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Some Practical Examples and Trading Strategies
The
interest in candlestick charting is quite high. In the past two sets of
articles on this subject we have explained the construction, the logic
behind the construction and the information that is gleaned from the
candle patterns that one sees on the charts. We also discussed
different types of candlestick patterns that one sees normally in the
markets. We discussed several types of patterns with single, dual and
multiple candlesticks. Certain rules pertaining to these patterns were
mentioned and we rounded off the second write up with some mention
about the salient points of the candle patterns.
In this part
of the ongoing topic of candlesticks, we shall look at some of the
practical applications of candlestick patterns and learn their
application in real time analysis. It will be seen from the examples
that candlestick charting is more about common sense and less about
recognizing the patterns. This is a common mistake made by most of the
people who seem to concentrate only on the pattern and try to memorize
all the funny sounding names and their appearance. If, instead, they
concentrate on the logic behind the pattern it may be easy to use this
excellent method to analyze and trade the markets.
Let us start
with the Index chart and see if we can spot some patterns and how
candle charting would have helped us analyze the index.
This
is a chart of the Sensex in the period of Oct-Dec 1998 when the index
was making a bottom. Note in the above chart four points marked 1
through 4. All these candles are around the same price levels. What is
notable about them is that they are the major drives to the bottom and
each one of them has a lower shadow. When a stock is trying to make a
low, one would usually find such a tendency. A lower shadow suggests
the rejection of lower prices by the markets. In other words, it shows
that buyers are entering the scrip at lower levels.
The chart
also has two candles marked LB on the left side. This stands for Long
Body. Notice that these are the two longest body candles in the period
under observation. Right through the three-month period, the index was
unable to move past these long body candles. Recall our earlier
discussion that long body candles will offer support/resistance at
their top middle and bottom. The chart also shows a horizontal trend
line drawn from the top of the long body candles. It can be seen that
the index managed to cross this major resistance only around the New
Year time.
The conclusions to be drawn from a candle analysis of
this daily chart are that the index is attempting a bottom but the
level around 3035 was offering considerable resistance. A breakout
beyond the top of the long body candles was a positive signal of
strength and since this also coincided with the breakout past the
consolidation range it was a double signal.
We
now move along another three months. The breakout that occurred in the
earlier chart carried the index strongly and it rose by about 500
points. This move ended in an Evening Star pattern – shown as a boxed
area marked ES. This bearish pattern coming at the end of a good
advance meant that the probability of the advance being over was very
high and hence profit booking was called for. Prices fell off and got
into a consolidation with no distinct candle patterns of reversals.
Within the congestion we had number of dojis and shooting stars and
engulfing patterns. But these have no value when they are found inside
a congestion zone. That fact is clearly shown here as the reversal
patterns produce no effect and prices remain confined within a band.
On
the right side note a candle marked LBW standing for Long body White.
This is the largest White (bullish) candle since the start of the
congestion. New moves or possible breakouts of congestions zones
usually occur in this fashion. One was alerted to the possible change
in gears by the market and this was confirmed on the following day when
the index continued upward with another gapped white candle.
In
Chart 3 we move along another few months ahead. There are no worthwhile
candle patterns down into the bottom in May. In this fall, there was
one classic false signal – marked FS on the chart. The candle marked FS
is a long white, which has followed two doji looking patterns.
Normally, double dojis are very strong reversal patterns. Since they
came in near the end of a decline, one would have been alert for
reversals. The long white following this would have prompted one to
action.
But on the following day, there was absolutely no follow
thru. In fact, the index stayed below the half way of the candle for
the next several days. This was signal enough of a failure. In keeping
with pattern failure, the market makes a new low (this is usually a
feature – pattern failure occurs at the penultimate stage)
The
index then takes off. Now we have points marked 1 thru 5. At 1 note a
Hanging Man pattern. Usually, the appearance of such a pattern suggests
an exhaustion of the trend. However, the pattern was not confirmed the
following day. A couple of days later, a Bearish Engulfing is seen at
2. It is immediately confirmed on the following day with a down black
candle. A sharp fall occurs which is arrested with a formation of a
Morning Star pattern at 3. The market waits for two days before
commencing on a rise signaled by this main reversal pattern. The rise
continues to 4 where another Evening Star forms. The damage from this
pattern is not much and at 5, the pattern has been swiftly reversed.
Now, this is pattern failure and should lead to a new high. Also, the
next high should be a strong one.
In
chart 4, at point 1 the upside breakout occurs to produce a strong high
from where a long consolidation begins which lasts almost four months.
A small decline is set off with a Dark Cloud Cover at 2.
This
phase is a good example of how even stronger patterns fail within
consolidations. An Evening Star at 3 and Morning Star at 4 have both
failed. Note that they both produced a new swing extreme beyond their
levels. At the end of October, it is seen that the movement is having a
gentle upward bias so an upward breakout is expected.
The
expected upside breakout of Chart 4 occurs at 1 and a brief run occurs
to a new high. But at 2 a murderous Evening Star is formed. Note how
deep the black candle is. Such star patterns seldom fail. This pattern
is then followed by a strong decline, which has a number of black
candles showing that the fall was strong. It ends with a long body
candle at 3. An equally long white candle suggesting a reversal of the
downtrend immediately follows this. Another long body white at 4 takes
the trend into overdrive with a big gap. This phase is a good example
of long body at work.
The
long white, which moved up with a gap, was succeeded by a congestion
(left) At the end of the congestion note a hammer type pattern. The dip
below the long white was a shadow and the body of the hammer remains
above the support trend line drawn.
More roles of long bodies
are seen at 2 and 3. The top ends with a long body black and the
acceleration down starts with a long body at 3. We find a rare pattern
at 4 called the Abandoned Baby Top (akin to the island pattern of
traditional technicals)
Though the index declines to 4200
levels, note the complete absence of any reversal patterns and that all
blacks are still long bodies. This suggests further fall to occur.
In
Chart 7, we find the market taking off like a rocket once again from a
bottom. This leads to a doji at 1 but that is quickly reversed and
market moves even higher. At the top at 2 it forms and Engulfing Bear
pattern which is immediate confirmed by strong declines. The decline
ends with a long body white at 3. Note that the long-range bar halted
the slide and prices took some time to move past it. Now its high is
providing support for declines.
The
rise continues to make a high where a Dark Cloud Cover pattern (at 1)
sends the index down. In the decline it breaks below the support
offered by the last long white (at 2) and proceeds further down. A
small consolidation pattern is broken by a strong black (at 3). This is
usually how all breaks happen. It should have been clear by now that
any good break happens with a long body. At 4 a long body reversal
white pattern ends the decline and sends the market up for another
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