Japanese Candlesticks and Technical Analysis, The Complete Picture.
In my final article on the topic of candlestick charting we are going to apply lessons learnt in my earlier two articles with an understanding of other areas of technical analysis to see just how complementary they are. I’ve found a couple of great examples to show just how powerful and profitable their combination can be. For anyone serious about making money in foreign exchange these examples are a must read.
The first example we are going to look at today is of the AUD/USD daily chart during the April 2012- April 2013 period. As shown in this chart (see the image below) we had a number of great tradable set-ups during the period.
Trade (1) SELL, comes after a bearish harami formation is followed by a CCI (Commodity channel index) sell alert the following session (see 1a), which along with the strong long down candle that day provides confirmation of the deteriorating outlook.
Trade (2) BUY, comes after a bullish hammer candlestick with an extremely long lower shadow indicates a repulsion of the bears by strong late in the day demand. The following session is another hammer (with a small upper shadow) followed by confirmation of the bullish outlook the next day when the CCI issues a buy alert (2a). To complete the set-up the CCI and RSI (Relative strength index) show a strong divergence (2b) with price to further highlight the inherent weakness of the bears.
Trade (3) SELL, comes after a bearish hanging man candlestick is confirmed by a CCI sell alert the same day (3b). The bearish divergence seen at (3a) completes the negative outlook.
Trade (4) BUY, comes after a bullish engulfing pattern which is also a tweezers bottom is confirmed by a CCI buy alert (4a) the following day.
Trade (5) SELL, comes after an evening doji star is confirmed the following day by a CCI sell alert (5a) and strong down candle close near the lows of the day. Whilst the ideal evening star pattern would see a gap between the second and third real bodies in reality this rarely occurs and is not necessary for the success of the formation. As is typical with the forex market a gap isn’t seen between the first and second candles of the pattern either due to the continuity of pricing. The tiny half pip overlap of the real bodies is meaningless given the 94-pip range observed that day. Note also that by the close of this peak session we had seen a strong rejection from those same highs observed previously on the day before the hanging man candlestick session of (3).
Trade (6) SELL, comes after dark cloud cover and a tweezers top near resistance put in place earlier (see 3 and 5) is confirmed by a CCI sell alert (6a) after four days of lateral price movement where the price was unable to break the highs of these two candlestick pattern signals.
Trade (7) BUY, comes after another bullish hammer candlestick with an extremely long lower shadow is confirmed the next day by a CCI buy signal (7a).
Trade (8), SELL, the final trade comes after an evening star formation again near resistance is confirmed by a strong down move and CCI sell alert two days later. Unfortunately the near 230+pip slump from a 1.0523 high the day of the CCI sell alert made this a difficult trade to execute.
The move however foreshadowed a significant slump to the lows of ~.9037 set on the 4th of July by the time of writing. Longer-term swing traders could have used the nearby 1.0625 resistance for protection on shorts if they had opened the position at the start of the day of the significant down move.
Our second example today is an excellent showcase of the power of candlestick charting when it is combined with knowledge of technical indicators and support and resistance principles. The case highlights how important it is to have an understanding of the overall market context at the time of the candlestick signal. The image shows the GBP/NZD cross from November 2011 to October 2012 with daily candlesticks.
Trade (1) SELL, comes after a dumpling top. This is a reversal pattern that typically has a group of small real bodied candlesticks forming a convex shape as the market tops. Confirmation comes when the market gaps lower (see 2). This gap down is known as a “falling window” and indicates a complete lack of demand as the new session opens. Two days earlier the RSI had also issued a sell alert (1a), which was to be joined by a CMO (Chande momentum oscillator) sell alert (1b) on the day of the falling window session.
Trade (2) BUY, comes at point (3) after a tweezers bottom is backed by a bullish engulfing candlestick. The timing of the CMO buy alert 3 days later (3a) unfortunately made this indicator of little assistance for this trade.
Trade (3) SELL, here we have seen the market rebound from the earlier tweezers bottom low. The failure at (4) is an evening star formation but more importantly traders should note the failure level at the bottom of the earlier ‘falling window’. Many Japanese chartists say to “go in the direction of the window” this is said because windows are continuation signals. They also say that “corrections stop at the window” and indeed this is the case that we have see here. At this point stale longs, which had bought on the day the falling window formed, would be looking to exit their positions adding to the overhead supply. A close above the top of the window at this point would have negated the bearish outlook.
Trade (4) BUY, comes at point (6) after a two month sell off. This bullish hammer candlestick is supported by strong divergence between the RSI/CMO indicators and price (6a). The trend-line break at (5) a few days earlier also served as a warning flag to traders that the downside momentum was waning.
Trade (5) SELL, at point (7) was a shooting star formation preceding a small week-long correction in the new emerging uptrend, the correction ended with a strong bullish engulfing candlestick on the 14th March.
Trade (6) BUY, emerges at point (8) after a strong bullish engulfing candlestick lays the foundation for a strong gains over the ensuing weeks culminating in a fantastic shorting opportunity at the old November 2011 highs, set six months earlier.
Trade (7) SELL, few come easier than this shorting opportunity. The five-week rally from (8) fails almost exactly at the old highs from November 2011 (see 1). At the same time we see a powerful divergence set-up between the indicators and price (9a). The scene is set perfectly the following day with the completion of the shooting star pattern (9), the trend-line break (10) and the RSI sell alert (9b) all on the same day. The CMO sell alert (9c) had raised the initial alarm two days before the double top highs.
Trade (8) BUY, at point (11) results after another bullish engulfing pattern, which is supported by an RSI buy alert the same day (11a) and CMO buy alert the previous day (11b).
Trade (9) SELL, at point (12) is the result of a bearish engulfing pattern and precedes a two week long 870 pip sell-off.
Trade (10) BUY, at point (13) occurs after another dual engulfing and tweezers formation which is supported by a trend-line break of the earlier steep sell-off from (12) and buy alert from the RSI and CMO (13a&b) on the same day.
Trade (11) SELL, at point (14) is an evening star (and also tweezers top) formation which is backed by a same day RSI sell alert (14a) and CMO sell alert the following day (14b).
The piercing pattern at (15) halts the slide from the prior evening star formation and sees the market enter a prolonged period of lateral price movement, which ensues for the majority of the remainder of 2012. Note how the long-legged doji at (16) showed support from buyers at the earlier lows of (15) re-enforcing the range-trading environment.
This will be my final piece of the series on the centuries old art of Japanese candlestick charting, today we have seen just how helpful it can be for market timing especially when combined with the other facets of technical analysis. For traders interested in a more complete discussion on the topic I would encourage them to read ‘Japanese Candlestick Charting Techniques’ – A contemporary guide to the ancient investment techniques of the far east, by Steve Nison. I found this a really helpful and quick read for a complete introduction on the topic.