by Mike Lally
When you look at your charts, do you understand everything they’re telling you?
It is a purely subjective decision whether you use candlesticks or any other popular tool, most notably the OHLC bar chart.
I believe candlesticks are a fabulous tool for analysing price action; they are visually appealing, have a rich history and can take charting to a new level.
They are not quite as old as Confucius but are much older than the bar chart.
The names of the patterns often bewitch, dazzle and captivate – candlesticks almost deserve recognition for this alone.
The visual splendour makes them intuitively didactic.
It’s not surprising they are growing enormously in popularity.
The rectangular part of the candle is known as the real body and is generally believed to be more significant part of the candle.
The real body contains the opening and closing prices of a period.
The formations we are concerned with are known as the reversal patterns and we find there are several that dominate. We cover these in Part 3.
Successful use of candlestick patterns requires the prevailing trend to be identified.
It is important to note that price predictions based on patterns are effectively a short-term forecast – they work best over a brief timespan with the optimum number of periods being between one and eleven.
The tails of candles can play a vital role in the analysis of the chart.
Major turning points may occur when the tails are long.
Long tails represent uncertainty.
An upper tail is bearish and a lower tail is bullish.
What this signifies is that the market has rejected the prices reached by the significant tail lengths and astute traders can use this in their deliberations.
A common feature of candlestick formations is the tendency for them to act in pairs. This is not a convention but it practically implies that if a top reversal pattern was altered by a dark cloud cover pattern then the bottom of the new trend will often be altered by the piercing pattern, its counter pattern.
The notable consequence of using candlesticks is the help they provide at predicting potential turning points in price movement.
In a bull market you can use all the reversal patterns particularly the engulfing patterns but in a bear market it may be wise to confine yourself to the stronger reversal patterns such as the engulfing patterns given they are more reliable.
It is often advantageous to use candlesticks alongside familiar western indicators such as the MACD to provide confirmation or to apply a weight of evidence consensus approach.
It is important to guard against relying on a single pattern to signify a potential change to a trend. It pays to seek confirmation.
Often it is vital you tiptoe a little and look at other indicators before acting on a pattern.
Do not make the mistake of trying to apply reversal patterns in the wrong place.
You cannot use a bearish reversal pattern in a downtrend and likewise, you cannot
have a bullish reversal pattern in an uptrend.
Reversal patterns are very powerful signals but must be used to signal a reverse
to the trend that caused them to be identified in the first place.
It is very important that you do not neglect to set your stops when using candlesticks.
See the recommendations in the Further Reading section for a more exhaustive description of this enchanting but pragmatic topic.
A white candle means the period was bullish because the closing price finished above the opening price whereas a black candle indicates the period belonged to the bears since the close ended the period below the opening price.
A period could be a day, week, month or any time interval under analysis.
One of the strengths of candlesticks are the formations which are established over one or a number of periods to pictorially demonstrate the result of the struggle between supply and demand.
MORE ON CANDLESTICKS IN PART 3!