Light up your portfolio returns
How Candlestick charting techniques can illuminate price action.
The goal of the trader should not be “activity”, it should be to trade well so you can make money. But to do this you have to get a few things right.
There’s a concept that I find even experienced traders miss. Even though it’s blatantly obvious, I’ll bet it has been hiding in plain sight from you, and you are about to slap your forehead and say “d’oh!” when you hear it because you didn’t think of the markets in this juicy, lucrative way.
A bit of background first.
Isaac Newton and motion
One of the key quotes that has affected my share trading was from Sir Isaac Newton: “When a body is set in motion, it will continue in that direction.”
Translated to the sharemarket, it indicates that if a share is already uptrending, it is likely to continue in that direction. This is the ideal situation to time your entry into a new position with a candlestick pattern.
(Editor’s note: Candlesticks charts, a Japanese invention, are a form of technical analysis to identify market and stock turning points. The ASX Charting Library has useful background information on Candlesticks that will help with key terms in this article).
There is an important concept to note that is often missed by many analysts, even if they are more advanced in assessing trends.
- In a medium-term uptrend, bottom candlestick reversal patterns are more likely to inspire vigorous bullish enthusiasm. Top reversal patterns in this situation are less likely to be as effective.
Read that again and I guarantee it will help your trading success, block you out of cruddy trades and get you piling into ones that are high probability.
Have a look at The A2 Milk Company. Below is a weekly chart of A2M with a 30-week exponential moving average on it. What a pretty, well-behaved uptrend.
Taking a closer look into the heart of the chart, it is trying to tell you something and you have to listen carefully.
The top reversals are basically ignored. It’s as if the shares take one look at that halt in action, laugh and do exactly what they wanted to in the first place – trend happily upwards (And no, I don’t own them; and yes, I’m feeling touchy about that.)
Look at the chart this way…
Now, let’s look at the bottom reversal patterns on the chart below. They are slavishly obeyed, even if they do not conform to the exact definition of a bottom reversal pattern.
I mean… that final harami isn’t even that strong as candlestick patterns go, but look at how ballistic the uptrend was after that.
This concept explains why the retracement trade is a particularly useful tool. By acting on a bottom candlestick reversal pattern, during an existing uptrend, your trades are much more likely to become immediately profitable. The bottom reversal will, in all probability, create a strong bullish reaction because the overall trending behaviour is upwards.
During an existing medium-term uptrend, you can use top reversal patterns to lighten your positions (if, for example, your shareholding has crept over 20 per cent of your total equity). You could also use top reversals to exit your positions if you need to go on holidays, or if you need to take a break from active trading.
Some traders jump out at the first sign of trouble. For example, they take the appearance of a top reversal to be an ideal opportunity to time their exit. There would be little point, however, in exiting every time a top reversal pattern appears. This strategy would run contrary to the concept of “letting your profits run”. Candles are a short-term trading tool; mostly, their impact just lasts three to 10 periods.
By really internalising this lesson, it will mean you’ll trade less but earn more per trade. It will keep you out of less than optimal opportunities, but help you to dive on in when the probability is on your side.
It works in reverse too
This concept also works in reverse.
- In a medium-term downtrend, top reversal patterns are more likely to have a more significant effect on share price action than bottom reversal patterns.
So, a word of warning – look at the overall medium-term trend as well as the trend of the previous few periods.
As you can see from the chart below, Harvey Norman (HVN) is in a medium-term downtrend. Given this type of share-price activity, it is likely that top candlestick reversal patterns would inspire a stronger reaction, in relative terms, than bottom candlestick reversal patterns.
Let’s just compare three haramis on this chart, one at the top and two at the bottom. Check out the strength of that top reversal, and the diluted energy of the second and third haramis as they feebly try to reverse the downtrend.
Those two bottom reversals are very sick. They certainly didn’t have a lasting effect on reversing that strong downtrend, did they?
These types of top reversal patterns in an existing downtrend can be used to guide your entry into short-sold positions (where investors bet on a falling share price). Another alternative strategy could be to buy a put or open a written call position, given the correct set-up for an option trade.
So, listen to what the markets are telling you. Their whispers can become shouts if you focus on the charts.
About the author
Louise Bedford (www.tradinggame.com.au) is a full-time private trader and author of several best-selling books, including The Secret of Candlestick Charting, Charting Secrets and Trading Secrets. For her free trading plan template, register here. Louise is giving away her Special Report – Candlestick Pattern Summary to the first 200 people who click here. It’s a free crash course. Follow: @TheTradingGame
Louise Bedford (www.tradinggame.com.au) is a full-time private trader and author of several best-selling books, including The Secret of Candlestick Charting, Charting Secrets and Trading Secrets. For her free trading plan template, register here.
Louise is giving away her Special Report – Candlestick Pattern Summary to the first 200 people who click here. It’s a free crash course.
ASX Charting Library explains a range of charting terms and concepts.