You will also be able to get in and out of your trades quickly without holding them overnight. The smaller time frames can contain more risk if you are inexperienced. If things go wrong, then they can go wrong quickly. If you are thinking about trading price action on the smaller intraday time frames you need to ensure you use strict money management and you are always using a stop loss for account protection.
Some of the simplest trading strategies involve using price action. The reason is because when price action trading you are simply looking and reading raw price action. From there you can create any system that suits you. Some of the best systems you will find are also the simplest with the clearest rules. Trading with a price action trend can be one of the easiest ways to start increasing your trades odds.
The trend is your friend, except at the end when it bends. Two of the easiest ways to find trend trades with price action are using trendlines and moving averages.
When using a moving average you are looking for a clear move in either direction. Using a moving average combination such as the 50 and EMA exponential moving average can also show us when price action is either looking to start a new trend or is strongly trending. Another simple way to find and then trade trends is using trendlines. As the example shows below; price is in a trend higher. Price continues to test the uptrend line.
Potential trades could be found in the trend higher at the next test of the trendline. One of the most popular price action strategies is using candlestick patterns. The reason for this is because they are very easy to spot and they can help with entry and exit levels. The most popular chart type among professional traders is the candlestick chart because it shows the price action in the clearest form.
The candlestick chart will also help you easily and quickly spot candlestick signals. The pin bar has a long upper or lower tail, shadow, or wick and a much smaller real body. A bullish pin bar shows that price is rejecting lower prices. You can see this as the price moved lower, but by the end of the session it had snapped back higher to reject the lower prices.
Price tried to move higher, but by the end of the session it had been snapped back lower rejecting the higher prices. Engulfing candlesticks are reversal price action signals. Following the first small candlestick price will then form a second candlestick that fully engulfs the first small candle. For example; a bullish engulfing pattern will show that price first formed a small candle, in the second session it moved lower, before reversing and breaking completely above the first candle.
This pattern is a popular candle formation, but does come with some risks. The inside bar candlestick pattern is a two candle pattern that is showing indecision. This shows that price could not break either higher or lower and is indecisive. This is true of some candlestick patterns.
Depend- ing on my source of information, these were instances in which I came across different, albeit usually minor, definitions of what constitutes a certain pattern. For example, one Japanese author writes that the open has to be above the prior close in order to complete a dark-cloud cover pattern see Chapter 4.
Other written and oral sources say that, for this pattern, the open should be above the prior high. In cases where there were different definitions, I chose the rules that increased the probability that the pattern's forecast would be correct.
For example, the pattern referred to in the prior paragraph is a reversal sig- nal that appears at tops. Thus, I chose the definition that the market has to open above the prior day's high. It is more bearish if the market opens above the prior day's high and then fails, then it would be if the market just opens above the prior day's close and then failed.
Much of the Japanese material I had translated is than specific. Part of this might be the result of the Japanese penchant for being vague. The penchant may have its origins in the feudal ages when it was accept- able for a samurai to behead any commoner who did not treat him as expected.
The commoner did not always know how a samurai expected him to act or to answer. By being vague, many heads were spared. However, I think the more important reason for the somewhat ous explanations has to do with fact that technical analysis is more of an art than a science. You should not expect rigid rules with most forms of technical analysis-just guideposts.
Yet, because of this uncertainty, some of the ideas in this book may be swayed by the author's trading philosophy. Another example of subjectivity: In the Japa- nese literature many candlestick patterns are described as important at a high-price area or at a low-price area.
Obviously what constitutes a "high-price" or "low-price" area is open to interpretation. This could be viewed as a limitation. Extended experience with candlestick charting in your market specialty will show you which of the patterns, and variations of these patterns, work best.
In this sense, subjectivity may not be a liability. As you gain experience in candlestick techniques, you will discover which candlestick combinations work best in your market. This may give you an advantage over those who have not devoted the time and energy in tracking your markets as closely as you have. As discussed later in the text, drawing the individual candlestick chart lines requires a close.
Therefore, you may have to wait for the close to get a valid trading signal. This may mean a market on close order may be needed or you may have to try and anticipate what the close will be and place an order a few minutes prior to the close. You may also prefer to wait for the next day's opening before placing an order. This aspect may be a problem but there are many technical systems especially those based on moving averages of closing prices which require a closing price for a signal.
This is why there is often a surge in activity during the final few minutes of a trading session as computer- ized trading signals, based on closing prices, kick into play. Some tech- nicians consider only a close above resistance a valid buy signal so they have to wait until the close for confirmation.
This aspect of waiting for a close is not unique to candlestick charts. On occasion, I can use the hourly candlestick charts to get a trade signal rather than waiting for the close of that day. For instance, there could be a potentially bullish candlestick pattern on the daily chart. Yet, I would have to wait for the close before the candlestick pattern is com- pleted. If the hourly charts also show a bullish candlestick indicator dur- ing that day, I may recommend buying if the prevalent trend is up even before the close.
The opening price is also in the candlestick lines. I hope that, as candlestick charts become more common, more newspapers will include openings individual stocks. Candlestick charts provide many useful trading signals. They do not, however, provide price targets.
There are other methods to forecast tar- gets such as prior support or resistance levels, retracements, swing objectives, and so on. Some Japanese candlestick practitioners place a trade based on a candlestick signal.
Candlestick patterns should always be viewed in the context as to what occurred before and in rela- tion to other technical evidence. With the hundreds of charts throughout this book, do not be sur- prised if you see patterns that I have missed within charts. There will also be examples of patterns that, at times, did not work. Candlesticks will not provide an infallible trading tool. They do, however, add a vibrant color to your technical palette.
Candlestick charts allow you to use the same technical devices that you use with bar charts. But the candlestick charts give you signals not available with bar charts. So why use a bar chart? In the near future, candlestick charts may become as standard as the bar chart. In fact, I am going to make a bold prediction: A s more technicians become comfortable with candlestick charts, they will no longer use bar charts.
I have been a tech- nical analyst for nearly 20 years. And now, after discovering all their benefits, I only use candlestick charts.
I still use all the traditional West- ern technical tools, but the candlesticks have given me a unique perspec- tive into the markets. Before I delve into the topic of candlestick charts, I will briefly discuss the importance of technical analysis as a separate discipline. For those of you who are new to this topic, the following section is meant to empha- size why technical analysis is so important.
It is not an in-depth discus- sion. If you are already familiar with the benefits of technical analysis, you can skip this section. Do not worry, if you do not read the following sec- tion, it will not interfere with later candlestick chart analysis information. Yet the markets are influenced at times, to a major extent, by emotionalism.
An ounce of emotion can be worth a pound of facts. As John Keynes stated, "there is nothing so disastrous as a rational investment policy in an irra- tional Technical analysis provides the only mechanism to mea- sure the "irrational" emotional component present in all markets. Here is an entertaining story about strongly psychology can affect a market. Soybeans were sharply higher.
There was a drought in the Illinois Soy- bean Belt. And unless it ended soon, there would be a severe shortage of beans. Suddenly a few drops of water slid down a window. More than pairs of eyes [the traders- editor's note] shifted to the big windows. Then came a steady trickle which turned into a steady downpour. It was raining in downtown Chi- cago. The shouts cascaded from the traders' lips with a roar that matched the thunder outside.
And the price of soybeans began to slowly move down. Then the price of soybeans broke like some tropic fever. It was pouring in Chicago all right, but no one grows soybeans in Chi- cago.
In the heart of the Soybean Belt, some miles south of Chicago the sky was blue, sunny and very dry. But even if it wasn't raining on the soybean fields it was in the heads of the traders, and that is all that counts [emphasis added]. To the market nothing matters unless the market reacts to it. The game is played with the mind and the emotions [emphasis added].
In order to drive home the point about the importance of mass psy- chology, think about what happens when you exchange a piece of paper called "money" for some item like food or clothing? Why is that paper, with no intrinsic value, exchanged for something tangible? It is because of a shared psychology. Everyone believes it will be accepted, so it is. Once this shared psychology evaporates, when people stop believing in money, it becomes worthless.
Second, technicals are also an important component of disciplined trading. Discipline helps mitigate the nemesis of all traders, namely, emotion. As soon as you have money in the market, emotionalism is in the driver's seat and rationale and objectivity are merely passengers. If you doubt this, try paper trading. Then try trading with your own funds. Technicals can put objectivity back into the drivers seat.
They provide a mechanism to set entry and exit points, to set ratios, or levels. By using them, you foster a risk and money management approach to trading. As touched upon in the previous discussion, the technicals contrib- ute to market objectivity. It is human nature, unfortunately, to see the market as we want to see it, not as it really is. How often does the fol- lowing occur? A trader buys. Immediately the market falls. Does he take a loss. Usually no.
Although there is no room for hope in the market, the trader will glean all the fundamentally bullish news he can in order to buoy his hope that the market will turn in his direction. Meanwhile prices continue to descend. Perhaps the market is trying to tell him something. The markets communicate with us.
We can monitor these messages by using the technicals. This trader is closing his eyes and ears to the messages being sent by the market. If this trader stepped back and objectively viewed price activity, he might get a better feel of the market. What if a supposedly bullish story is released and prices do not move up or even fall? That type of price action is sending out volumes of information about the psychology of the market and how one should trade in it.
I believe it was the famous trader Jesse Livermore who expressed the idea that one can see the whole better when one sees it from a distance. Technicals make us step back and get a different perhaps, better perspective on the market. Third, following the technicals is important even if you do not fully believe in their use.
This is because, at times, the technicals are the reason for a market move. Since they are a market moving factor, they should be watched. Fourth, random walk proffers that the market price for one day has no bearing on the price the following day. But this academic view leaves out an important component-people. People remember prices from one day to the next and act accordingly. To wit, peoples' reactions indeed affect price, but price also affects peoples' reactions.
Thus, price, itself, is an important component in market analysis. Those who disparage technical analysis forget this last point. Fifth, and finally, the price action is the most direct and easily acces- sible method of seeing overall relationships. There may be news not known to the general public but you can expect it is already in the price.
Those who have advance knowledge of some market moving event will most likely buy or sell until current prices reflect their information. Thus, current prices should reflect all available information, whether known by the general public or by a select few.
For those who are in a rush to get to the "meat" of the book that is, the techniques and uses of candlesticks , you can skip this chapter, or return to it after you have completed the rest of the book. It is an intriguing history. Among the first and the most famous people in Japan to use past prices to predict future price movements was the legendary Munehisa He amassed a huge fortune trading in the rice market during the s.
Before I discuss Homma, I want to provide an overview of the economic background in which Homma was able to flourish. The time span of this overview is from the late s to the mids. During this era Japan went from 60 provinces to a unified country where commerce blossomed.
From to , Japan was a country incessantly at war as each of the daimyo literally "big name" meaning "a feudal lord" sought to wrestle control of neighboring territories. This span between and is referred to as "Sengoku Jidai" or, literally, "Age of Country at War. By the early three extraordinary generals-Nobunaga Oda, Hideyoshi Toyotomi, and Ieyasu Tokugawa-had unified Japan over a year period.
Their prow- ess and achievements are celebrated in Japanese history and folklore. This era is referred to as the Tokugawa Shogunate. The military conditions that suffused Japan for centuries became an integral part of candlestick terminology.
And, if you think about it, trad- ing requires many of the same skills needed to win a battle. Such skills include strategy, psychology, competition, strategic withdrawals, and yes, even luck. So it is not surprising that throughout this book you will come across candlestick terms that are based on battlefield analogies. There are "night and the "advancing three soldiers pattern", "counter attack lines", the "gravestone", and so on.
The relative stability engendered by the centralized Japanese feudal system lead by Tokugawa offered new opportunities. The agrarian econ- omy grew, but, more importantly, there was expansion and ease in domestic trade. By the 17th century, a national market had evolved to replace the system of local and isolated markets. This concept of a cen- tralized marketplace was to indirectly lead to the development of techni- cal analysis in Japan.
Hideyoshi regarded Osaka as Japan's capital and encour- aged its growth as a commercial center. Osaka's easy access to the sea, at a time where land travel was slow, dangerous, and costly, made it a national depot for assembling and disbursing supplies.
It evolved into Japan's greatest city of commerce and finance. Its wealth and vast store- houses of supplies provided Osaka with the appellation the "Kitchen of Japan. In Osaka, life was permeated by the desire for profit as opposed to other cities in which money making was despised. The social system at that time was composed of four classes.
In descending order they were the Soldier, the Farmer, the Artisan, and the Merchant. It took until the for merchants to break down the social barrier. Even today the traditional greeting in Osaka is makka" which means, "are you making a profit?
In Osaka, Yodoya Keian became a war merchant for Hideyoshi one of the three great military unifiers. He became very wealthy-as it turned out, too wealthy.
The Bakufu was apprehensive about the increasing amount of power acquired by certain merchants. In , certain officials and merchants tried to corner the rice market. The punishment was severe: their children were executed, the merchants were exiled, and their wealth was confiscated. The rice market that originally developed in Yodoya's yard was insti- tutionalized when the Dojima Rice Exchange was set up in the late s in Osaka. The merchants at the Exchange graded the rice and bargained to set its price.
Up until , the Exchange dealt in actual rice. After , the Rice Exchange began to issue and accept rice warehouse receipts. These warehouse receipts were called rice coupons. These rice receipts became the first futures contracts ever traded.
Rice brokerage became the foundation of Osaka's prosperity. There were more than 1, rice dealers. Since there was no currency standard the prior attempts at hard currency failed due to the debasing of the coins , rice became the defacto medium of exchange. A daimyo needing money would send his surplus rice to Osaka where it would be placed in a warehouse in his name. He would be given a coupon as a receipt for this rice. He could sell this rice coupon whenever he pleased.
Sometimes the rice crop of several years hence was mortgaged. These rice coupons were actively traded. The rice coupons sold against future rice deliveries became the world's first futures contracts. The Dojima Rice Exchange, where these coupons traded, became the world's first futures exchange. Rice coupons were also called "empty rice" coupons that is, rice that was not in physical possession. To give you an idea of the popularity of rice futures trading, consider this: In , there were a total of , bales rice used to trade in bales of empty-rice coupons traded in Osaka.
Yet, throughout all of Japan there were only bales of Into this background steps Homma, called "god of the markets. The Homma family was considered so wealthy that there was a saying at that time, "I will never become a Homma, but I would settle to be a local lord. Sakata was a collections and distribution area for rice. Since Homma came from Sakata, you will frequently come across the expression "Sakata's Rules" in Japanese candlestick literature. These refer to Homma. This was in spite of the fact that he was the youngest son.
It was usually the eldest son who inherited the power during that era. This was probably because of Munehisa's market savvy. With this money, Homma went to Japan's largest rice exchange, the Dojima Rice Exchange in Osaka, and began trading rice futures. Homma's family had a huge rice farming estate. Their power meant that information about the rice market was usually available to In addition, Homma kept records of yearly weather conditions.
In order to learn about the psychology of investors, Homma analyzed rice prices going back to the time when the rice exchange was in Yodoya's yard. Homma also set up his own communications system. At prearranged times he placed men on rooftops to send signals by flags. These men stretched the distance from Osaka to. After dominating the Osaka markets, Homma went to trade in the regional exchange at Edo now called Tokyo.
He used his insights to amass a huge fortune. It was said he had consecutive winning trades. His prestige was such that there was the following folk song from Edo: "When it is sunny in Sakata Homma's town , it is cloudy in Dojima the Dojima Rice Exchange in Osaka and rainy at Kuramae the Kuramae exchange in Edo. This song reflects the Homma's sway over the rice market. In later years Homma became a financial consultant to the govern- ment and was given the honored title of samurai. He died in His trading principles, as applied to the rice markets, evolved into the candlestick methodology currently used in Japan.
This gives you an idea of the difficulty of translating Japanese into English. The same Japanese symbols for Homma's first name, depending on the translator, can be Sokyu or hisa.
His last name, again depending on the translator, can be either Homma or Honma. Johannes and Yui, Tsunehiko.
Exhibit 3. On the candlestick chart, prices seem to jump off the page presenting a stereoscopic view of the market as it pushes the flat, two-dimensional bar chart into three dimensions.
In this respect, candlecharts are visually exciting. Drawing the daily bar chart line requires open, high, low, and close. The vertical line on a bar chart depicts the high and low of the session. The horizontal line to the left of the vertical line is the opening price. The horizontal line to the right of the vertical line is the close. Although the daily bar chart lines and candlestick chart lines use the same data, it is easy to see that they are drawn differently. It represents the range between that session's opening and closing.
When the real body is black filled in it means the close of the ses- sion was lower than the open. If the real body is white empty , it means the close was higher than the open.
The thin lines above and below the real body are the shadows. These shadows represent the session's price extremes. The shadow above the real body is called the upper shadow and the shadow under the real body is known as the lower shadow.
Accordingly, the peak of the upper shadow is the high of the session and the bottom of the lower shadow is the low of the session. It is easy to see why these are named candlestick charts since the individual lines often look like candles and their wicks. If a candlestick line has no upper shadow it is said to have a shaven head. A candlestick line with no lower shadow has a shaven bottom. To the Japa- nese, the real body is the essential price movement. The shadows are usually considered as extraneous price fluctuations.
Exhibits 3. Prices had a wide range and the market opened near the low and closed near the high of the session. They are called spinning tops and are neutral in lateral trading bands. Doji Examples tions on stars and harami patterns , these spinning tops do become important when part of certain formations.
The spinning top can be either white or black. The lines illustrated in Exhibit 3. It is the diminutive size of the real body that makes this a spinning top. Instead, they have horizontal lines. These are examples of what are termed doji lines. A doji occurs when the open and close for that session are the same or very close to being the same two- or three-thirty-seconds in bonds, a cent in grains, and so on.
The lengths of the shadows can vary. Doji are so important that an entire chapter is devoted to them see Chapter 8 The Magic Candlestick charts can also be drawn more colorfully by using the classical Japanese candlestick chart colors of red and black.
Red can be used instead of the white candlestick. This could be especially useful for computer displays of the candlestick charts. The obvious problem with this color scheme is that photo copies and most computer printouts will not be useful since all the real bodies would come out as black.
Some readers may have heard the expression yin and yang lines. These are the Chinese terms for the candlestick lines. The yin line is another name for the black candlestick and the yang line is equivalent to the white candlestick. In Japan, a black candlestick is called in-sen black line and the white candlestick is called yo-sen white line.
The Japanese have a proverb that says, "the first hour of the morning is the rudder of the day. It furnishes the first clue about that day's direction. It is a time when all the news and rumors from overnight are filtered and then joined into one point in time. The more anxious the trader, the earlier he wants to trade. Therefore, on the open, shorts may be scrambling for cover, potential longs may want to emphatically buy, hedgers may need to take a new or get out of an old position, and so forth.
After the flurry of activity on the open, potential buyers and sellers have a benchmark from which they can expect buying and selling. There are frequent analogies to trading the market and fighting a battle. In this sense, the open provides an early view of the battlefield and a provi- sional indication of friendly and opposing troops. At times, large traders may try to move the market on the open by executing a large buy or sell order. Japanese call this a morning attack.
A straightforward yet powerful trading strategy is to analyze candlestick patterns using a moving average. This tutorial assumes a basic understanding of candlestick patterns.
Despite their often mystical names like Engulfing and Shooting Star , candlestick patterns are not magical. They are merely distinct price action patterns. Nonetheless, you can apply a similar approach using other types of moving averages. Do not apply this strategy rigidly. Use candlestick patterns together with the moving average to locate a starting point for your analysis. The Evening Star is a bearish pattern consisting of three candlesticks. When trading candlestick patterns with a moving average, use the distance between the candlesticks and the EMA to judge the momentum.
In this case, the large gap between the candlesticks and the EMA highlighted the bearish momentum. However, its higher frequency is not an excuse for negligent trading. We will need to scrutinize each Engulfing pattern even more to find the outstanding ones for our trading setups. Finally, the projected target worked splendidly here.
Projecting a target from a price thrust is a great way to set an initial profit target. Instead of analyzing one particular setup, this example highlights the role of the market context in determining the success or failure of a candlestick pattern. We will focus on the same candlestick pattern Morning Star and observe how its performance is affected by changes in the market context. For a balanced discussion, this last example focuses on a losing candlestick setup.
A fundamental candlestick trading principle is to wait for confirmation. The typical approach is to wait for one more candlestick to form in our intended entry direction. Waiting for confirmation indiscriminately is not a good idea. This is why our default trading rules above did not mention anything about waiting for confirmation.
The body of the baby bar must be entirely within the body of the mother bar. Typically, in a bullish Harami, the first bar closes lower than it opens while the second bar closes higher. Similarly, in a bearish Harami, the first bar closes higher than it opens while the second bar closes lower. The candle body stands for the real price change of the candle regardless of its intra-candle excursions.
Hence, it represents the real and conclusive movement of the candlestick. The smaller candle bodies point to decreased volatility.
Thus, it is not surprising that many Harami candlestick patterns are also inside bars. Again, the focus on the candle bodies looks for a real reversal. In this case, the second candle body fully engulfs the first and represents a strong reversal signal. Learn how to trade the Engulfing pattern using the market structure of swings as a guide.
The Piercing Line and the Dark Cloud Cover refer to the bullish and bearish variants of the same two-bar pattern. Due to the first criterion of both patterns, the second bar must open with a gap away from the close of the first bar. Hence, these candlestick patterns are unusual in intraday time-frames where gaps are uncommon. In the Piercing Line pattern, the second bar opened with a gap down, giving an initial hope of a strong bearish follow-through.
However, not only did the bearishness fail to materialise, it proceeded to erase more than half of the bearish gains from the first bar. This bullish shock offers a great long trade. Likewise in the Dark Cloud Cover pattern, the first gap up prompted hope from the bulls before the lower close crushed it. Both the Hammer and the Hanging Man patterns look exactly the same. The difference is this. The Hammer pattern is found after a market decline and is a bullish signal. However, the Hanging Man appears as an ill-omen at the end of a bull run and is a bearish signal.
The Hammer pattern traps traders who sold in the lower region of the candlestick, forcing them to cover their shorts. As a result, they produce buying pressure for this bullish pattern. Its bar pattern equivalent is the bullish Pin Bar. The Hanging Man pattern is a seemingly bullish candlestick at the top of an upwards trend.
Infected by its optimism, traders buy into the market confidently. Hence, when the market falls later, it jerks these buyers out of their long positions. This also explains why it is better to wait for bearish confirmation before going short based on the Hanging Man pattern. The difference is in where you find them. An Inverted Hammer is found at the end of a downtrend while a Shooting Star is found at the end of a uptrend.
The Inverted Hammer is a bullish pattern.
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