Candlestick Fundamentals

Candlestick Fundamentals

Japanese Candlesticks are a method of following market price action and identifying market reversal points and trends. Some people have tried to trivialize the technique - but I believe the more you know about them, the better you will become at trading with them. I explain it like learning a language. If you only learn five words - you won't be able to speak and understand the language well - right? If you learn to speak and understand the entire language base, then you will be fluent in it - and thus be able to use it more effectively.

The same thing applies to candlesticks. The more you know and the more you practice, the better you will become at using them. "Reading a candlestick chart" is something that comes after much experience with them - I call it the "Grasshopper Effect". After sometime, my clients contact me and normally say "It's Great! I see what you are saying now". This is when they have achieved a level of understand that allows them to "see the chart in TOTALITY" - they are able to see everything and how it all inter-relates. This is the ultimate goal of most traders - where they will get the most out of using candlesticks.

To get to this level, beginners must start with the basics and build upon this foundation to achieve a higher level of understanding. Let me start by explaing some of the basics..

Candlestick Basics (for beginners)

White Candles are also called "Empty" candles.
Black Candles are also called "Filled" candles.
The open~close range is call the "Body" of the candle.
The upper and lower wicks on the candle are called the "Upper Shadow" and "Lower Shadow".

Dojis are generall any small ranged bar where the open~close range is equal or very close to one another.
True Dojis are when the open = the close.
Dojis are a sign of congestion/weakness in the markets.
The body of all Dojis are support/resistance.

Size, Shape and Location are key factors when analysing candlesticks.
Size - shows the strength of the move. A larger candle shows more strength than a smaller candle.
Shape - different candle shapes (patterns) provide clues as to the potential future moves in the market.
Location - where the pattern forms can help determine the potential future market moves.

Candlestick patterns are the basis of the Japanese candlestick technique. We use the patterns as clues to the future of the market movement. The trick is to NOT concentrate on just one or two patterns, but to "read the entire chart". For example, if a BUY signal formed today, we would want to review the entire chart (most recent activity - 3 months or so) for other clues to the potential future moves in this chart.

The next level of analysis (for intermediate level users) is to blend (or filter) Western Technical indicators into the candlestick analysis. This process is somewhat simple, it requires the users to be familliar with technical indicators and their actions/reactions to price movement on the chart.

Ideally, when we find a potential "trigger" (buy or sell), we should review the candlestick chart for other patterns that help confirm or deny the current signal. At the same time, we should look at the technical indicators for signs of strength or weakness in this signal. We want to find triggers that are "timed" well with our technical indicator levels/conditions.

Another important fact is to review a longer term chart (normally a weekly chart for end-of-day traders), for other signs of strength or weakness. For example, if the weekly chart also shows a buy signal with good technical indicator conditions, we may have found a really strong contender. But if the weekly chart shows weekness or the technical indicators are not "timed" with this buy signal, then we may have only found a short-term "pop" in the market.

Candlestick Theory for Intermediate Level Users

Identify the candlestick pattern, then look for conditional "timed" setups in the technical indicators.

Remember to review the rest of the chart for other clues.. Try to find support/resistance (dojis) and other clues to help support this signal.

Now, use the longer-term chart to provide further confirmation of this potential.

Don't try to force the trade. Let the trade come to you - be patient.

At this point, we are getting into some of the more advanced topics of candlesticks. This is for people who already have experience with them and have mastered most of the basic skills. This next section is designed to help those people who need more than the basics above.

These advanced topics are partially from my own experience with candlesticks and the markets.

Candlestick Theory for Advanced Level Users

Follow the longer term charts
It is best to follow longer term charts (weekly for end-of-day traders and 15, 30, 60 minute for intra-day traders) to identify longer term trends. Then fall back to the shorter time frame (Daily for end-of-day traders and less then 15 minute for intra-day traders) to execute trades. In other words, never loose focus of the overall market trends. The reason everyone needs to follow the longer-term trends is simple - you need to know what direction the market is moving. The shorter term charts focus on the "mirco trends". The longer term charts focus on the overall trends. Blend the two together for the best view.

Use Risk Management to Protect Your Trades
Use appropriate risk management when trading. Don't trade out of fear or greed. Wait for the trades to come to you and execute a "smart" trading plan.

Know what to do at all times
Know what will happen before it happens. In other words, know what to do if your decision is correct and know what to do if your decision is wrong. Have a plan and use it. The most important factor here is "what to do if you're wrong"

Identify targets and have an "Exit Plan"
Identify a profit target or projected target level. If you buy a stock, know where you think it will go, then plan an exit strategy at (or near) that level.

Example:

Let's say I purchased 500 share of XYZ at $13 off a buy signal. I should know exactly what to expect if I'm wrong or right about this trade. If I'm wrong, My $0.50 stop will protect me from extended loss. If, I'm right, my initial target will be $14.50 (where I'll probably sell 300~400 shares). At this target, I'll move my stop above my entry price and continue to trail the stop higher as the stock trends.

This is the type of "plan" you should have for all your trades. The only thing you want to leave to chance is the price action. You should know exactly what to do in any event within your trade.

Time your Entry Trades to Maximize Profits and Minimize Risk
Time your entry trades. You don't have to just use market orders to enter trades. Let's say you see a buy signal on the weekly chart, but see some weakness on the daily chart (or market volatility - up and down swings in price). You could enter a MARKET order and your STOP to enter the trade, or you could try to "time" the entry using a LIMIT order and a stop.

Example:

Let's say I wanted purchased 500 share of XYZ at off a buy signal (say it closed at $13). If I see some potential for a better entry price (below $13), I might try to use a LIMIT order to enter the trade. Say I place a limit order to buy 500 shares of XYZ @ $12.75. If, I'm correct, I'll have cut my risk in half and added $0.25 to my potential profit target. If I'm wrong, I might have to get in at a higher price.

You can see how, if properly used, this technique can help you maximize your potential. The drawback to this is then you were right and the market just runs. Then, you might have to get in with a market order (after canceling your limit order).

Don't leave exposed profits on the table
If you entered a trade and it is moving in your direction, use a trailing stop to find the best place to protect your trade. I like to use DOJIS and support/resistance for these levels. Here are some hints...

After my trades move in my favor, I try to find the best place to move my stop to breakeven or better. Normally, you have to see a decent price move before you can safely do this.

After moving higher, I might try to move my stop above breakeven (to try to lock in profits).

If the stock reaches your initial target, liquidate 50+% of the trade (you've achieved your goal - a profitable trade). Now, move your stop to lock in the rest.

At the first sign of weakness (especially if your target has been reached), move your stop to protect against a pullback. Think of it this way, better to place a tighter stop and lock in profits, than leave it unprotected. So what if it gets stopped out, you made a profit and will get the next one.

CONTINUE

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