Bulkowski’s Candle Shadows

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Background

If you do much candle prospecting in the library, you will find references to shadows and wicks in finance books. Those are the same thing, of course. The accompanying chart shows two candles, one white and one black but both have the shadows drawn in red. The theory says that tall shadows mean price is going to turn in the direction opposite the spike. In other words, a tall upper shadow suggests a downturn is coming while a tall lower shadow means the stock is going to rise. I decided to test that theory.

A tall upper shadow forms when price moves up during the day but the bears knock it back down. Such abundant selling pressure suggests that the environment has turned bearish.

A tall lower shadow signifies enthusiastic buying demand. After the bears force price down, buying pushes it back up, leaving a long line on the chart. Again, the theory says that this is bullish because the bears could not hold price down in the face of such buying.

Methodology

I tested various stock durations, 2 years, 5 years, and all data (about 15 years). The most consistent results came from 5 years ending February 15, 2008. I used 547 stocks in the test but not all stocks had the full 5 years of data, so the average was 4.8 years.

For each stock, I calculated the average height of the upper and lower shadows (separately). Then I compared the average upper/lower shadow height to each candle’s upper and lower shadows, respectively. Candles with wicks taller than two times the average shadow height were classified as tall. Those with wicks shorter than one half the average height were short shadows. I measured both, with the short shadows as the "control" group as a way to determine whether tall ones worked as expected.

In a separate test, I also used the average height instead of twice that, to determine short or tall. The results were similar to those reported here (as were the results from 2 year and 15 years worth of data).

Once I determined whether a shadow was short, tall, or in between, I measured the close-to-close change from the candle to each day into the future for ten trading days (two weeks), then after three weeks, and a month. I averaged the price change for those 12 periods, for each stock. By that I mean I averaged the results for all stocks for day one, then created a separate average for day 2 for all stocks, and so on to a month later.

The idea behind this approach is that if a tall shadow predicts a decline in price, you would see that over time while candles with short shadows would show price continuing to trend upward.

Once I had the data into a spreadsheet, I used a frequency distribution to count how often price climbed or fell over the 12 periods. I also used a sum of the price changes for the 12 periods to confirm the results, which they did.

Results

The following table of results is discussed in detail below. Each row represents a count of how many candles closed higher ("Rising") or lower ("Falling") over time. Day+1 means the day after the candle with the tall/short shadow; 4 wks means a month after the main candle.

Tall Upper Shadows

For candles with long upper shadows (more than twice the average height), price climbed. This is counter to candle theory which says price should drop after a candle with a tall upper shadow.

For example, I found that a day after a tall upper shadow (Day+1 in the above table), 360 candles closed higher and 181 lower, a ratio of about 2 to 1. At the end of a week, the numbers were 322/222. In all 12 periods, more candles closed higher than lower but toward the end, the difference narrowed: at 1 month, 286 closed higher ("Rising") and 261 closed lower ("Falling").

Short Upper Shadows

How did the control group do, those shadows that were less than half the average height? Price also climbed in each of the 12 periods. The difference started out narrow and widened over time. For example, the next day saw 281 candles close higher and 258 lower. A month later, the numbers were 470/76, a ratio of over 6 to 1.

Tall Lower Shadows

When the lower shadow was tall (more than twice the average height), price closed lower over time. Again, candle theory says that tall lower shadows should show a price rise, not a decline. The ratios started at 158/381, or over 1 to 2 and ended narrower, at 213 to 333.

Short Lower Shadows

The control group for lower shadows saw price rise and the ratios were huge. A day after a candle with a short lower shadow saw price closed higher 483 times and closed lower just 61 times. A month later, the difference remained the same: 491 to 55. Of the four variations of upper and lower shadows, short lower shadows show the most promise. In other words, if price has a short lower shadow, it strongly suggests price is going to rise.