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Trader's Corner

Summing Up

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It's time to sum up previous Traders Corner articles on candlestick charting methods. Those articles appeared in OptionInvestor editions from Saturday, June 11 through Saturday, July 9. They covered the basics of candlestick charting methods, including identifying important candlesticks and key candlestick patterns. Candles offer many advantages over traditional charting methods, enthusiasts feel. Some of those advantages concern the ability to quickly assess the health of the market and see a potential pattern setting up before it might be recognized on other charting methods. Some find accumulating basic understanding of how candlesticks work to be easy, also an advantage.

However, some points from previous articles need reiteration. For example, wait for a reversal signal's confirmation before assuming that it will confirm. A doji at the top of a climb may be a signal of indecision or waning strength, but that indecision might be resolved the next day with another climb.

Also, consider the market climate when deciding on the reliability of candlestick reversal patterns. Previous articles pointed out that reversal signals prove more reliable when they occur at known or likely resistance or support. Conversely, a reversal signal occurring in the midst of a strong trend and signaling a reversal from that trend, perhaps not at support or resistance, may not be as reliable.

Note: Charts were searched over several weeks to find appropriate charts to illustrate the formations and do not indicate current prices.

Annotated Weekly Chart of the SPX:

Annotated Monthly Chart of TIE:

Obviously, account management skills prove as important with candlestick signals as they would with other technical analysis methods. The first account management skill to be addressed concerns whether a trader would open a trade based on a first reversal signal following a strong trend, with that reversal signal not at proven resistance or support. Just as with traditional charting methods, reversal signals against the trend might warn of a need to hedge positions or alter stops rather than suggest new entries against the trend. Steve Nison mentions this way of utilizing candlestick reversal signals in BEYOND CANDLESTICKS.

Because TIE's reversal signal indicated on the last chart was against trend and occurred at a new high without known resistance levels to guide traders, prudent traders would not have entered a bearish trade on the reversal signal. However, imagine that cowboy (or girl) traders, seeing that the reversal signal occurred as $20.00 was being challenged, decided to test the waters with a bearish play. Such traders might have felt that they could set a reasonably close stop for their plays if they were basing them on a reversal signal produced at possible round-number resistance. TIE's chart demonstrates that such traders needed a logical stop. Aggressive trader or conservative trader, candlestick pattern or more traditional pattern, logical stops are needed.

Nison probably wouldn't have liked the risk versus reward parameters of a bearish entry on TIE as it was testing $20.00, and neither would this writer. However, Nison does offer guidelines for setting stops. He suggests that in an instance such as this one, when a bearish trade would have been entered on the evidence presented by a bearish engulfing candle, that the stop be set on a close above the bearish engulfing candle. He points out that sometimes prices are pierced on an intra-period basis, but the bulls or bears may not have enough strength to invalidate the reversal signal on a closing basis, so he emphasizes closing values. Traders must evaluate whether waiting for a close works for their trading and account-management styles if prices are moving strongly against a trade intra-period, of course.

Similarly, if the reversal signal had been an evening-star formation, the stop might have been set at a close above the doji that formed the central candlestick of that three-candle formation. Setting a stop at a closing value that invalidates the reversal signal helps determine risk, but what about the reward? While candlestick charting methods provide many advantages, one disadvantage comes to mind when matching risk versus reward to one's preferred trading style. Unlike some other types of technical analysis, candlestick reversal signals offer no targets. The candlestick chartist must rely on other types of technical analysis to establish likely targets. For example, consider the morning-star formation depicted in this article's first chart, the SPX weekly chart showing last summer's action.

Annotated Weekly Chart of the SPX:

The points made in this article include considering preceding action when deciding whether to trust a candlestick reversal signal. Has a security been trending strongly higher within a rising regression channel, just now testing the top of that regression channel? A bearish reversal signal might not represent a good risk versus reward parameter. Such a signal might precede sideways consolidation or a brief pullback to the other side of the regression channel rather than a strong decline. Has an entity been trending strongly downward, bouncing back after each test of a 21-pma? A bullish entry on a morning-star formation just below that 21-pma might not represent a good risk versus reward parameter, either.

Since candlestick charting methods do not offer targets, traders' favorite tools for determining targets must be combined with candlestick charting methods to determine risk versus reward parameters. Good account management is as necessary for trades entered on candlestick reversal signals as for any other type of trade. Set stops on closes that violate the reversal signal.

Whether or not one elects to take trades based on candlestick signals, they offer many advantages, including easily assessed visual clues as to the market's strength or weakness. Even if you do not anticipate ever taking a candlestick buy or sell signal, they offer enough advantages to argue that they ought to be utilized. If these articles have interested you in this method of charting, consult Steve Nison's JAPANESE CANDLESTICK CHARTING TECHNIQUES, Greg Morris' CANDLESTICK CHARTING EXPLAINED or other books on candlestick charting.

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