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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 ...

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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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...International journal of finance and managerial accounting vol no autumn analyzing the effectiveness candlestick technical trading strategies in foreign exchange market seyyed behshad yassini ph d student department financial management science research branch islamic azad university tehran iran fereydoon rahnamay roodposhti professor faculty member corresponding author f rahnamayroudposhti srbiau ac ir mir feiz fallahshams assistant central abstract charts are a type chart for tracking movement securities some earliest analysis was used to track prices rice th century investors find them more visually appealing than standard bar price actions easier interpret pattern is shown graphically on that believe can predict particular this paper it analyzed whether various patterns trends first group minor hypotheses include candle with an inverted color proceed by these second analyze profit after significantly profitable three open candles considered as different possible stop points have re...

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