Long tail days in candlesticks are defined as candlesticks with long tail or wick with an smaller body than the tail. It is a bullish/bearish reversal patter also known as Hammer.
In order to test and validate the use of these formations as a trading strategy, I am going to use the last five years of daily data in the Eurostoxx50. As we will see in the final results, we can beat the index by using these formations and only staying in the market 30% of the time (we assume we do not get any interest on cash).
- Long_condition: Down long tail is higher than the body and more than double the up tail.
- Short_condition: Up tail is higher than the body and more than double the down tail.
- Go long at close if Long_condition is met. Exit at close the following day.
- Go short at close is Short_condition is met. Exit at close the following day.
I have left the Python code here to show the way it has been tested.
- We have 388 trades during this five years period. From those, 225 were long trades and 163 where short trades.
- The win rate for a long position was 56.44% and the win rate for a short position was 50.9%. That makes an overall win rate for the strategy of 54.12%.
- Moreover, the average winning points are 27.01 per positive trade and the average losing points per negative trade are 24.19 points.
- During the 5 year period the index Eurostoxx50 has made 454.91 points, it is a 14.9% return. During the same period the strategy has made 1365 points, is is more than 44% return.
- To sum up, we have made more than 3x the index return by being in the market only 30% of the time (being in cash the rest of the time with no interest).
However, after all the results we have shown, we must mention that all this can be improved if we define where and when we should trade this “Long tail days”. For example, we can define to trade them only when they appear near a Fibonacci level o major support or resistance levels. Moreover, we can set up some restrictions to trade this formations, such as to impose that the long tail of the day must form a maximum / minimum for the last x days.
On the other hand, as it is important in every trading strategy, money management becomes a very important issue here. Since the long tail can be thought as a near term extreme low/high, this levels can be used as stop-loss in order to set the correct position sizing for the trading strategy.
We have a candidate strategy with an edge, we only need to know how to use that information.