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A Crash Course on Candlesticks

Online Trading Academy
Tue May 06, 2014 12:11 EST

This week, I am back in my hometown of London to teach one of Online Trading Academy's foundational classes, the Professional Forex Class. Here in the UK, currency trading is huge, and as an asset class, it is without doubt the most popular market to trade for most who are interested in getting into trading. I find that before actually trading, the majority of people out here have maybe bought or sold some stocks at one time or another, and after this, if they maintain interest, they take a shot at actual trading, which is very different from the world of buy-and-hold Investing. I have found that when I spend time teaching in the United States, people tend to not begin with FX, but instead, they carry on trading stocks but with a little bit of margin and more frequently.

Irrespective of what market you trade, you really do need to know what you are doing from the very start, or you will likely end up losing more than you ever set out to in the first place. For some people, education begins officially in a classroom, which is by far the best possible start you could have. The majority, though, pick up some books and read some articles on the Internet, much like this one, before they take their education any further. If that is the route you're taking, one of the first trading tools you will learn about is the Japanese candlestick. This is probably one of the most vital lessons because without candlesticks, it's pretty hard to read a price chart. The candlesticks themselves tell us if prices are going up, down, or sideways, and if used in the correct manner, they are a powerful tool for honing our entries, stop losses, and exits. But much like any other regular conventional technical analysis, Japanese candlesticks can also cause as many problems as they attempt to actually solve.

When I first got into trading myself, I picked up a few books that were entirely devoted to Japanese candlestick charting methods. Let me tell you, these were not short books, and it took me a very long time to learn all the different names of all of the different candles and what they actually meant on a price chart. I remember drawing each one out and revising and testing myself to see if I knew what it was called and if I also knew what it meant on the chart when the candle formed. It was a nightmare, and I felt like I was reviewing for an exam when I was back in school! I distinctly remember looking at my price charts and getting excited when I saw those special candles form before my eyes and then confusing myself wondering what it actually meant as I quickly rustled through my notes to see if I should be buying or selling. Typically, I wasted a lot of time and then jumped into the market way too late. I would find myself getting stopped out or maybe I dismissed the trade completely. But that was all I knew at the time, and from what I had read, these candlesticks were pretty powerful tools. Only after getting the right education and starting to look at the market from a logical perspective was it that I really started to see candlesticks in a very different light... no pun intended.

Before I go any further, let's take a look at some of the most basic candle patterns you will find on most charts today:
basic candle patterns

Above shows six of the most common and widely recognized candlestick formations from conventional technical analysis. They each may indicate a certain change in price direction, when they appear at specific points in a trend. The "engulfing" candle suggests a continuation of trend. The "hammer or hanging man" is usually found at the end of a trend and suggests a reversal. The "Harami" also suggests a potential reversal. The "shooting star" is much like a hammer and can be a signal that trend is about to change direction while the "spinning top" and the "doji" are both signs of indecision and signs that a shift in momentum may be looming in the market. While it may sound neat to know the different names of these particular candlesticks, just by looking at their structure, you can get a good idea of whether or not we are seeing strong buying and selling pressure or simply a state of indecision without having to actually know what they're called.

For example, a hammer candle really shows that prices were pushed down significantly, only then to see strong buying stepping in to push the price back up. The shooting star is the exact opposite of this because it shows that while prices did rise on the candlestick, intense selling pressure came in at the top of the candle's range, resulting in the price being pushed back down and closing much lower in the overall range. In terms of conventional technical analysis, I expect to see patterns and events like this forming around major market timing points, where trends tend to end and new ones likely begin.

Now, I'm not trying to discredit the advantage in recognizing these particular candles and what they suggest about looming price action. However, as with most things in trading, you also need to focus on price itself. A common issue with most strategies that I find in regular publications and books is that the typical methods that the majority of traders use to incorporate candlestick patterns into their trading tend to lead to poor entries and weak risk-to-reward scenarios. Let's take a look at this in a little bit more detail:

area of Institutional Supply

In the above example, I have marked off a quality area of Institutional Supply that represents the dynamics of the Online Trading Academy Core Strategy. The imbalance between the buyers and the sellers was seen when prices dropped from the area at 1.3875, an area which was originally formed on April 28. Our rules-based strategy tells you to sell the currency pair as prices enter the zone of supply with a tight stop just above the zones itself in case you are wrong about the trade. The stop has you out closest to the point in which you are proven wrong, but also this has us getting into the market at the best time, which offers you the greatest potential reward.

As you can see, the prices fell from the supply area, and by getting in early, you had a great trade. If you would have just used traditional candlestick patterns on the other hand and waited for "confirmation," things would have been very different. You will see that a "Doji" reversal candle formed in the zone that would have given conventional traders a heads up to get ready for a short. They would have then waited for another candle to break the lows of the doji before getting short, giving them a much later entry and a lower potential reward and bigger risk. The justification of waiting for the doji confirmation is that it appears safer to wait because we have all been conditioned to be safe rather than sorry. In reality though, what appears initially to be safer ironically turns out to be higher risk as you are forced to sell short after prices have already fallen down significantly.

Yes, you could argue that the trade still worked out, and of course, I can't deny that, but the overall risk-to-reward ratio is significantly reduced, and in the long run, this is one of the most fundamental dynamics that a trader needs to pay attention too. Typically in our experience and in using our core strategy, candlestick patterns are really nothing more than another odds enhancer for your trades. The first reason to take a trade should always be due to what the prices are telling you and then everything else becomes supplementary. So my friends, please breathe a sigh of relief as you really don't need to memorize every candle and every name of each one to be successful at market speculation! In two weeks, I will continue this discussion and look at how candle patterns can be used with supply and demand in the most effective manner. I hope this was useful to you.

Editor's note: This story by Sam Evans originally appeared on Online Trading Academy.

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