Last Updated on August 25, 2016 by Mark Ursell
This article discusses why candlestick trading is an ideal way to trade binary options.
Viewing price action in the form of Japanese candlesticks was popularised by Steve Nison. Candlesticks are now the default view in most trading software and glancing at a chart shows why.
The use of colours to distinguish bull and bear bars makes them easy to identify. The charts make a clear contrast between the real body (between the open and close) and wicks (between the high and low)
Automated Trading using Candlestick Charts
Candlesticks are not only useful for viewing the markets and getting a quick understanding of price action, they also are easy to incorporate into automated trading systems. Automatic trading relies on the designer being able to replicate what is happening on the screen into a series of logical steps.
Candlestick charts are constructed using open, high, low, close price data and many patterns will use only a few bars of data. They are therefore much easier to program compared to systems that rely on data from many bars.
Candlestick Trading for Binary Options
Options were developed to allow investors to hedge risks in a portfolio. Purchasers of an option have the right to buy or sell the underlying instrument at a certain price before a certain time. For investors, options act as a form of portfolio insurance.
Traders buy and sell options to make a profit from market moves and market volatility. Options allow traders to take advantage of margin to make bigger profits and losses they would do by trading the underlying instrument.
Binary options look similar to traditional bets. Trading a binary option risks a set amount of capital and wins a set amount. With an 80% payout a binary option trade of $100 risks $100 and wins $80.
The most popular type of binary option trade is the Higher-Lower trade. To win the trader must correctly guess whether the market will be higher or lower than the current price at a set time. This type of bet often has a payout around 80% and so the trader must be correct more than 55.5% of the time in order to be profitable.
In normal trading, a winning percentage of more than 55.5% would be easily attainable, however, for binary options the problem is that the trade will expire at a fixed time. Therefore any trading strategy must take account of the time element.
Candlestick trading is one way to address the issue of timing.
A Candlestick Trading Strategy
I have come up with a trading strategy that is simple to use and deals with the issue of timing by trading one bar ahead. Therefore the strategy will enter at the close of a bar and exit at the close of the following bar.
As you will see when you watch the video below, the trading strategy has been profitable over the past 4 years on the EUR/USD 15 minute timeframe. The trading strategy is a reversal strategy.
- Long trades require 3 consecutive lower bars. Short trades require 3 consecutive higher bars. All of them with a minimum body size that can be varied.
- 4th candle must be a Doji with a small body. Doji body to be a minimum size that can be varied.
Video Describing the Trading Strategy and how it can be Backtested
Using Excel to Backtest the Binary Option Strategy
Microsoft Excel is a very useful tool for backtesting trading strategies. Binary options are comparatively simple way of trading and are ideal to be backtested using Excel. Excel can handle quite a lot of data, in the video above I am testing 100,000 15 minute periods.
In the video I showed how the rules for this simple candlestick strategy can be programmed into Excel. I did this using an IF statement
The long trades were opened using the following:
Short trades were opened using the following:
How to Improve the Strategy
In the video I discuss a number of ways that this trading strategy could be improved. Once we have the basic model in Excel, it is easy to change variables to refine the strategy.
- There are 2 variables built into the strategy. The size of the Doji and the size of the preceding candles. Either or both of these could be tweaked.
- I have set the number of preceding candles at 3. This number could be changed to 4 to identify a longer trend or 2 for a shorter trend.
- Most dojis have a small body, the colour of this could be used to identify preferred trades. For example a red Doji may be more profitable for short trades and a green Doji may be more profitable for long trades.
- The trading strategy does not distinguish between types of Dojis. Different shapes of wicks give the pattern a different look. Hanging man or shooting star patterns may be more profitable.
- The profitability of the pattern may be affected by the preceding momentum. We could test whether the pattern is more effective in a downtrend or an uptrend.
Use Excel to Backtest Trading Strategies
If you are interested in using Excel to backtest trading strategies my Ebook course: How to Backtest a Trading Strategy using Excel is available in the Amazon Kindle Bookstore.