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FIGURE 6.16RealTick graphics used with permission of Townsend Analytics, Ltd.
New Trading Systems and Methods (Wiley, 2005) quoted my work fromsuch magazine articles. Many other educators have come to listen to meteach, have taught my ideas, and have seen improvement in their students.I have had the opportunity to share my work and research with others, andI would like to share it with you. These trading ideas are not new, and theyhave stood the test of time.Here is an excerpt from an online interview I had in February 2003 (seewww.nationalfutures.com). The concepts I was talking about then prettymuch cover what we have gone over so far and will continue to cover in thefollowing chapters. The difference is that I am going over in detail what thespecific signals, settings, and rules are for the trading triggers.Q: How long have you been involved in the markets?A: I started in the business back in 1979 as a runner on the floor of theChicago Mercantile Exchange [CME]. I then worked for George and CarrieLane, the innovator and premier educator for the stochastics oscillator.Back then, we looked for day trading opportunities in agricultural commodities, bonds, and foreign currencies. The best markets that we used
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specifically for quick day trading were in the Swiss franc and the Germandeutsche mark. Floor traders used these numbers and kept them to themselves as a secret formula for their day trading numbers. These are knownas the pivot point calculations. I started incorporating them in my tradingapproach back in 1984 and have been using them ever since.Q: How do you calculate pivot points?A: I use the traditional formula. To determine current support/resistance levels, the first step is to find the pivot point [PP] number: PP = (H +L + C) divided by 3The first resistance level (R-1) = (PP × 2) – LThe second resistance level (R-2) = PP + H – LThe first support level (S-1) = (PP × 2) – HThe second support level (S-2) = PP – H + LQ: What time frames do you apply to calculate the pivot points?A: I find it extremely important to use multiple time frames in my research and analysis. For those who are familiar with the “numbers” fromthe pivot point calculations, the idea of applying them from any time periodother than the prior day’s session may make little or no sense. However, Iapply the daily, weekly, and even monthly target numbers and incorporatethese in my traders “tool box.” Often traders will comment, “If I am a daytrader, why would I want to be concerned with a monthly or a weekly market outlook?” Consider that in every month, there will be a high and a low,and the close will be somewhere in between. In one week, a high or a lowwill be established; and in one day of the week, the market will form thatpoint of interest. More often than not, in an hour or so, trades will takeplace that will establish that high and subsequently that low!Q: What are the various time periods in forex markets from which youtake the data to calculate the numbers?A: For the daily numbers, I take the New York Bank settlement. Forweekly numbers, I use the data beginning from the open on Sunday night tothe close on Friday afternoon. Monthly numbers are calculated by calendarperiods.Q: What is the main purpose for using the pivot points, and how cantraders use them?A: One popular application of the pivot point concept is to go long orcover any short positions at either of the two support levels or to go shortor sell at the projected resistance levels. Knowing these fixed price levelsgives the trader unambiguous points to trade off, to enter, or to exit themarket or, more important at times, where not to enter a position. For example, you should not buy right at either of the resistance levels. These levels act as boundaries that can turn back price advances or declines, at leaston the first attempt. Another technique is to trade the breakout of the firstsupport or resistance levels. If prices do break through the S-1 or R-1 level,
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traders have a new target at the R-2 or S-2 level to take profits. The benefitsof using the both short- and longer-term pivot points for a short-term daytrader are numerous: They give a trader a better edge due to the ability towork with predetermined price levels, which lead to precise entry and stoploss points, all of which give the trader the additional edge in the quest forbigger profits.Q: You use different technical tools in your daily videos. On which onesdo you put more trust or emphasis?A: Great question! I use stochastics as an overbought/oversold indicator, and I use it to help me determine divergence and convergence signals.I use three-period variable moving averages to help keep me focused on thetrend. Moving averages also help me identify potential turning points whenthe short-term average crosses over or below the longer-term average.Q: You use candle charts over bar charts. Why is that?A: Each candle has different characteristics that represent the difference, or the distance, between the high, the low, the open, and the close.These characteristics use colors to differentiate the relationship betweenthe open and the close, referred to as the real body. Candlestick chartingacts as an immediate way to illustrate and to help identify the current market’s environment and the current time frame’s acceptance or rejection ofa specific support or resistance level in a clear visual manner. If, for example, on a given trading session, prices move higher from the opening price,establish the high, and then fall, the distance formed from those points ofinterest is called the “shadow.”Candle charts give me color and depth, which help me almost immediately determine where current prices are in relation to past price levels.Candlestick charting techniques can be used from data for whatever timeperiod you are looking at: hourly, daily, weekly, or monthly. There are 60 to70 different classifications of named candlestick patterns—from one on upto several candle components. They can signal reversal, stalled, and continuations of a market’s price move. Day traders want to focus on a smallarsenal of the more consistent and reliable reoccurring formations. Severalpatterns that a trader wants to home in on and recognize are the more powerful reversal formations at tops and bottoms of price ranges.Q: How do candlesticks help you in your trading?A: My trading approach incorporates time-tested techniques but usesthe aid of candlestick charts, which help me identify the true condition ofthe markets. If you believe market prices are simply the reflection of humanemotion on perceived current value and focus on what the market is doing,rather than on what the market might do, then you are ahead of the crowdin understand how markets function. With that understanding, you willthen be able to have the confidence to act swiftly and to execute or triggerinto a trade or position in the market.
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Q: Which do you favor more—fundamental or technical analysis?A: I watch what reports are coming out, as some can generate wild gyrations (e.g., monthly unemployment report). I rely heavily on technicalanalysis. After all, it is the purest and most objective study of price action.It is used for expedience. You can review one, five, ten, or even twentycharts in a matter of seconds or minutes to get a quick overview of the general trends. How long would it take to study the fundamental reports on theeconomy or interest rates in various countries to develop an opinion to buyor sell a foreign currency? That process could take hours, days, or evenweeks to figure out. Specific chart patterns and price actions have a highdegree of repetition. They are not 100 percent accurate; however, they dohave a high percentage of reoccurrences. Success comes in the simple formof managing risk when applying a systematic method to these principlesand being able to quickly identify when and why a particular pattern fails.Q: You learned that certain candle patterns developed near these pivotpoints. Which ones do you look for near support or resistance levels?A: Top reversal or bearish, such as dojis, bearish haramis, haramicrosses, dark cloud covers, and evening star formations. And for bottom reversal or bullish candle patterns, I look for bullish haramis, harami crosses,bullish piercing patterns, bullish engulfing patterns, or, my favorite, a rareoccurring pattern called a morning doji star.Q: How significant are doji patterns?A: Extremely significant, especially if you know what to look for. Thereare specific criteria that dojis need to meet; but if you know what these are,they can be very powerful in helping your trading decisions. Doji formations help confirm reversals. There are different names and nuances associated with certain dojis. Dojis indicate indecision, the market ends orcloses, where it began or opened. Dojis signify that confidence is lost frombuyers or sellers after the open as the market made a lot of intraday noiseas the range during the day was established. In a bullish or bearish trendingmarket, indecision is the last thing you want to see. Strong rejection or failure from the high and/or the low is a significant telltale sign that changesare coming.Q: What other considerations can you share with us regarding dojis?A: In a strong uptrending market, usually the market will close near ahigh, as larger capitalized traders will hold positions overnight. If the largemoney traders are not confident the market will move higher in price, thenusually the market closes back near the open. I find it uncanny how manytimes dojis form at or very close to the actual pivot point calculated supportor resistance numbers. That is what helps me set up my trades; it is the relation of the next candle’s close after a doji that triggers my entries, especially if they are lined up at the pivot points.Q: What is the shortest time frame that you use for charting?
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A: Five minutes.Q: What other time frames do you track?A: Besides monthly, weekly, and daily charts, I use the 5-, the 15-, andthe 30-minute and even the 60-minute for overnight trend trading.Q: What is your favorite or most reliable time frame?A: For day trading, the 5- and 15-minute are equally important; so Iwatch both.Q: Do you just use pivot points, or do you use other methods for forecasting support and resistance levels?A: In my book A Complete Guide to Technical Trading Tactics: Howto Profit Using Pivot Points, Candlesticks, and Other Indicators, I demonstrate many powerful ways to anticipate support and resistance levels, including Fibonacci retracement, Fibonacci extensions, and projectionmethods. In fact, in my trading course, I teach specific trade setups andconfirm signals to trigger or execute trades, how to manage a trade, andhow to know when to exit or even reverse a position.Q: What signals or rules do you follow for a trading trigger?A: Without giving away too many of my trade secrets, there is one thatcan be found in my advanced trading course—a special trading setup that Ilook for in a bullish setup.• When the market approaches a key pivot point, buy on the close oron the next open once a new closing high is made above the previous bullish reversal candle pattern or a doji.• Place your initial risk-management stop below the low of the lowestlow point of the bullish candle pattern on a stop-close-only basis.• Exit the trade on the close or on the first open of a candle thatmakes a lower low after a prolonged uptrend, especially if it is neara pivot line.• One can use a “filter,” or a back-up process, to confirm the buy signal against a major pivot point number, such as a bullish convergence stochastic pattern.Remember, a bullish candle pattern can be a harami, a harami dojicross, a bullish piercing pattern, a bullish engulfing pattern, a doji, or amorning doji star.Q: Tell us about this course and book you have mentioned?A: The book was published by John Wiley and Sons in May of 2004. Iput the course together based on several seminars I conducted, one ofwhich was at the Chicago Board of Trade back in May 2003 and then againin December 2004. I had a huge response from folks who could not attendbut were impressed with my methods. I offer it on my web site, which iswww.nationalfutures.com. Both the book and the course are available onmy site, and I do get asked to autograph and add a personal message whenthese are prepurchased from my web site.
CHAPTER 7
Candle Charts andTop ReversalPatterns
andlestick charting is an extremely pronounced and effectivemethod for tracking and examining the four most important pricepoints: the open, the high, the low, and the close. Using candlestickcharting helps me visually to better compare current price activity in relation to past price points of interest. The advantage of using candlestickcharting in place of bar charting is that you can use the same techniquesand analysis that you do with bar charts and have the diversity and uniquesignals that candlesticks generate. As you learn this method of charting,you will come to see how it is a great barometer of human emotion, namely,fear and greed.In addition, this is a simple, yet certainly more specialized format ofcharting. It has gained in popularity in the United States and is currentlyfollowed by more and more analysts. My first book covered most ofthe top formations, and I want to review what I believe are the more frequent and reliable patterns. This chapter will show some statistical evidence that there are certain patterns that develop over and over again.Candlestick charting is extremely easy to learn; and once you rememberthe sequence of events that form a trending market condition, the candleswill certainly be your best tool in spotting market reversals at topsand bottoms. Having that information will certainly stack the odds inyour favor for making money consistently in the markets as an independent trader.
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CANDLESTICK CHARTINGCandlestick charting gives a detailed depiction of a price graph with almosta three-dimensional effect. What stands out most is that a chartist can seepatterns more clearly and distinctly than with other types of charts. Thereare over 60 candle patterns that form to create certain setups. This bookwill focus on only a few select patterns and, what matters most, the triggersthat initiate a call to action.If you are not familiar with candlestick formations, I am going over thefoundation of how to construct a candle and what it represents. If you wishto become an expert at each of the patterns, several authors have writtengreat books on the subject. One is Steve Nison, who introduced the Western world to candles. (In my first book, on page 44, I wrote about how hediscovered candles.) Others are Steve Bigalow and Greg Morris.For the expert, this section will be a great review. Since each markethas a different trading characteristic, such as volatility or price moves, certain candlestick patterns vary and may occur more or less frequently. Eachcandlestick pictured has a different characteristic that represents the difference or the distance between the high, the low, the open, and the close.Candlestick charting techniques can be used from data for whatever timeperiod you use: hourly, daily, weekly, or monthly. Candlestick charts lendthemselves to pattern recognition and trendline support, resistance, andchannel lines. Candles also help to corroborate other forms of technicalanalysis, especially pivot point analysis.I want to explain the basics, and then I want to show you specific patterns so you can see for yourself how to utilize them. I will also show a fewexamples of the more popular named candle formations. Moreover, I willexplain the psychology of what is behind creating the pattern as it relates tothe open, the high, the low, and the close of a given time period. Armed withthe knowledge of which patterns have a higher frequency of occurring andwith the understanding of what they symbolize, you should be able to tradethe markets from recognizing them; and when patterns do develop, youshould be able to instinctively act on the signals, thereby increasing yourability to make money as a trader.The components of a candlestick are derived from the open, the high,the low, and the close. In Figure 7.1, we see a dark candle (in a color charting software package, it would be a red candle). This signifies that this particular time period’s close is below the open. It does not indicate whetherthe market closed higher or lower than the previous time period did. Thecomputer code for this sequence would be C < O—the close is less than theopen. We can also assign a negative (–) value or reading to help determinethe relative strength of a trend.In Figure 7.2, the white, or hollow, candle signifies that the concluded
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FIGURE 7.1
Selling or Short
FIGURE 7.2
Buying or Long
time period shows that the close is above the open (in a charting softwarepackage, you would universally see this as a green candle). Keep in mindthat you can adjust almost any parameter in any software package to yourliking. Therefore, you may want the candle to be white. The point is that thecolor of a “lower close than open” candle should be different from the colorof the “higher close than open” candle. The computer code for this sequence would be C > O—the close is greater than the open. We can also assign a positive (+) value or reading to help determine the relative strengthof a trend by how many more positive, or “higher close than open,” candlesexist.The three main components of candle charts that we need to identify are:1. Relationship between Open and Close (Candle Bodies). With the real
candle body colored and representing a negative or a positive reading,we can see what is dominating the market.In uptrends, or bullish market conditions, we see buying come inon the open; and as we learned from the stochastics indicator, the market should settle closer to the highs. It should also close above theopen; and that is why in bullish market conditions, we see hollow,white, or green candles. This is why I assign it a positive (+) reading.How much the bulls are dominating the market is reflected by thelength or the distance between the open and the close. If the marketopens on the low and has a large range where it closes at the high of thesession, that signifies that the bulls are in strong control. However, ifthe market has a wide-range session and the market price closes back
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near where it opened—say, in the middle of the range—that is not asign that bulls dominate the market for that particular time period.In a bearish market condition, or a strong downtrend, we wouldsee dark- or red-colored real body candles. This represents sellers entering the market on the open and dominating the session right into theclose of that time period. If the market opens on the high and prices decline where the close is at or near the low, this shows that the bears arefirmly in control. This is why I assign a negative (–) reading. The distance factors between the open and the close are illustrated in a muchmore defined way in candle charts than in bar charts due to the shapeand color coordination of the candles.2. Shadows and Correlations to Candle Body. The distance of a lowand/or a high in relation to the real body as created by the open and theclose can really illustrate the market’s denial of a support or a resistance level. Long shadows, tails, or wicks, as they are called, that formafter a long downtrend indicate a potential that the trend has exhausteditself and that demand is increasing or supply is dwindling. Shadows,tails, or wicks formed at the tops of real bodies, especially after a longprice advance, indicate that demand is drying up and supply is increasing. The overall size of shadows is important to watch in relation to areal body and can be easily identified.3. Size or Length of the Overall Candle. Now this is one that is hard tomiss using the color-coded method of candle charts. A long candle thatopens at the bottom and closes at the high, which would be an abnormal occurrence, has significant meaning. After a long downtrend, seeing this formation indicates that a major trend reversal is taking place.After a long uptrend, seeing an unusually long candle that closes abovethe open (a positive value) would indicate that an exhaustion or blowoff-top condition may exist.The reverse is true in down trades. After a long price decline, a tallred- or dark-colored candle, which represents the market close belowthe open (a negative assigned value), may indicate that a capitulationor an exhaustion bottom has formed. After a long uptrend or price advance, if that same candle was formed, it might indicate that a majortrend reversal is occurring.
CANDLE FORMATIONSThe candle development will give us immediate identification of the currentmarket’s environment and the market participant’s acceptance or rejectionor a support or resistance level in a clearly visual manner.
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The DojiThere is a special candle that has no real body to speak of and is calledthe doji. The close of this candle is at exactly the same price as the close.I generally am a little more lenient with this formation; if after a long rangetrading session the close is less than 8 percent of the overall high and low,I consider it a doji. For example, if the Dow has a 100-point trading rangeand the close is within 8 points of the open, I consider it a doji. In currencies, for example, if the British pound had a 150-point range and the marketclosed within 12 points of the open, I would consider that a doji formation(Figure 7.3).
FIGURE 7.3
Doji formations help confirm reversals. There are different names andnuances associated with certain dojis, such as the gravestone, Figure 7.4,which, when formed after a major downtrend, signals that the trend is nearan end and that slightly lower prices are expected to come. It is similar inappearance to what is called an inverted hammer at market bottoms or ashooting star at the top of a prolonged price advance.
FIGURE 7.4
The dragonfly, Figure 7.5, resembles another candle pattern withsimilar implications, which is a hanging man formation. This candle gen-
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erally develops after a long uptrend and has very bearish implications atmarket tops.
FIGURE 7.5
FIGURE 7.6
Then there is a long-legged, or rickshaw, doji in Figure 7.6. It has an extremely wide range, which heightens the collective market participant’s indecision.The secret weapon of candlestick charting is knowing the power ofwhat the doji represents. Dojis indicate indecision—the market ends whereit began. Confidence is lost from buyers or sellers on the open as the market made a lot of noise as the range was established. In a bullish or bearishtrending market, indecision is the last thing you want to see. Strong rejection or failure from the high and/or low is a significant telltale sign thatchanges are coming.We use the phrasing of Sir Isaac Newton’s law in the markets an awfullot because it really applies to market moves: “A body in motion tends tostay in motion until a force or obstacle stops or changes that motion.” I believe and teach that the doji represents that force: It generally stops orchanges the motion or momentum due to the uncertainty or indecision thatis created at peak and troughs.In a strong uptrending market, usually the market will close near ahigh, as larger-capitalized traders will hold positions overnight. If the largemoney traders are not confident the market will move higher in price, thenusually the market closes back near the open. If large-capitalized traderslose confidence, then it is best to wait before making a trading decision,right? Well, that is the indecision that forms a doji.Dojis help form two- and three-candle formations that can develop intomore powerful and trustworthy signals once identified. A few of these formations are morning doji star, the evening doji star, and the bullish andbearish harami doji crosses, which are discussed later in this chapter.With each of these patterns, we need to see a specific sequence of eventsfor these patterns to develop, such as a gap lower open and a gap higheropen than a previous close. Due to the electronic age and 24-hour market
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access, these patterns have several variations. Therefore, I have simplifiedmy search for what really matters most and concentrated my attention oncertain high-frequency formations.That is not to say that other patterns are not worth notice, such as thebullish piercing pattern, the bearish dark cloud cover, the engulfing patterns, the harami, and continuation patterns, such as the rising and fallingthree methods. There are many combinations that end up becoming great“after the fact” type patterns. There are the fry pan pattern, the advancingsoldiers, the towers, the three crows, the separating lines, the tower topsand bottoms, the belt hold, the counterattack lines, the three river bottoms,et cetera.
Other Important Candle PatternsFor practical trading application, it is very difficult to program code formost software trading applications to automatically alert you to a trade signal based on the exact patterns and sequences of a particular formation. Itis most important that you be able to act on that signal. However, it is possible to program a few select patterns once you identify what the most frequent and most reliable candle patterns are that reproduce desirablemarket reactions or price moves, especially when these patterns occur at ornear the predicted support and resistance levels derived from pivot pointcalculations. We have done that in a small sample and a back test, which Iwill share with you. First, let me give an overall description of what the second-most-important candle patterns are after the dojis and of how to triggera trade based on the specific relationship of those patterns to the four common denominators to which we all have equal access: the opens, the highs,the lows, and the closes of a respective time period. There is one more element that stock traders have, and that is real-time trading volume analysis.Volume can highlight candle patterns’ significance, such as the hammerpattern shown in Figure 7.7.
FIGURE 7.7
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• The hammer indicates that a reversal or a bottom is near in a downtrend. When a hammer appears at the top of an uptrend, the namechanges to a “hanging man” and indicates that a top is near. There arethree main characteristics that a pattern needs in order to qualify.1. The real body is at the upper end of the trading range; the color(white or black) is not important.2. The lower part, or the “shadow,” should be at least twice the lengthof the real body.3. It should have little or no upper shadow, like a shaved head candle.After a long decline, if a hammer forms on higher or increased volume, this adds to the certainty that a capitulation low has occurred.Hammers can be created both by a closing below the open, whichwould be assigned a negative change value (shown in Figure 7.8), andby a higher close than the open, which would be assigned a positivechange value (shown in Figure 7.9).
Hammer
FIGURE 7.8
Hammer
FIGURE 7.9
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FIGURE 7.10
• The shooting star is the inverted formation of the hammer and forms attops (Figure 7.10). It usually signals a major reversal. The color doesnot matter, but the body should be at the lower end of the trading rangewith a long shadow. Its significance is that it shows that the marketopened near the low of the day, then had an explosive rally that failed,and closed back down near the low of the day. Usually there is little orno lower shadow like a shaven bottom. When it is at the bottom of adowntrend, it is called an inverted hammer. Figure 7.11 shows a positive assigned candle, or a higher-close-than-open star. Figure 7.12shows a negative assigned candle, or a lower-close-than-open star.
FIGURE 7.11
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FIGURE 7.12
• The morning star is a major bottom reversal pattern that is a threecandle formation (Figure 7.13). The first candle has a long black realbody. The second candle has a small real body that gaps lower than thefirst candle’s body. The third candle’s body sometimes gaps higherthan the second one but does not happen often. It is important that thethird candle is a white candle and closes well above the midpoint of thefirst candle’s real body.A variation of the morning star doji pattern is shown in Figure 7.14.There are 10 or 12 different variations of this pattern; therefore, I lookfor the candle following the doji to generate a signal.
FIGURE 7.13
FIGURE 7.14
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• The evening doji star (see Figures 7.15 and 7.16) is the exact oppositeof the morning doji star. It is the second-most-bearish top pattern, nextto the abandon baby or island top formation.
FIGURE 7.16
FIGURE 7.15
• The harami is a small real body within the body of the prior body’s candle (Figure 7.17). This is known as a reversal pattern or a warning of atrend change, especially at tops of markets. It is not important that thecolors be opposite, but I notice that the more reliable signals are generated when they are.
FIGURE 7.17
• The bearish harami doji cross formation is a long white candle, signifying that the market closed above the open, with little or no shadow atboth ends of the candle (Figure 7.18). It was followed in the next timeperiod by a doji within the middle of the real body. This tells me thatsellers are entering the market.
FIGURE 7.18
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• The bullish harami doji cross would occur in a downtrending market.The first candle is usually a long dark candle, signifying that the marketclosed below the open, with little or no real shadow at both ends. Thenthe next trading session, a doji forms (Figures 7.19 and 7.20).
FIGURE 7.19
FIGURE 7.20
• The dark cloud cover is a bearish reversal signal that usually appearsafter an uptrend. The first white candle is followed by a dark candle.The important features here are that the dark candle should openhigher than the white candle’s high and close well below the midpointof the white candle’s real body (Figures 7.21 and 7.22).
FIGURE 7.21
FIGURE 7.22
• The bullish piercing pattern is considered the opposite of the darkcloud cover. It requires that the first candle is a long dark candle, thatthe second candle gaps open lower than the first candle, and that itcloses well above the midpoint of the long dark first candle. Look for 50percent penetration of long dark candle (Figures 7.23 and 7.24).
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FIGURE 7.24
FIGURE 7.23
• The bullish engulfing pattern is indicated when a white candle’s realbody completely covers the previous dark candle’s real body. Theopening is lower than the first candle’s real body, and the close is abovethe first candle’s middle portion of the body. The more “wraps” or pastcandle’s real bodies that are engulfed, the stronger or more significantis the signal (Figures 7.25 and 7.26).
FIGURE 7.25
FIGURE 7.26
• The bearish engulfing pattern is distinctive. The engulfing bearish lineis signaled where a dark candle’s real body completely covers the previous white candle’s real body