By Sam Evans, Co-Founder & CEO
What are candlestick patterns? Put the term into a search engine and you’ll get a ton of hits. If you have searched the term it means you’re interested in learning more, and I’m all for that. It has been said that an investment in yourself is by far the best investment you can make. Personally, I could not agree more with this statement. One of the biggest advantages today, is that information is literally at our fingertips.
When I began my own trading and investing journey, I could not get enough education! I bought many books, combed through as many articles as I could find online, and spent hours at the charts. I digested a lot of information and the experience overall was useful to some degree. However, I also soon realized that “information” is not always the same thing as “education”.
If you are currently expanding your financial education, Japanese candlesticks and candlestick patterns are likely something you have studied. They are an important price of the puzzle, as without candlesticks it is hard to read price charts. The candlesticks themselves tell us if prices are going up, down, or sideways. Used in the correct manner, they a powerful tool for honing our entries, stop losses, and exits. Without a doubt, Japanese candlesticks and their patterns are a vital tool for analysis. However, they can also cause as many problems as they solve.
It took me a long time to learn all the different names of the various candles and what they meant on a price chart. I remember drawing each one out and revising and testing myself to see if I knew what it was called and if I also knew what it meant on the chart when the candle formed. It felt like I was revising for an exam when I was back in school! I distinctly remember looking at my price charts and getting excited when I saw those special candles form before my eyes. Rushing through my notes to see if I should be buying or selling. I wasted a lot of time staring at the screen. Other times I jumped into the market way too late after reacting to a pattern, only to get it completely wrong.
It soon occurred to me that the problem was not with the candlestick patterns, it was with me. With how I was using them in my analysis and executions. As you will soon find, all patterns and indicators lag price. This means they are nothing more than signals of what may happen. They are no guarantees and reacting to a signal is not the same thing as planning a setup. Always remember this first and foremost.
Before I go any further let us look at some of the most basic candlestick patterns you will find on most charts today:
Above shows five of the most common and widely recognized candlestick formations from classic technical analysis. They each represent a certain change in price direction when they appear at specific points during a trend. The engulfing candle suggests a continuation of the trend. While the hammer or hanging man is usually found at the end of a trend and suggests a reversal. Another sign of a potential price reversal is the Doji, which implies signs of indecision and that a shift in momentum is looming in the market. While it is good to know these different names of these candlesticks, just by looking at their structure alone you can get a good idea of whether we are seeing strong buying and selling pressure, or simply a state of indecision.
A hammer candle really tells us that prices were pushed down significantly, only then to see strong buying stepping in to push the price back up. The hanging man is the exact opposite of this. It shows us that while prices did rise on the candlestick, intense selling pressure came in at the top of the candle’s range, resulting in the price being pushed back down and closing much lower in the overall range. We expect to see patterns and events like this forming around major market timing points where trends tend to end, and new ones likely begin.
As with most things in trading we also need to focus on price itself too. The typical methods that most traders use to incorporate candlestick patterns into their trading, tend to lead to poor entries and weak risk to reward scenarios. One of the most common uses I see of candles, is when a trader or investor waits for a candle to close positive or negative before entering a position. This often leads to a late entry and greatly impacts the overall risk to reward profile of the setup. Here is such a scenario in more detail:
In the above example, I have marked off a Support Zone area, one of our ideal buying setups at StockAbility. The zone suggested a key price transition area on UBER where new buyers jumped on board the mover after a nice pause and accumulation. The plan is to buy a retracement back to the zone with a tight entry and a stop loss order set just below the lower of the 2 lines in the support zone. This is a protection order to get out of the trade if we are wrong, with just a small loss. We have planned and will set the trade accordingly. The results were follows:
As we can see, the price dropped rapidly down to our support zone and triggered a buy opportunity immediately. We then saw a decent rally up to resistance around $55. This gave a move of around $3.50 with a risk of about $0.50. before buying. This risk to reward ratio was only achieved by buying when the price first came back to the support zone. If we had waited for the candle that triggered the support zone to have closed higher before buying, we would have entered around $53.00 and right now if still holding, would be sitting on a losing position. I personally prefer a situation where I am already in a position. The candle pattern just then confirms that it is a good trade.
This first reason to take a trade should always be due to what the prices are telling you. Everything else becomes supplementary. Understanding candlestick names and patterns is a useful skill to develop. Just remember that like most things, it is just one piece of the overall puzzle. Candlestick patterns should be a decision support tool and a way to increase probabilities in your favor. If you combine candlestick patterns with a rules-based trading and investing plan, then potentially you have something which can greatly enhance your consistency and reduce your risk on your trades. I hope this was of help.
Be well and take care,
– Sam Evans