Bearish Engulfing Patterns are the Least of Your Problems

engulfingBearish

Bearish engulfing patterns seem scary. They have an ominous name and the market behavior that forms them is usually pretty nasty.

The real question is: do they have any predictive value? Is there any reason to pay attention to them after they’ve happened?

In bear markets they are a decent signal for very disciplined traders, but in the long sample they don’t offer much value in understanding the market going forward.

The criteria used in this study is bearish engulfing patterns in the $SPY which also lost more than 1% value in the session. The statistics period is 25 days after the pattern occurred.

First we’ll look at 2008, which is (not surprisingly) the last time period bearish engulfing patterns worked well.

The statistics presented are from a short bias. And for a disciplined trader in one of the worst bear markets of all time, bearish engulfing patterns present a decent trading opportunity. They key here is that even in the worst market conditions, bearish engulfing patterns produce less than 50% short-side winners.

Market Memory bearish-engulfing-patterns-2008

Below is 2008 – present. Once you incorporate a full market cycle the statistics change dramatically. The risk-reward no longer makes sense and over 70% of the instances actually produce a positive outcome. Changing the study from 25-days to a shorter time frame does very little to change these statistics.

Market Memory bearish-engulfing-patterns-2008-2014-short

This post is not to suggest that there is nothing to fear from this market just because the latest bearish signal doesn’t product consistent negative returns. Far from it. The point is to give some context to how often these patterns work out and where they fit into the larger picture.  Engulfing patterns are useful in assessing the overall supply and demand relationship of the market. They can serve as a great reference point for traders and investors. As a stand alone buy or sell signal they are not effective in generating alpha.

Data provided by Market Memory


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