Discussion 4 (Part 2) : My Broker Says... Don't Use Candlesticks!

When I talked about Technical Analysis with my friends who scholastically come from Fundamental Analysis, I often hear comments such as,

"Candlesticks don't take latest market news into considerations. It is not useful in the ever fast volatile market."

"It doesn't make sense to predict the market based on Candlesticks."
"You don't 'time' the market in investments. That's not the way to invest!"

"We are investors, not mathematicians or statisticians. Why buy probability? We invest because we are 'certain' of the outcome."

I immediately stopped speaking on TA. Their minds were closed the moment they made such comments, and they wouldn't have made themselves to consider how candlesticks could've impacted on their wealth. They've already gone defensive.

Surprisingly, many stock brokers gave such similar comments as well whenever they hear the word "candlesticks". They'll just go on an auto-pilot, relentlessly going about saying how 'bad' candlesticks are. When I finally asked them, "Wow, you seem to know a great deal about candlesticks, so how much have you read on them?" They replied, "Not much." I then gave them a customary friendly smile.





Illustration (i) : Candlesticks

First, let me introduce to you what a candlestick is. To put it simple, a candlestick is a record (in the form of a bar) of what happened during the day of the market. Please see illustration (i) for more explanations.

A candlestick is made up of 2 components - body and shadow.

The body of the candlestick is the solid bar that is either in white, or in black. In a bullish candlestick, the bottom of the bar would represent the opening price, while the top represents closing price (showing the differences between the opening and closing prices of the day). The reverse applies to the bearish candlestick.

The shadow, on the other hand, are the lines which extends below, or above of either candlesticks. These shadows represent the intraday high and low of the stock (Note: "Intraday" means "within the day of trading").

The candlesticks give a pictorial view of the price movements of a particular stock or index. It clearly shows a pattern, which all Technical Analysts look at to spot short term opportunities. "Short Term", in Technical Analysis' definition, may range from minutes, to hours, days, or even weeks. However, it rarely goes into months.

"How do I make use of candlesticks to spot opportunities?"

Analysts (technicians) usually will see opportunities where there is a signal of reversal of an uptrend or downtrend. "Reversal" means the point of change from an uptrend to downtrend, or from a downtrend to uptrend. Analysts will technically base upon two basic candlestick concepts to spot these opportunities.

Now imagine that you are playing a computer game. The rule of the game is simple. You will need to gain 2,000 points to clear each level. Once you've cleared a level, your game would automatically be saved at the beginning of next level, so that if you fail to achieve 2,000 points in the new level, you could restart the game at the beginning of that level. But there's a catch! If you are unable to gain at least 1,000 points in the new level, you will need to restart your game from the beginning of the previous level!

Say, I'm now in level 5, and I gained 1,700 points. I can restart from the beginning of level 5. However, if I gained only 500 points, the game would think that I cleared the previous level on luck, and will send me back to the beginning of level 4. I would need to climb all the way up to level 5 again!



Illustration (ii) : Support & Resistance Concept

You see, the beginning of each level is known as your support level (you know you'll be back there if you failed), and the ending of each level is known as your resistance level (you need to beat this to proceed). Also know that when you've beaten the level (breaking the resistance), the once resistance level then become your support level, and vice versa. Same goes to share prices.

This is the first concept, support and resistance. Candlesticks play as an important component of recognizing support and resistance. The only difference between the real world and the game above is that in the game, you already have known support and resistance levels (level 3, 4, 5, etc), but in the real world, you will have to determine the levels (support and resistance) on your own.



Illustration (iii) : Support & Resistance Candlesticks

So, how do you go about knowing your support and resistance levels?

As a rule of thumb,

Uptrend
Support (in a Retracement) - Previous trend high.
Resistance (in a Break Up) - Preceding higher trend high.

Downtrend
Support (in a Break Down) - Preceding lower trend low.
Resistance (in a Pull Back) - Previous trend low.

Study the example in illustration (iii).

Notice that a stock price, most of the time, would linger around the support and resistance levels. Thus, when a stock price hits support level, it is time for investors to enter the position (buy signal). Similarly, when the price hits resistance level, investors would need to be wary of a potential downturn (sell signal).

Also note that, the more often a resistance or support is tested, the stronger that resistance or support is. Stronger here means that the level would not be broken as easily as those untested ones. However, once such strong level is broken, the price would most likely either skyrocket to another resistance level, or free fall to the next support level.

However, all these show only an indication of what would be happening in the next few days. There are times when the prices reversed when they aren't even near any support or resistance at all. In that case, the new high or new low would be the new resistance or support that investors should look out for.

Always remember that any techniques that you learn from Technical Analysis (TA) should not be used in isolation. It should be used together with other TA techniques, or even crossover with Fundamental Analysis (FA) to bring out its full potential. TA is never conclusive, as it's purpose is only to increase the probability of you making profits in the share market.

The second concept you would need to know about candlesticks is Candlestick Patterns. Sometimes, it is called Candlestick Formation. A pattern is formed when one or more candlesticks appear in a particular sequence.

There are many candlestick patterns, and it'll take days to finish sharing all of them with my readers. However, allow me to first share two sets of the most basic patterns with you today.


Illustration (iv) : Hammer / Hanging Man

The first set of candlestick pattern that I would introduce to you is the hammer set.

Any candlesticks belonging to the hammer set should have a shadow of at least twice the length of the body extending from the bottom of the body.

Hammer set candlesticks play a very important part in identifying the reversal of a price trend. Referring to illustration (iv), these candlesticks are either called a Hammer, or a Hanging Man, depending on where it is found.

If the candlestick (be it white or black candle) is found at the bottom of a downtrend, it is called a Hammer. I usually express this as "The Power of Thor", relating it to the Norse mythology's God of Thunder. This is a very common candlestick pattern that is usually seen prior to a bullish reversal (end of downtrend, beginning of uptrend). I always say, "I've found the power of Thor" whenever I see this pattern. :-)

If the candlestick (be it white or black candle) is found at the top of an uptrend, it is called a Hanging Man. It resembles a man being hanged from a ceiling. It is a signal that the uptrend has almost come to an end, and again, this candlestick pattern is most commonly seen prior to a bearish reversal (end of uptrend, beginning of downtrend).
 

Illustration (v) : Inverted Hammer / Shooting Star

A variation to the Hammer set can be seen in illustration (v). Similar in nature, If the pattern is seen at the bottom of a downtrend, it is called an Inverted Hammer, which shares the same functionality with a Hammer.

Conversely, if the pattern is found at the top of an uptrend, it's called Shooting Star, deriving its name as it resembles stars shooting down to the Earth. It shares the same function as a Hanging Man.

Both of the variations are also commonly found at the end of an uptrend or downtrend.

Take note that strength of the candlestick patterns belonging to the Hammer set, and its variation set, is usually influenced by the length of its shadow. The longer the shadow is, the more affirmed the signal is.


Illustration (vi) : Bullish Engulfing / Bearish Engulfing

The next set of patterns I would like to share with my readers is the Engulfing set.

Engulfing set is built with 2 candlesticks, with one large candlestick eclipses or engulfs the other.

A Bullish Engulfing is found at the bottom of a downtrend, and it usually sends a bullish reversal signal.

A Bearish Engulfing, on the other hand, is found at the top of an uptrend, usually signalling that a bearish reversal is imminent.


Illustration (vii) : Candlestick Reversals

Have a look at illustration (vii) and see how candlestick formations correlate with support and resistance!

It may seem illogical to most who are new to TA. But before you go all defensive, it is good to take a breather, grab yourself a cup of coffee, or maybe workout a few minutes before continuing the following exercise. You need to maintain a clear mind for what is coming.

Having equipped with these two basic TA knowledge (support & resistance and candlestick formation), please make an effort to refer back to Part 1 of this Discussion. Review the charts and see if you have spotted the reason(s) for my suggestions or advise.

I will unveil everything in the third instalment of this discussion. :-)