Candlesticks Technique: A Panacea Or A Big Frog In A Small Pond?

Just like a vast number of mind-boggling and revolutionary inventions, Candlesticks originate from Japan, where they were initially used by rice traders yet in the 17-th century. This gives the technique an air of Oriental charm, invoking associations with precision, technical eminence, and some innate, hidden ancient wisdom, which, of course, can never fail. Candlesticks were first introduced as a technical analysis technique by Steven Nison in his acclaimed book Japanese Candlestick Charting Techniques. Did the guy do the right thing? - new version - as a technical analysis technique by the esteemed Steven Nison in his acclaimed book Japanese Candlestick Charting Techniques. Did the man do the right thing? We think he did, but let's try to answer this question at a greater depth.

To create a candlestick pattern, you need a data set that will contain an open, a high, a low, and a close. A candlestick is formed by a "body" and two "tails" that grow out of this body. The four milestone points, passed by every trade, are located as follows:

In this pattern, the tails represent the whole range of prices, used during the trade, whilst the body represents the opening and closing prices for the selected period. If the closing price is higher than the opening one, the body will be colored blue or green; when the opposite is the case, the body will be colored red.

Basically, the Candlesticks pattern provides exactly the kind of information that you can observe on about any other kind of chart. The thing is definitely a lot more pleasant to look at than most of the other types of charts, but what's the big deal in terms of its usefulness?

The most powerful advantage that this technique can give is, undoubtedly, the easily discernible respective relationship between the four points that make up the pattern. One look is enough to size up the underlying price action in terms of the two key relationships.

But, the most important advantage, offered by Candlesticks, is that there are a number of sure (well, most of the time, you know) signs of a market development occurring that no other technique can offer. So what is this bag of tricks?

For example, if the body of your candlestick is green and rather prolonged, this means that buyers are very active - a definitely bullish sign. Conversely, a long red candlestick body will be a sure bearish sign.

Another useful sign, offered by the Candlesticks technique is Doji - the situation, when the opening and closing prices coincide. The so called Dragonfly variation of Doji, whereby the prices coincide at the top of the trading range, serves as a sign of trend reversal and a forthcoming upward advance.

An equally useful sign is the so called Piercing Line, whereby the closing price point of the green bar is just slightly higher than the middle of the preceding red candlestick. This situation signals a forthcoming reversal of a downward trend.

The technique offers several more eloquently referred to pattern variations, whose names sound like the names of some mortally dangerous jab or a bizarre and potentially lethal posture from an Oriental martial system. But are these tricks really as dependable as the great ancient fighting legacy of the Orient?

Of course, the technique is not infallible and just like any other trading method is a bit on the dodgy side. One of the main drawbacks of the technique is that despite it clearly shows the relationship between the opening and closing prices, it does not allow seeing how volatile the price action actually was during the different stages of the trade. Actually, some significantly different scenarios can be possible.

All told, a great many traders reckon candlesticks to be the primary trading method in technical analysis. Our opinion would be that although Candlesticks are, certainly, a lot more reliable than most of the other technical analysis methods, one shouldn't still rely entirely on this single method.

Are There Optimum Indicator Parameters?

A question asked by both professional and private traders alike

I have been training traders for around 15 years and perhaps the most frequently asked question of all goes something like: "What parameters do you use for your moving averages?"

My sincere and honest response is that I don't use any in my analysis and if I did there is no such thing as an optimum parameter … except in hindsight. However, hindsight is not much worth to us right now.

Is there any such thing as an optimum parameter for any indicator? Not as far as I am aware.

Are there any mystical powers about indicators which make them predict the market? No.

Let's get this straight. All indicators are lagging. This is intrinsically so since they are all calculated from historic prices and there is categorically no argument to say that price develops in a linear fashion that implies indicators can be used to forecast price. I have not found one that predicts the market.

Let's take an RSI. The default in most platforms is 14. This is because it was considered by Welles Wilder who created RSI that there is a common 28 day cycle in the market and thus an indicator length of half the cycle length is a broad yardstick to use.

If you look back at price history and apply several different length RSIs over that history, at times you will find that (for example) an 8 period will work well during sharper oscillating markets while during broad swinging markets a 14 period may work better.

Well, now we have a game plan. We can use an 8 period RSI when the market is choppy and a 14 period when it's not... Now look at your chart and decide what will happen from now. There is always an element of judgment involved and no way of saying for certain which length you should use.

The next argument is to optimize the RSI and choose the most profitable periods. Well, it can be done but having written systems I have never found a parameter that works without substantial a drawdown, certainly not one I would care to trade through. In addition, developing a system is not as straightforward as it seems. What if the optimum period is 14 with a profit of 100 but parameters of 12, 13, 15 and 16 only have profits of 25? (This is not an uncommon occurrence.) Would you feel confident that the optimum period was not just an aberration? (In all probability it is.)

So after all that it seems that there is no safe parameter to use for indicators. Frankly I use the default in most cases - at least for momentum indicators - but the bigger issue here is not the indicator but how you use it.

Again let's take an RSI. Broadly it is commonly used as an overbought/oversold indicator. This is only true during consolidating markets and not trending. You should never use these types of signals from momentum indicators while a trend is in place. Does this mean it is right that, as soon as RSI moves above 70 it is time to sell and below 30 is a time to buy?

No. Definitely not… Here is one of the best bits of advice I can give.

Never take a trade taking a signal from only one form of analysis.

The biggest piece of the puzzle that many (and probably most) traders fail to understand is price. For instance, why take a sell signal because RSI is above 70 but has not moved back below a strategic low. It could be beginning an uptrend and the lows and highs are still moving higher. It could be pausing in a flag formation which is a strong continuation pattern. Remember that many of the best profits come from long positions when momentum indicators are overbought (and short positions when momentum indicators are oversold.)

Always make sure that price is doing something to confirm your trade…

Maybe you see daily RSI above 70. Fine, move down into the hourly charts and see if:

• There is a price/momentum divergence, or
• A reversal pattern is developing - then confirmed, or
• A trend support has been broken.

If any of these occur then your short trade because daily RSI is overbought stands a much greater chance of success.

But what has this got to do with the parameter you choose for the RSI?

Nothing really, but as long as you are using one that is not an extreme and follows the market on the majority of occasions the actual parameter is not important - the combination of the RSI and price should be enough for the majority of trades in this way. Just understand that indicators have their limitations and do not expect them to magically tell you what trade to take. Study price. Understand price. Combine it with indicators and you will have taken a step forward to better profits.

ATR: Reading Volatility

As buyers and sellers pass through the marketplace throughout the course of a trading session, the price charts will simply reflect the behavior of the two opposing forces, and their varying waves of strength and weakness. Like ocean currents, the market will oscillate between relative degrees of volatility and direction. Volatility decreases and trading ranges develop as the market inhales to absorb capital from both buyers and sellers. Eventually price action break's out as the volatility increases, and the market exhales in the direction of least resistance. The ATR (Average True Range) gauges the average range from low to high of each candlestick during its respective period of time. In the first segment of the following chart, we can see a trading range develop as the ATR indicated a decreasing amount of volatility. Eventually as the market became complacent, one side of the market took control; in this case the sellers, as a breakdown occurred to new low prices. Understanding this basic mechanism can help us understand when it is a good time to 'play the range'; as volatility decreases, and 'buy the breakout' as volatility increases.

Change Of Direction And Exhaustion Spikes

We constantly face the question, what ingredients make up a good trade? Entry; the closer that we buy off the bottoms, and sell off the tops, the greater amount of profit we can enjoy, while taking on a smaller amount of risk. Assuming the market establishes a 100-pip trading range between 1.2100 and 1.2200, it clearly makes sense that buying at 1.2110 is a better trade than buying at 1.2150, or 1.2170. However the dilemma we face is as follows: If we continue to buy market bottoms, we run the risk of buying a seemingly never ending downtrend, a practice also known as 'catching a falling knife'. So the $10,000 (demo dollar) question remains how can we buy the bottoms and sell the tops, only when the trend is in the midst of a change in direction? The following chart may help add some light to this predicament.

The following (1-hour) chart shows the GBPUSD breakdown, below it's established up trending channel. We may interpret this as a sign of a change in trend, as the market now shows a greater likelihood to now reverse back to the downside. With this in mind, it clearly makes sense that as we should only look to sell-short as a broken up-trending channel tells us we have a better chance to see lower prices in our near future.

As a general rule of thumb, while buyers try to go long at the lowest possible price, those who wish to sell-short should look to do so at the highest possible level. We can see that after the up-trending trading channel failed to contain the market's price action, a long-candlestick wick popped up above the upper Bollinger Band. In this application, I prefer to set the Bollinger Bands to a 3rd standard deviation as this will help isolate only the extreme market spikes.

To summarize, our goal is to enter the market as it takes its last exhausted attempt at a failing trend. Putting this together, this trade set-up allows us to identify short-term changes in trend, and then enter the market at its relatively extreme price levels. Although this scenario may not 'play-out' as cleanly every single time, it provides us with the criteria to wait for the right trade, and wait for the right price. Best of luck in trading!!!

Eight Short-term Technical Tools that can Make You Money

There are several valuable technical trading tools that I use on a shorter-term and even an intra-day basis. While I am not a "day trader" and am more of an intermediate-term "position trader," I do have many readers that are day traders or trade shorter timeframes. Thus, I like to provide analysis and clues that do help out those traders who use shorter trading timeframes. And even for the longer-term position traders, shorter-term trading tools can help refine their all-important entry and exit strategies. Below are some of my favorite shorter-term chart signals that I employ.

(You'll note that my favorite shorter-term trading signals are not computer-generated, in keeping with my philosophy that while computers certainly aid traders in many ways, they can never replace the extreme value of the human eyes examining a price chart.)

Collapse in volatility:

A collapse in market price volatility occurs when trading ranges (price bars) narrow substantially. This price pattern is evidenced by price chart bars (the bars can be daily, hourly or in minutes) that suddenly get smaller. The smaller price bars should number at least three in a row, and do not necessarily need to get progressively smaller with each bar. This "collapse in volatility" usually sets off a significantly bigger price move--either up or down. As the smaller price bars accrue on the chart, there is no set number of bars that will set off the bigger price move. It could be three bars, or it could be 10 bars or more before the bigger price action is set off.

Outside days (or bars):

Outside days (or bars) occur when the last price bar is bigger (a bigger trading range) than the previous bar on the chart. If the close (or last trade of the bar's timeframe) is higher than the previous bar's last trade, then that is considered a bullish "outside day" (or bar) up. A bearish "outside day" (or bar) down occurs when the close (or last trade of the bar's timeframe) is lower than the previous bar's close, or last trade.

Inside days:

These occur when the last price bar is "inside" the previous bar--meaning the trading range is smaller and inside the previous bar's trading range. In other words, the last bar's high is lower and the low is higher than the previous bar's trading range. Inside days (or bars) signal that the market is taking a break after a busy period. Inside days can also be an indicator that a collapse in volatility may be setting up and that yet another bigger price move could be on the horizon. After a big price bar and busy trading day, one can expect the next session could be an "inside" rest day.

Key reversals:

These are more important chart signals that occur less frequently than most others I discuss in this feature. Key reversals are one important signal of a potential market top or bottom. A key reversal occurs when a new for-the-move high or low occurs, and then during that same day (or trading bar), the price sharply reverses direction to form an "outside day" up or down. Some analysts will call this, alone, a key reversal. But in my trading rules, a key reversal must be confirmed by follow-through strength or weakness the next trading session (or trading bar). Follow-through greatly helps eliminate false signals and makes a market "prove itself" after a bigger move.

Exhaustion tails:

These occur when either buying or selling apparently is exhausted after prices make a fresh-for­the-move high or low that creates a bigger price bar on the chart. Then prices reverse course to close at the other extreme of the bar's earlier move. Thus, you get the bigger bar that creates a "tail." These tails are then important guideposts because they then become an important resistance or support level on the chart.

Closing Price:

Most traders agree that the most important price of the trading session is not the open, the high or the low--but it is the closing price, or settlement. After an entire session of buyers and sellers doing business, this is the level at which they have agreed (voluntarily or involuntarily) on price. I place more emphasis on a closing price below an important support level or above an important resistance level, or above or below a trend line or chart pattern--as opposed prices just probing above or below those levels during the session only to then pull back.

Daily or weekly high or low closes:

If a market closes near the session high or at the weekly high close, that's a sign of market strength and suggests there will be at least some follow-through strength the next trading session (or price bar). On a close near the daily low or a weekly low close, this suggests market weakness and that follow-through selling could occur the next trading session or price bar.

Gaps:

These chart formations occur when price bars push well above or below the previous bar to form a gap on the chart. (The last bar's low is higher than the previous bar's high for a gap-higher move. The last bar's high is lower than the previous bar's low to form a gap-lower trade.) Gaps can be created on a minute, hourly, daily, weekly or monthly chart. Price gaps indicate a strong market move and many times the gaps will then serve as important support or resistance levels on the chart.

Intersecting Lines: Multiple Signs of Confirmation

Every technical indicator and trading technique allows us the chance to see the market through a specific angle or point of view. These indicators standing alone may not provide accurate buy and sell signals as the market is very much multi-dimensional. However simple chart analysis allows us to isolate those points on the chart where multiple signals agree. At these points, our probabilities of being "right" increase in our favor as the market moves somewhat under the influence of a ‘self-fulfilling prophecy'. As more traders note the same signals, this implies a greater amount of buy and sell orders which inevitably drives the market higher or lower.

With this in mind one of the most widely used and easiest approaches is the use of trend-lines. This can take the form of horizontal lines extending from left to right on the chart, diagonal sloping lines, and Fibonacci retracement lines. We can see the following 1-hour chart shows us how the USDJPY recently traded near the 115.50 large round figure. These large numbers standing alone may represent a degree of either support or resistance, as many traders and institutions tend to use these price levels as a basis to buy and sell. More importantly, this horizontal line also intersected with the 38.2% Fibonacci retracement level drawn from recent highs. Furthermore, we can see our former support line (which often times becomes new resistance) also intersected these two aforementioned lines at nearly the same time. With that said, it is important to note that these lines may not necessarily meet at the same "exact" price level. However within a matter of 20-30-pips, every line met at nearly the same spot on the chart. What's more, as the current trend appears to be to the downside, traders who choose to sell-short have the benefit of trading in the same direction as the overall trend, which typically is in our favor. Best of luck and happy trading!!!

Pivot Points & Divergence

In the hopes of keeping things as simple as possible, it may be helpful to understand exactly what our intentions are, when maneuvering through one market or another. I like to think of trading as nothing more than simply the process of weighing all the relevant information at hand, finding the next probable direction of the market, and then waiting for the movement where the appropriate trade provides us the highest possible reward for the least amount of relative risk.

The technical indicator used simply gives us another clue to the multi-dimensional relationship between the buyers and sellers over a given period of time. With this in mind, we may opt to use a common technical indicator known as "Pivot Points". These horizontal lines are simply a formula calculating the previous days high, low, and closing price, which are plotted as 3-support and resistance levels typically found on daily, weekly, or monthly charts.

These lines, like any technical indicator simply provide us with a suspect price level at which the market 'may' establish its next support or resistance level. As the market subsequently tests one of these price levels, we should now employ another technical indicator in order to determine if the market has in fact found new support or resistance. For example, the following (1-hour) chart shows the current position of the EURUSD. We can see the market established a double bottom pattern very close to the 1st Weekly Support Pivot Point. As this occurred the MACD began to trend back to the upside indicating a level of divergence in the trend. Traders noting this relationship may have decided to go long or buy the market at this point as the potential reward far exceeded the risk in the trade.

The market subsequently rallied and failed to break above the 1st weekly resistance Pivot Point standing just below the 1.2800 large round figure. As this occurred, the MACD began to travel back to the downside again indicating a level of divergence. Traders once again may choose to anticipate this current range to continue, placing their faith in Pivot Points and MACD Divergence. There is no way to know ahead of time with certainty if the market will in fact act as we believe it may. However through the use of Pivot Points and other technical indicators, our probabilities of success grow in our favor, and will surely help us in the long-run. Best of luck!!!