February 24, 2019

Candlesticks with Context

Candlesticks are exactly the same as any other charting method in that they represent historical market activity in one form or another. A moving average for example is just an average of price over a set period rather than the price at a particular point within a set bracket of time. Whichever method is employed, it must allow the user to see certain facets to how a market traded historically and thus give them a better idea of what the activity might mean for future prices. Candlestick patterns are particularly helpful in quickly and visually identifying the various repetitive price movement patterns which often lead to the market subsequently moving in a particular direction. However, if it were always as simple as just trading the occurrence of a candlestick pattern, far more traders would be successful than there currently are. The key to adding a greater level of consistency to trading these patterns resides in knowing what the market has done and where the pattern is located. This is technical context.

All markets where you can buy or sell a product or contract are fundamentally auctions. The very basics of this idea are that current prices can be seen as fair with the market moving back and forth through accepted fair value or they can be seen as unfair and the market moves directionally ‘searching’ for fair value. What it really boils down to is that any market can be range-bound or it can trend and all markets move from one to the other and back again in various different timeframes. Using this principle, we can identify places where a market changes from one condition to the other or remains the same and therefore gain some context about how it might move given a certain reaction to this context. This reaction can be interpreted using candlestick formations. Merely spotting a formation and assuming it will always mean the same thing however, is never going to be as consistent as assessing each occurrence on its own contextual merits.

Here’s an example from Apple (AAPL) where I’ve simply highlighted a few different patterns:-

Clearly there are many more candlestick patterns within this snapshot, but for the purposes of this exercise I wanted to point out a few which clearly failed.

Let’s elaborate on the context of the same example. Here’s a zoomed out view AAPL over a longer period, just prior to the previous chart:-

Although there is a clear uptrend in force in the longer term, the reason I’ve noted that the trendline is only “possible” is due to the fact that it’s only touched twice up to this point. So it’s there to be aware of, although not necessarily to be used as a support line.

Moving forward in time and back into the first chart we looked at:-

You can see much better now that once the short-term trend (green line) breaks, a range is established. You might have decided that actually it would be better as a pennant-like formation with a descending trendline from the top of the range. Even though you’ll probably notice that there are opportunities by doing this, I’m focusing on going with the long-term trend. Therefore what matters is where support is coming in and that the market has come into balance. Ranges can break or they can expand. Here, we see two expansions down. The first is followed by a decent move upwards and the second is followed by a test and break of the entire range in the opposite direction. Taking another look at the long-term picture:-

In the second expansion, you can clearly see that not only was the attempted downside range break a bullish hammer reversal candlestick, but also it completed or verified the potential long term trendline already in place. Using all of these ideas in combination to form broader context would have given a trader the confidence they needed to place a very good trade indeed. So when you trade with candlestick patterns, make sure you use them with technical context.

Trade well.