7l~ but could not have established a price target. condition. Point and figure would not have given an investment Stochastics, at the point of the bullish engulfing signal but would have set a price objective of 65 after pattern, are hovering just above the oversold zone the breakdown. This price target was achieved five

d!i? MTA JOURNAL / SUMMER - FALL 1994 PRICE GRAPH for FNM US ZB RANGE m TO PERIOD 0 (D-W-M-Q-Y) VOL (V-N) MOVING AVE PERIODS BAR/CANDLE CHART 1 (B-C) VOL MAVE B PERIODS . .m:. : r : : !Ei$!c;;i;;;;;; ; [-...; -..- .iI :1 .<. . . . , . . . . ., .. . . . ,. . . . . ,. .. . . ( . . . . II ;:P ?O!~rr+9.~K!+;~.. .. .;.. .. j... ..$ : . . :.. . . i.. . . :. . . . -1.. It I .+oi,p . . 1 . r-bin g+ . . . . 11

lwu 6 15 22 29 WEC 13 20 27 3JAH92 10 17 24 31 7FEB 14

Figure 6: Federal National Mortgage Association Candlestick Chart of Daily Activity 10125191-2114192 Source: Bloomberg

STOCHASTICS for FNM US s PERIOD 0 (D-W-M-Q-Y) %K/%D CHART’B Slowed %D CHART T%?OTDi %D q %D-Slow G!DS) E] Smoothed %D-Slow (%DS-Slow) . . . . . 1...... : ...... +..+#&~Jd’ ‘- ’ ‘I 1;’ -l-r1 1 -‘(A: ’I : t:I . :r-. . ,

2SOCTSl 1WJ 15 22 I291 6oEc 13 20 17 24 3 7FEB 14

Figure 7: Federal National Mortgage Association Stochastics Analysis: 10125191-2114192 Source: Bloomberg

MTA JOURNAL / SUMMER FALL 1994 43 days later for a 5.63% return. The reward/risk ratio on the strength of one weapon alone. But: was 3.44 to 1. Point and figure had insufficient data to develop MACD confirmed the sell signal four days later. a strategy Relative strength showed a reduction in strength MACD issued no signal. but gave no signal. Relative strength issued no signal. Stochastics confirmed the sell signal either simultaneously or shortly after the bearish engulf- Stochastics issued no signal. ing pattern, depending on how this indicator is Alone, Japanese candles would not have won a used. victory; the army of the bulls gained no ground and ultimately was forced to retreat. However, Western Decision Point 3: February 3-4, 1992 technical analysis saved the infantry from entering On February 3, after four days of the bears the battle, a testament to how the East and West can beating back the bulls on the battlefield, the bears work together for their mutual benefit. lose ground. Starting at 647/~, the bears tight the bulls down to 635/a but are moved back to 643/8. On When Japanese Candles Do Not Work Well February 4, happy with having fought the bears back With Equities the previous day, the bulls retreat at the open to 64, 1. Japanese candles do not work as successfully but fight the bears with renewed vigor back to 65 3l4, alone as when their signals are confirmed by other and rest at the end of the day at 653l~, having re- technical disciplines. A confluence of technical indi- gained all the price territory lost the previous day caters becomes particularly important when the sig- In this case, the bullish engulfing pattern would nals by candles illuminate a move contrary to the send the investment decision to buy which, if acted existing trend. on in isolation, would have been executed on Janu- 2. Candles do not give price objectives or targets, ary 5 at 653/~. There was no follow-through, and in but candles and point and figure analysis together this case the “reversal” in trend was from down to can provide entry and exit strategies. sideways and not to up. The bullish army would not 3. The validity of engulfing patterns needs to have gained ground and ultimately would have lost be more carefully assessed with NASDAQ stocks. ground if its general had made a tactical move based A wide spread between the bid and the offered price

226-m ’ “-9-%g$~2ti~rY~d~&~~~~~ 19~19~~’si Figure 8: Federal National Mortgage Association MACD Analysis: 10125191-2114192 Source: Bloomberg

44 MTA JOURNAL / SUMMER - FALL 1994 HISTORICAL PRICE RSI FNM US S El DfiY k~L~fl’f/~ Sm EXCHANGE COMPOSITE RSI P P=PRICE OR Y=YIELD MARKET n (T=TRADE, B=BID. A=ASK)

Figure 9: Federal National Mortgage Association Historical Relative Strength: 10129191-2114192 .Source: Bloomberg

In one day can create an engulfing pattern relative 6. As seen in one of the three examples, the o the previous day if the previous day has a narrower engulfing pattern may signal either a loss of drive or pread or traded within a relatively narrow range. of the prior trend or a reversal in trend in engulfing pattern under these circumstances to neutral. ends to be subject to greater “whipsaw” trading lerformance. Conclusion In general, I have found trading NASDAQ equi- Japanese candles light the investment battle- ies with candles has a significantly higher risk- field and, when supported by additional weaponry eward ratio than trading NYSE stocks, due in part from Western technical analysis, assist investment o illiquidity and factors. One must be warriors in achieving performance success. The uepared for the attendant circumstances of the bullish and bearish Engulfing Pattern can provide espective markets. an early signal and improve investment perfor- 4. In order to create Japanese candlesticks, one mance when used with point and figure and other ias to wait for the close of a session before being able technical tools such as MACD, relative strength, o draw a candle. A simple solution to this specific and stochastics. broblem is to use intraday candles. However, intraday When not confirmed or supported by Western andles raise new concerns. technical analysis, however, Japanese candles may 5. For intraday candles the period to be used for give signals which are misinterpreted or should not he drawing of the candle will vary with each equity be acted upon. md market each equity trades in. I have found lo- Federal National Mortgage Association, a stock ninute candles to afford a good starting place for trading on the New York Stock Exchange, provided flSE-traded equities with good liquidity and rea- three examples of how Japanese candles can work with ionable volatility If too many dojis or no candles at Western technical analysis in late 1991-early 1992. At 111are created (as can be the case for NASDAQ stocks Decision Point 1, a bullish engulfing pattern signaled vith high illiquidity), 30-minute candles when ana- a reversal in trend from sideways to up. At Decision yzed over two or more days give successful signals Point 2, the bearish engulfing pattern signaled a vhen combined with Western technical analysis. reversal in trend from sideways to down. At Decision

MTA JOURNAL / SUMMER - FALL 1994 45 Point 3, a bullish engulfing pattern signaled a reversal Wagner, Gary S. and Matheny, Bradley L., “Candlestick and in trend from down to sideways. Intraday Market Analysis”, Technical Analysys of Stocks and Given the relatively recent entry of Japanese Commodities: April, 1993. Wagner, Gary S. and Matheny, Bradley L., Trading Applications candlestick analysis to U.S. markets, much research of Japanese Candlestick Charting, New York, John Wiley & needs to be done to integrate this centuries-old analy- Sons, Inc., 1994. sis with tools the West is more familiar. The success of candles in many other markets, over several cen- turies, increases the probability that this research will find numerous ways to integrate the technical analysis of the East with that of the West Candles do light a path on the investment battle- Dodge 0. Dorland is a Registered Investment Advisor field, but investment warriors need additional and Chief Investment Officer for LANDOR Investment Management, Inc. He is a Board member of the Market weaponry to cross it successfully. Technicians Association and has been instrumental in expanding its CMT program. His prior experience includes extensive investment and commercial banking, focusing on the Media, Communications, and Entertain- FOOTNOTES ment industries. He received his MBA in Corporate 1. Nison, Steve, Japanese Candlestick Charting Techniques: A / F’ inance from New York University. Contemporary Guide To The Ancient Investment Techniques Of The Far East, New York, New York Institute of Finance, 1991. 2. Steve Nison pointed out in Barron’s (8/23/93): “To illustrate the importance of the candles to the Japanese, the following is a segment from a European magazine EuroLoeek. That article quotes an English trader who works at a Japanese bank. He states that ‘all of the Japanese traders here-and that’s in the foreign exchange, futures and equity markets use the candles. It might be difficult to work out the billions of dollars traded in London on interpretations of these charts each day, but the number would be significant.’ ” 3. The Japanese have used the color red for positive bodies. Red cannot be differentiated from the color black in monocolor photo copies and, therefore, positive bodies are white. 4. During this time, two major transitions occurred. First, hundreds of local fiefdoms fought for control of their neighbors, with the final result being one unified country. Second, Japan’s agrarian society took advantage of the first transition to move from a system of local markets which operated independently to a centralized market. For a more detailed description, read Chapter 2 of Nison’s book. 5. Nison, ibid., pp.3839. 6. “RSI determines...overbought or oversold conditions by identifying the percentage of days it closed higher than the day before. An RSI value above 75 indicates an overbought condition. Avalue below 25 indicates an oversold condition.” “Stars to Steer by in Your Technical Analysis”, Bloomberg, March, 1994.

BIBLIOGRAPHY Bloomberg, LP, 499 Park Avenue, New York, N.Y. 10022 (provider of charts as indicated). Long Term Values Charting Service, Los Angeles, Ca., Daily Graphs, Inc. Market Charts, Inc., Quarterly Long Term (20 x 3 Hourly) and Semi-Monthly (20 x 1 Hourly), New York City, 1994. Murphy, John J., Technical Analysis of the Futures Markets: a Comprehensive Guide To Trading Methods and Applications, New York, New York Institute of Finance, 1986. Nison, Steve, Japanese Candlestick Charting Techniques: a Contemporary Guide to the Ancient Investment Techniques of the Fur East, New York, New York Institute of Finance, 1991. Shaw, Alan R., “Market Timingand Technical Analysis”, Financial Analysts Handbook. seconded., chap. 11, Homewood, Ill., Dow Jones-Irwin, Inc., 1988. “Stars to Steer by in Your Technical Analysis,” Bloomberg, March, 1994.

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