Better than Candlestick Patterns – Part Three

In parts 1 and 2 of this short article series we discovered a technique for determining the short-term sentiment displayed by any sequence of candles.

(Go here first if you missed part 1 or part 2)

It’s time now to consider the context.

‘Consider the context’ means we consider where the current price pattern appears with respect to the background market environment and price action, and what that means.

The same pattern can have numerous meanings, depending on where it occurs in the market.

Referring to the diagram below, we can see that the Low Close Range Candle on the left hand side is occurring after a weakening of an uptrend right into an area of resistance. The first bullish candle broke above recent price action and penetrated the resistance area by a couple of pips before being rejected. Trapped longs will be exiting on any break below this candle. Although a low close range candle is generally considered to display neutral sentiment, when we consider the location of the pattern it has reasonably bearish connotations.

Compare that to the low close range candle on the right hand side, which is occurring within the middle of a period of narrow range sideways congestion. The occurrence of this pattern in this location shows absolutely no sign of any potential change to market bias. This is clearly neutral.

 

 

In determining the impact of a candle pattern, you MUST consider where it is occurring on the chart.

While I monitor all candles as they develop, and the ebook will go into more detail on this process, what we’ll consider here in this article is the most important locations, at which you MUST observe price action.

Changes of sentiment at these location can have very significant meaning for future market bias.

These ‘important locations’ will typically be any location which plays a part in defining your market structure or your trend. I trade based upon support and resistance levels, so in considering the context of background market structure and price action, I primarily look at three main areas…

Where is price in relation to the higher timeframe S/R? Where is it in the trend? Where is it in relation to key swing highs and lows? And what does this mean?

 

Support and Resistance

  • Where is the pattern occurring with respect to higher timeframe support and resistance?
     

  • Has the market shown strength or weakness on approach to the S/R area? Is the current candle pattern sentiment continuing this strength or weakness, or has something changed?
     

  • Is the pattern showing signs of orderflow opposing the move into S/R, such as tails rejecting price at or near the S/R level?
     

  • Has the pattern breached the area of S/R? If so, is it now showing signs of acceptance or rejection of this new area?

 

Trend

  • Where is the pattern occurring within the current trend?

  • Is it on an extension? Is it early in the move, or late and overextended? Has it managed to pass the previous swing high/low?
     

  • Is it on a pullback? Is it early in the move, or has it continued deeper than anticipated? Is it a single swing pullback, or is this pattern a part of a multiple swing retracement.
     

  • Or is the pattern within a sideways trading range or other form of consolidation pattern?

 

Swing Highs and Lows

  • Is price testing any areas of swing highs or lows?

 

For an uptrend:

  • Pullbacks to previous areas of swing low support should be watched closely. We expect them to hold. Is the price action showing signs of the level holding, or is it threatening to break? If it breaks, is price showing signs of rejection (opposing orderflow / difficulty continuing) or is price accepting this new area?
     

  • Pullbacks to previous swing highs (within an uptrend) are not as critical, but should still be watched for their reaction.
     

  • Extensions are expected to break the previous swing high. Is price action supporting that premise, or is the candle pattern showing weakness. If it can’t exceed the previous swing high, we need to be alert for further signs of weakness which may forecast a complex correction or reversal.

 

For a downtrend:

  • Pullbacks to previous areas of swing high resistance should be watched closely. We expect them to hold. Is the price action showing signs of the level holding, or is it threatening to break? If it breaks, is price showing signs of rejection (opposing orderflow / difficulty continuing) or is price accepting this new area?
     

  • Pullbacks to previous swing lows (within a downtrend) are not as critical, but should still be watched for their reaction.
     

  • Extensions are expected to break the previous swing low. Is price action supporting that premise, or is the candle pattern showing weakness. If it can’t break the previous swing low, we need to be alert for further signs of weakness which may forecast a complex correction or reversal.

 

For a sideways trend:

  • Is price testing a range boundary?

  • Has the market shown strength or weakness on approach to the boundary? Is the current candle pattern sentiment continuing this strength or weakness, or has something changed?
     

  • Is the pattern showing signs of orderflow opposing the move into the range boundary, such as tails rejecting price at or near the level?
     

  • Has the pattern breached the area of range S/R? If so, is it now showing signs of acceptance or rejection of this new area?

 

 

You’ll note as we discussed these areas of influence that they simply raise a lot of questions rather than provide you with answers. Fixed rules don’t apply here. There is no rule that states if a bullish sentiment pattern occurs at position xyz on a chart, then it means …

Every occurrence of every pattern is unique.

By considering the pattern in the context of background structure and price action, we are ultimately attempting to gain a feel for how that pattern will impact upon the strength and weakness of the underlying trend, and how that might influence future orderflow.

While many elements of a price pattern can be objectively seen on a chart, determining the influence that pattern will have on future price action is a purely subjective process.

You gain that subjective feel through questioning what you see on the charts.

The next step…

So, having defined the sentiment of the current pattern, and considered the behaviour of price at key context areas, what’s the next step? We’ll talk about that in the next article, part 4, where we wrap up this series and discuss how we use this information…

More to follow in Part 4…

Lance Beggs

Followup Articles:

Part 4 – http://yourtradingcoach.com/trading-process-and-strategy/better-than-candlestick-patterns-part-four/

Part 5 – http://yourtradingcoach.com/trading-process-and-strategy/better-than-candlestick-patterns-part-five/

 

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