How predictive of a reversal is a day where there is a strong reversal (a “hammer” on a candlestick chart, or a “kangaroo tail” in the parlance of Alexander Elder; I like the latter terminology, because it’s funny)? There have been two recently, so I wondered.

I have looked at this question for the S&P 500, and played around a little. There may be an edge here — there are not many instances, but the effect seems to endure.

The system:

  • A kangaroo tail is formed when both the open and close are in the top (or bottom) third of the bar, and the low (or high) for the day is a new 60-day low (or high). 
  • True range must be above average.
  • Trade with the long-term trend (200-day moving average is moving in the direction of the trade) and against the short-term trend (10-day moving average is moving in the opposite direction to the trade).
  • Stop at the extreme of the kangaroo tail.
  • Profit target at 4x the stop distance (because eyeballing the chart suggests these things predict major reversals). This requires a long-term success rate over 20% for the system to be profitable.
As you can see from the following chart, over 30 years both long and short trades have more than double the success rate required to make money. The cumulative success rate for longs never drops below 30%; shorts are more variable (because signals are much rarer). The little chart at the bottom is a counter — there have been 21 long signals and 5 short signals over 30 years.