Advanced Candlestick Analysis (Part 2 of 2)

 

Welcome to part 2 of our short article series on Advanced Candlestick Analysis.

If you haven’t read part 1, you’ll find a copy posted at this webpage: https://yourtradingcoach.com/trading-process-and-strategy/advanced-candlestick-analysis-part-1-of-2/

In the last article we reviewed some of the key concepts from basic candlestick analysis:

• The importance of identifying the market context – where the pattern is happening within the market structure,
• The importance of trading (primarily) with the trend – yes, a reversal pattern can also be applied at the end of a retracement, signaling continuation of the larger timeframe trend, and
• The importance of understanding the probabilistic nature of the markets and the need for risk and money management to protect your downside.

 

We discovered that contrary to popular belief by those new to the industry, Advanced Candlestick Analysis (if there is even such a thing)^* does NOT involve:

• Better, and more secret, candlestick patterns, or
• Some Holy Grail combination of western technical indicators and candlestick reversal patterns.

 

Instead, it simply involves seeing the flow of price in a whole new way.

I like to think of it as being like the Magic Eye books, posters and prints (http://www.magiceye.com/3dfun/stwkdisp.shtml) that became popular back in the 90’s, where to the uninitiated the picture was just a blur of color and shape, but through a slight refocusing of our vision the trained observer is able to see a hidden 3D image.

Thankfully, Advanced Candlestick Analysis does not require squinting or changing the focus of the eyes.

All it takes is an understanding that candlesticks are a visual representation of the bullish or bearish sentiment within the timeframe represented by that candle, and then using the power of questions to compare the current candle with those preceding it, in order to sense the changes in bullish or bearish sentiment as price flows from one candle to another.

We finished up last time with a small collection of sample questions, to help you see the changes in sentiment:

• Is the current candle able to push beyond the previous candle high/low, in the same direction as the previous candle? Is it able to close in this area, or was the candle breakout rejected?
• Has the candle moved beyond the previous candle’s high/low, against the direction of the previous candle? Is it able to close in this area, or was the candle breakout rejected?
• How far does the current candle penetrate within the body (or the range) of the previous candle?
• How far does price extend beyond the previous candle body (or range)?
• How does the current candle’s range compare with previous candles?
• Is there a long tail at either the high or low of the candle, and what is the significance of this price rejection?
• How has price acted on reaching any significant areas, such as areas of support or resistance, previous swing highs or lows, previous day’s high, low or close, today’s opening price or opening range (or any other areas you deem to be significant)? Did the market accept these prices, or reject the area?
• Is the momentum of the current price swing increasing or decreasing, especially as it moves towards the significant areas listed above?
• Has this candle trapped anyone long? Or short? Or trapped anyone out of a position prematurely?

 

These of course are just examples, and can easily be replaced by any others which allow you to better sense the shift in market sentiment.

Ultimately, your aim is to answer the following question – “Does the current price action confirm my previous bias? If not, how is the sentiment changing and does that change my bias?”

Confused? Hopefully an example will help…

We showed the following chart in Part 1 (GBP/USD, 26 May 09, 5 minute) which has a hammer at the bottom of a downtrend. Perhaps not a perfect textbook hammer as there’s a little more ‘tail’ above the candle body than necessary, but a great signal nonetheless.

 

 

I left you with some homework, which involved analyzing this chart bar by bar, questioning the bullish or bearish nature of each bar, and how it relates to the previous bars to determine your bias. The aim of the exercise was to see if you could find some reason why the hammer was a great BUY entry trigger; apart from the fact that it matched (or was close to) the hammer pattern displayed in the text books.

So, let’s now have a look at how I see the changing sentiment within this chart.

Two quick points before we start though:

1. In the interests of keeping this article a little shorter than it otherwise would be, I won’t comment on every candle. Only those that provide significant information, most relevant to supporting or altering my market bias. Comments on each candle will be kept relatively short as well. I won’t be answering each of the above questions in detail – only pointing out what I feel are the obvious and relevant points after having asked myself the above questions.
2. I am well aware that this analysis is carried out with the benefit of hindsight (try as hard as I can to not look at the right hand side of the chart; it’s just not possible to ignore the rally from the hammer). That doesn’t mean this is a worthless exercise. Take it for what it is – an example of the kind of analysis that can be used live, as the market unfolds, to maintain or change your market bias. The reality is that live market analysis will be much more complex. I personally also include a larger timeframe to provide a market structure identifying key support and resistance zones, and a shorter timeframe to fine-tune my analysis and my entries and exits. Neither of these are considered in this analysis example (the article would become too complex). However, the concept demonstrated here is the same. Take what appeals to you, and adapt it to your own methods.

 

 

The starting point prior to candle 1 is a weak-bearish bias. While the sideways congestion prior to candle 1 would normally indicate a neutral bias, the preceding price action (not shown) is a strong downtrend with the current sideways movement representing a pause in this trend. Those operating on multiple timeframes may have an opportunity to fine-tune a short entry at the upper boundary of the congestion, anticipating a continuation of the downtrend, however that’s not an option based on today’s single-timeframe analysis.

 

Candle 1 –     A strong bearish candle breaking the lows of the congestion. The range is noted as significantly greater than previous candles and closing right near its lows – a great show of bearish strength which confirms the continuation of the previous bearish bias. Breakout traders (short) would have scored a nice entry here, so the point of breakout is now a key level for future price action. Any rally back to this area is likely to face some resistance as the bears who missed the breakout take advantage of the second entry opportunity, and any bulls who are now trapped long take the opportunity for an exit at a smaller loss. If price returns to the breakout area, I’ll be looking for an entry short in the direction of both the trend and my bias.

Candle 2 –     An upper tail representing a small fight back by the bulls. No change to sentiment, although it’s noted that these lower price levels are now attracting some buyers and/or profit-taking on the part of some of the earlier shorts.

Candle 3 –     A second push by the bulls. I personally love second attempts at a move – especially when they fail as they often lead to a great move in the opposite direction. In this case though I’d expect a continuation upwards, especially as the breakout of candle 2 lows would have attracted some late shorts, who will now be feeling a little stressed and will possibly exit (long) if price can continue above candle 3 highs. The bias is still bearish due to the inability of candle 2 and 3 to penetrate significantly into the body of candle 1. However I wouldn’t be surprised to see continuation of the rally, perhaps up towards the original candle 1 breakout point.

Candle 4 –     As expected, price continued to rally. No change in sentiment yet, as it’s taken three candles to retrace two-thirds of the single bearish breakout candle. Pressure is still to the downside, with price now approaching the area of expected breakout resistance.

Candle 5 –     A bearish engulfing pattern, signaling continuation of the downward bias, anticipating at least a test of the candle 3 lows. Single timeframe traders may wish to enter a break below this candle. That’s not my game though (too much risk for this little risk-averse trader). My preference would have been to fine-tune an entry on a lower timeframe somewhere closer to the highs of candles 4 and 5. But that’s not the point of this exercise, which is to demonstrate changes in sentiment and bias. Downward bias remains intact.

Candle 6 –     A retest of the candle 3 lows, with a lower tail showing buying support at this level. The downward bias remains intact but is threatened. This support level is now a key level. A break of this level is essential to maintain a bearish bias. Failure to do so will indicate a change to weak bearish, or even neutral. There’s no evidence of any reason yet to be bullish.

Candle 7 –     The minor support is broken with an increased surge of bearish momentum. Our bearish bias continues. A new breakout point has been established offering potential future resistance, although not as strong as the original point at the candle 1 breakout.

Candle 8 –     Continuation of the bearish sentiment through rapid rejection of the downtrend rally.

Candle 9 –     A bullish candle (possible hammer if confirmed) signifying potential end of this downswing. Of particular note is the fact that it closed near its highs and above the previous close, rejecting much lower prices. Bias is still bearish, although the downtrend is setting up for a potential rally.

Candle 10 –   Interesting…a fairly strong bullish push from the lows of candle 9 to the highs of candle 10 (also the breakout point on candle 7 where we expected some resistance). There was a significant fight back from the bears though in the latter stages of the candle, to close it below its midpoint. Both bulls and bears appear active now. The trend still remains down, and will remain so until the candle 4 & 5 swing high is exceeded, however the bearish bias is weakening.

Candle 11 –   A second rejection in the vicinity of the candle 9 lows. The bias is definitely weak bearish.

Candle 12 –   Third rejection of this price support area. What did I say before about failure of two attempts at a move? Failure of three attempts is even better. My bias here is neutral, or perhaps very weakly bearish considering that it’s still in the context of a larger downtrend. I very much expect a rally to a new lower swing-high, within the downtrend, and would have been looking to fine-tune a lower timeframe entry long, perhaps targeting the price rejection at the highs of candle 10. Please note that any attempt to go long at this stage would be with the expectation of a quick counter-trend trade only. There is still no evidence of a bullish move which could perhaps threaten the downtrend.

Candle 13 –   Maybe spoke too soon. Candle 13 is very unlucky for anyone in a short trade (short direction, not timeframe). This is a strong bullish candle, opening on the lows and closing right near the highs, producing the largest range bullish candle so far displayed on the chart. This is the first point at which my bias would be shifting to the bullish side of neutral, although only slightly as we’re still in a downtrend.

The key beyond here in development of our bias is being aware of the potential future actions of both bulls and bears, based on current price action. Bears would likely be threatened by this price action. A significant number of them may now be in drawdown on their position, but even those that are still in profit will note this rather bullish candle following three bullish rejections at the last swing low. Some bears may be exiting immediately, but more will probably just start reviewing their exit strategy. They may consider tightening up stops beyond swing highs (candle 10 or candles 4 & 5) if not already done so, and also perhaps taking profit on a retest of the candles 9-12 low if price shows evidence of further stall in this area.

The bulls, long from the candle 9-12 lows, will perhaps take partial profits in the vicinity of candle 10 highs, with the swing highs at candles 4 & 5 providing the next opportunity, so I wouldn’t yet have any reason to expect a runaway bullish move here. However any further stall on a retest of the lows could have me very interested in a change to bullish bias and an entry long.

So, the key area for me, if my bias is to change to bullish, will be how price handles any return to the area of congestion at the previous lows (candles 9-12 and the price action immediately above). If bearish sentiment is to remain the dominant theme, then the bears have to demonstrate an ability to take out these lows. Inability to break the lows will potentially signal a change of bias. Of course, this could be many candles away and our plan may change well before then, depending on future price action.

Candle 14 –   Stalling of the rally, in the vicinity of the candle 4 & 5 swing high. Note the reducing range in each of the four candles involved in this rally, showing a slowing of momentum into the swing high. Candle 14 is the first to close bearish though.

Candle 15 –   Nice lower tail indicating that more traders are becoming increasingly confident in a bullish move. This tail is likely the result of the lower timeframe traders entering on a lower timeframe pullback to the point of candle 13 breakout above congestion. My bias is still slightly bullish, but I’m not chasing prices and am waiting for a tradable entry on a test of the lows, as mentioned earlier.

Candle 16 –   Bearish candle. Good fight back by the bears taking the swing from candle 12 to 14 as an opportunity to reenter short. My bias remains very slightly bullish. This bearish candle won’t change the bias yet as I’m watching for signs of support to hold at the lows.

Candle 17 –   Possibly an opportunity for long entry on a lower timeframe. No indication of that though based on this single timeframe analysis. Of note is the slowing of bearish momentum evidenced by the reduced candle range and minor rejection of the lows as it hits support. Had the bears been a dominant force, they would have pushed straight through support. As this hasn’t happened, we see further evidence of the change to bullish sentiment.

Candle 18 –   As for candle 17, possibly a lower timeframe entry long. I’d personally be very happy with an entry here if it was offered. Although a doji shows indecision, this one has a slightly bullish feel to it as the candle 17 lows are once again rejected and price closed at about 2/3 of the way up the candle range. If I was a single-timeframe trader, just conducting analysis off this price chart, I’d be placing a stop-entry order above the highs of this candle.

Candle 19 –   Any candle 18 stop-entry order long would not have been triggered. However any lower timeframe intra-candle entry would have either been stopped out for a small profit, small loss or breakeven, depending on management – that’s fine.

We have a candle here which appears quite bearish, opening on the highs and closing below the lows. While that’s a fact, and there is good potential for some continuation lower, it’s not as bearish as it seems (in my opinion). Further bearish movement still has to work through the support at previous lows. In addition, you’ll note that the low of this candle has only just exceeded the low of candle 18. Intra-candle, at one stage, candle 18 also looked like a big, bad, red, bearish candle, just like 19 does right now. On as smaller timeframe, this candle 17 to 19 action would show up as a small 20 pip trading range. The slight breakout of the candle 18 lows could quite easily be rejected, as occurred in candle 18.

In any case, what are we looking for here? If the bias is to return to bearish, the bears need to continue this thrust, breaking and holding below the low of candles 9 – 12. However we are also in a prime position to confirm our change to a bullish bias, through any failure to breach the lows.

Waiting and watching…

Candle 20 –   Jackpot! Confirmation of my bullish bias and entry long. Note that the trend is down so I trade as always with constant vigilance, remaining alert for any information which shows resurgence from the bears, potential failure of my trade and resumption of the bearish bias.

Let’s summarize what we’ve got here at candle 20, because I did NOT simply enter due to the candle being a hammer:

1. A bearish bias in a downtrend, from candle 1 down to candle 9;
2. Finding support through clear evidence of buying at the lows of candles 9 to 12;
3. Breaking higher on candle 13 in what is the most bullish candle to date, signaling a potential change to bullish bias;
4. Followed by a reduced momentum move to retest the lows (upswing momentum from candle 12 to 14 being stronger than the downswing momentum from candle 14 to 20);
5. And a beautiful rejection of the retest at candle 20. Please note perhaps one of the most important points – candle 20 actually broke below the candle 9 – 12 swing low by one pip, which would have triggered a lot of breakout entries short. The rapid reversal will trap these traders in a losing position, leading them to scramble for exit on a break of the hammer highs, adding to the bullish order flow and helping to propel my trade into a profitable position.

 

Of course, that’s just entry. The ongoing trade management and exit are even more important, but they’re a topic for another time.

Hopefully his example of how I conduct analysis is useful to some of you. I’d like to repeat my earlier disclaimer – “Yes, I know it’s all been done in hindsight here.” It’s simply an example of some of my thought processes as I watch price move. As always, take from it what you find of value, and discard the rest.

A quick final comment – in discretionary trading such as this, risk management is ESSENTIAL. Trading in accordance with our feeling of bias is essentially trying to find the path of least resistance. While that’s great when it works, it can be devastating when you’re bias is not in alignment with the reality of the market. You must be willing to change your bias at the drop of a hat, as soon as evidence appears which is contrary to your previous opinion. We’ll have more on the dangers of a wrong bias, and the psychological challenges of maintaining and changing a bias, in future articles.

Till next time, happy ‘Advanced’ Candlestick Analysis,

Lance Beggs

 

*       When I mentioned Advanced Candlestick Analysis towards the start of this article, why did I add the bracketed comment, ‘if there is even such a thing’?

I did this because in many respects this more advanced analysis method has nothing to do with candles at all. The technique could just as easily be applied to bar charts, and in fact I often do this – alternating between candles and price bars depending on whatever is allowing me to see the flow of price better that day. So, you could if you wish refer to this as Price Action Analysis, rather than Advanced Candlestick Analysis.

 

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