This is the second of a four-part series of articles describing an options trading system that accomplishes better than averages outcomes.

This first installment (Part 1) explained methods for selecting companies and quantifying technical attributes. This installment (Part 2) explains the theory and its assumptions, and the selection of strong reversal or continuation signals

Future installments include:

Part 3: examples of applying the quantifying tests, with strong and weak outcomes

Part 4: the methodology and outcome of a two-year test

This theory was first documented in a paper written for and published by the Journal of Technical analysis (JOTA), which subjected the concept to a rigorous serious of peer reviews. The paper was published in the 2016 edition of JOTA, issue 69: JOTA issue 69 The theory was expanded and explained in greater detail in “Profiting from Technical Analysis and Candlestick Indicators” (FT Press)

 

In applying the signal correlation theory to actual trades, I first studied the attributes of candlestick signals and selected the 10 strongest ones I could find. There are dozens of candlestick signals, but many yield only a 50% reliability level. I wanted to use only those signals with the highest possible levels of outcomes. The 10 signals selected were based on a detailed study by Thomas Bulkowski, as explained in his book, “Encyclopedia of Candlestick Charts” (John Wiley & Sons, 2008). Using his rating system, the 10 candlestick signals used in my 2-year test were:

Bulkowski’s performance rankings

Signal Ranking
bullish reversal

three stars in the south

three white soldiers

morning star

 

100%

84

78

bearish reversal

three black crows

identical three crows

bearish engulfing

bearish belt hold

 

79%

72

82

71

bullish continuation

three-line strike (bullish)

mat hold

 

83%

78

bearish continuation

three-line strike (bearish)

 

84%

Note: the 100% ranking of three stars in the south was due to a small sample count, according to Bulkowski. Thus, although the ranking is high, the 100% outcome is statistically unlikely.

Looking beyond candlestick signals, many traditional Western signals were also employed to spot reversal or continuation, and confirmation points. These includes head and shoulders, double top or bottom, wedges and triangles, and price gapping patterns. Further confirmation was located through non-price signals, including moving averages, volume patterns, and momentum oscillators.

As a starting point, a set of assumptions was developed to spot recent trend strength of weakness (as opposed to price-specific behavior). With this in mind, the basic signal correlation theory can be summarized with the following:

Theory: Candlestick signals are reliable only when correlated.

A candlestick indicator is the initial forecast of likely reversal or continuation. This signal is not reliable even when confirmed, without existing in close proximity to resistance or support. A signal is quantified further through the strength of the preceding trend, strength of the initial signal, and strength of the confirmation signal.
Beyond the initial theory, resting primarily on candlestick signals (but allowing for other signals as initial action points). the theory relies on three additional beliefs. These are:

I: Strong reversal is likely to be followed by equally strong confirmation.

When a reversal signal is strong, confirmation is likely to also be strong. This observation increases confidence. Strong reversal is also likely to lead to an offsetting equally strong new trend.

 II: Strong continuation is likely to be followed by strong confirmation.

Strong continuation signals are likely to be followed by strong confirmation signals. As a result, continuation confidence is high, leading to strong possibility of successful breakout above resistance or below support. Strong continuation is likely to lead to trends at least equal to the strength of the preceding trend.

III: Weak signals are likely to be followed by weak confirmation.

Weakness in signals is followed by equal weakness in confirmation. The weakness of signals and confirmation is most likely to be located at mid-range and not in close proximity to resistance or support.

These observations grew from application of the initial theory of signal correlation, which means not only that proximity matters, but also that a relationship exists between strength or weakness of trends and also of signals.

In the next installment of this series, I will provide examples of how the quantifying fundamental and technical tests are used to locate strong options trade timing opportunities, as well as the consequences of trading at moments of weak signal and trend attributes.