Candlesticks - The Common Trap

One of the reasons Japanese Candlestick trading analysis is popular lies on the underlying assumption that they do not require the investor/trader to know intricate formulas or ratios. Conceptually, Candlestick trading formations produce a clear and easy to identify patterns that demonstrate highly accurate turns in investor sentiment. This awareness allows the investor/trader to map out possible alternate strategies.

But before you trade based on candlesticks, there are several rules you must follow. First of all, reversal candlestick patterns can act as both support and resistance depending upon where they show up in a chart's price structure. For example, a doji candle suggests most of the trade has taken place at a concentrated price level.

Confirmation Candle

However the reversal candlestick pattern needs a confirmation candle before the investor/trader should technically act on it. That means if you get a doji or a hammer in an uptrend, or any other reversal pattern, the investor/trader needs a following candle that has the close below the reversal candles close as a confirmation that the trend has changed. As always, when the trend 'reverses' it can go three ways: up, down or sideways. So just saying an uptrend has reversed doesn't mean that the trend has reversed lower; it could just be signalling a sideways consolidation.

When trading from Candlestick analysis, the investor/trader needs to see two candles for their trigger to enter the market, and importantly, further confirmation from the volume and stochastic.

Step 1 - A reversal candlestick occurring in either an uptrend or downtrend

Step 2 - A confirmation candle that breaks the trend.

Step 3 - High volume relative to recent trading, and stochastic crossing and reversing from overbought (in case of uptrend reversal) or oversold (for downtrend reversal) levels.

For example, if you have an uptrend, and you get a doji candle, you have STEP 1. That alerts the investor/trader of potential reversal.

STEP 2 would be the confirmation 'trigger' candle. That is, the doji signal on an uptrend is followed the next day by a confirmation candle which has a lower close than the doji's close.

STEP 3 verifies the quality of the signal. Both days should be accompanied by high volume, and there should also be an appropriate stochastic movement. This means that if the investor/trader identified a reversal candle on the Monday, they would wait for the confirmation candle to close lower on the Tuesday near or at the end of trading before entering the market, or alternatively, wait for Wednesday to enter the market.

"There is no such thing as a long-term aggressive trader: they simply go broke?".

Investors/traders will trade as soon as they see STEP 1. However, as the saying goes, "there is no such thing as a long-term aggressive trader: they simply go broke?". The risk reward is very different and going early can result in handsome profits. We will inevitably get less trade signals by going through the above process, however by ALWAYS following the confirmation steps, we will only trade the highest quality signals resulting in a higher probability of success.