In this journal entry I am going to describe my experience of using Pinocchio strategy during my trading sessions. I’ve tested two variations of the strategy: plain Pinocchio strategy and Pinocchio strategy with supportive technical indicators. In addition, I will show and explain several common mistakes that could be done using the strategy.
As a precondition, charting software should be customized to display the required information. I used 5-minute candlesticks with option expiry time equaling to 20-30 minutes. No additional technical indicators were added when I tested plain Pinocchio strategy. However, I used stochastic indicator with traditional parameters (14, 3, 1) when it came to utilizing technical indicators so that I could identify oversold and overbought assets.
Pinocchio strategy reminder
The strategy is basically about the identification of certain types of bars – Hammer and Inverted Hammer candles as well as Dragonfly or Gravestone Doji. Even Long Lower/Upper Shadow candles are acceptable if their wick is long enough. The main point in identification Pinocchio candlestick is to look for wicks which are as long as possible. Once a candle with a long wick is identified, it signals the trend reversal. The rule of thumb is “The longer the wick, the stronger the signal”. Candles with longer upper tails signal about the reversal of trend downward while bars with longer lower tails signal about trend reversal upward.
To make the signal even stronger, utilization of technical indicators is recommended such as Stochastic. That helps identify whether an underlying asset is oversold or overbought. If the value of the indicator is above 80, the underlying asset is considered to be overbought amplifying a put option signal. In case the value of the indicator is below 20, the underlying asset is thought to be oversold making a call option signal stronger. The stochastic indicator was also used in MACD strategy testing.
The first successful trade using plain Pinocchio strategy happened while trading NZD/USD currency pair. An inverted hammer candle was identified. Despite the fact the body was not considerably small comparing to the length of the wick, I decided to place a trade. The candle signaled a reversal downward, however, it did not turn out to be the case.
The price moved up. Since the trade was not placed right after closing the inverted hammer candle, the put option was purchased at a relatively high price. Eventually, the price moved down which resulted in a profitable trade. Here are several lessons that could be learnt from the trade:
- When dealing with hammer candles, the body of the bar should be more than 4 times smaller than the wick
- When placing a put option, the price should be close to resistance levels.
The second time I traded NZD/USD resulted in out of the money trade. When the candle was noticed, the signal was supported by the stochastic saying that the asset was overbought. However, the reversal happened and the following bar was bearish so that the price moved down drastically. The option expiry time was around 15 minutes. PUT option was purchased at 0.6858.
The option expired at 0.6860. The main mistake that had been done was the late option purchase. It’s recommended to purchase the option right after the reversal happened.
A long wick signaling CALL option was identified while I was trading Gold. Generally, that kind of candles signals about trend reversal. However, there were several factors that made the signals weaker. During that moment, the option’s expiry time was around one hour. In addition, the following candle showed that bears took over the market. For the sake of testing such case, I placed a call option.
The trade resulted in the money at the end. After that, I added Stochastic indicator in order to check whether the asset had been oversold or overbought. It turned out that gold had been overbought at that moment. Despite the fact that the trade ended in the money, the following mistakes were done:
- Technical indicators were not used
- Option’s expiry time exceeded the requirement (20-30 minutes)
- Call option was purchased even though the price was close to the resistance level
Another trade that finished in the money was executed with AUD/USD currency pair. A shadow candle was identified with a relatively long upper wick comparing to the body. At the same time, the asset was overbought. The option had nearly 30 minutes expiry time. Taking all those factors into consideration, a PUT option was purchased at 0.7696.
A half an hour later the option expired at 0.7690 which made me 75% profit.
The second trade with AUD/USD ended out of the money. A bearish shadow candle with long bottom wick and small body was identified. At the same time, the asset was oversold. Therefore, a CALL option with 25 minute expiry time was purchased. Despite all signals, the down trend lasted for another 15 minutes until it reversed into opposite direction.
That resulted, in out of the money trade. That proves that neither strategy can generate 100% correct signals.
During my trading sessions, I tested Pinocchio strategy with various assets: NZD/USD, AUD/USD, Gold. Three trades resulted in the money while two trades were closed out of the money. Based on the results received so far, the plain Pinocchio strategy is not as efficient as Pinocchio strategy with technical indicators. However, even that strategy does not guarantee 100% profitable signals. I would like to sum up the lessons learnt when using the strategy:
- Utilization of technical indicators and support and resistance levels is strongly recommended. Otherwise, the signals are weak
- Place a trade right after the reversal happened
- Mind the options expiry time
- The body of the candle should be more than 4 times smaller than its wick
Please share your thoughts/experience in comments below. Your feedback is very important.