By Alan Farley
Posted: December 7th, 2007
Candlestick charting found its way to the western world in the 1990s. Since then, it's become more popular than simple line or bar charts. But, traders still misinterpret these marvels of technical analysis in spite of their wide usage. The problem lies in the failure to interpret candlestick patterns within the context of other price action.
The candlestick's real body shows layers of movement within a single time period, highlighted by the relationship between the open and close of the price bar. The real body gets one color when the open finishes above the close and a different color when the close finishes above the open.
Shadows are drawn at the end of each candle. These thin lines show the extremes of price action into the high and low ticks for the time frame of each bar. I've found these extensions to be extremely useful in lowering noise levels when I'm looking for buy or sell signals because they filter out whipsaws and stop running.
Candlestick clusters, or sets of bars, yield popular patterns with intriguing names, such as dark cloud cover or concealing baby swallow. These formations are subject to misinterpretation because they sound really insightful. In truth, skilled traders can forget all the fancy names and just focus on the buy-sell conflict hardwired into these patterns.
Bollinger Bands overlaid on candlesticks generates a synergy that increases the accuracy of prediction. This powerful combination measures the underlying stretch in an evolving trend or range. Logically, a price move should stretch only so far before it snaps back to center. Standard deviation underlies the dynamics for this common swing behavior.
Bollinger Bands are traditionally set to 2 standard deviations. A hammer or doji that thrusts well above the top band, or below the bottom band, can hit 3 standard deviations in a running market. This often prints a piercing candle that clues the technician into the impending reversal or pullback through the long shadow that snaps back before the close of the bar.
Traders memorize popular candlestick patterns and take action whenever they show up on the price chart. But, to me, this is a pointless exercise because these formations rarely work according to a textbook definition. A much better strategy is just to step back and examine the context in which these candle sets show up.
For example, a valid candlestick reversal needs to print after a long trend hits relative strength extremes that signal exhaustion. Many traders act prematurely when these patterns show up in the middle of a congestion pattern or in the early phases of a new trend. In both cases, they get cut to shreds when the market moves against them.
Most candlestick patterns apply to short-term prediction and are only valid for three to four bars after they print. In other words, a hammer low on a daily chart will often get taken out in less than a week. Notably, price thrusting past a hammer or doji presents a more dependable trading signal (in the opposite direction) than the original candle.
Large-cycle candlestick patterns predict large-scale reversals or breakouts. Predictions based on these patterns may be valid for months or years. Positioning on the charting landscape holds the key here. For example, dark cloud cover that prints at a major recovery high on extreme volume sets the stage for a major reversal.
To make long-term predictions, look for patterns that stand by themselves after extreme rallies or selloffs. Many traders and investors get caught holding the bag at these turning points and create huge overhead supply or underside demand. Also, considering that these macro-formations take time to evolve, be patient and wait for your trading signals.
Once again, context is everything when it comes to effective candlestick analysis. For example, avoid taking a short position against a reversal pattern that appears right after a breakout. The rookie trader sees the first reversal candle as a failure of the emerging trend, but just the opposite is taking place.
Price commonly pulls back to support after a breakout before moving higher. The reversal candlestick hides this profit-taking event in a lower time frame, giving the pullback crowd a chance to get on board cheaply. The next bounce takes out the high of the reversal, sets off fresh buying signals and accelerates the trend’s momentum.
Rinse job candle sets provide the swing dynamics for one of my favorite setups. These add a twist because the trading signal isn't confirmed until price moves sharply in the opposite direction. Price drops out of a sideways pattern and sets off a wave of entry signals. Amazingly, it then retraces and jumps back into congestion within a bar or two.
This price action cleans out stops on one side of the market and sets up short-term, oversold technicals in an uptrend and short-term, overbought technicals in a downtrend. This increases the probability of a sharp trend in the opposite direction within one to three bars after the rinse job.
*Reprinted (and modified) with permission from Alan Farley