Fine-Tuning Candlestick Trading: Combine Moving Average Techniques

[brownsfan019 17]

Fine-Tuning Candlestick Trading: Combine Moving Average Techniques

(note - link does not work in Firefox for me - use IE or IE tab)

 

A candlestick reversal signal reveals an important market insight that makes it more powerful than all other methods of technical analysis. That signal reveals an actual change in investor sentiment—not just the anticipation of a possible change. The candlestick signal or pattern is the visual picture formed in the wake of a sentiment change. Having this tool in an investor’s arsenal can dramatically improve profits while reducing risk exposure.

 

 

STANDING THE TEST OF TIME

 

If one were searching for the “golden goose” of investment programs, the criteria would be simple: well researched, proven track record and easy-to-identify reversal points. This is the definition of candlestick analysis. All three of these elements are incorporated into candlestick signals. Hundreds of years of rice trading resulted in the identification of high-probability profitable trades. Candlestick signals exist today because of those many years of actual profitable trades. Not computer backtesting. Not theoretical results. Profits produced from using the signals are the only reason we are still witnessing these signals today.

 

 

IT’S A SENTIMENT PICTURE

 

Exploiting fear and greed created by the masses is a large factor behind professional investors’ profits. The candlestick signal is actually a visual depiction of investor sentiment and it graphically illustrates a change. This analysis allows a trader to pinpoint when the masses are creating a profitable opportunity. Most investors panic at the bottom, and they get overexuberant at the tops. Knowing this and visually seeing it happen forces the candlestick trader to buy when the buy signal is formed at the bottom, and they sell when the sell signal is at the top.

 

Candlestick signals also offer an additional powerful insight not found in other charting techniques. Not only did the Japanese rice traders identify high-profit reversal signals, they added another significant aspect to candlestick analysis. They interpreted what investors were thinking (sentiment) when forming a signal. This process alone creates insights that put candlestick analysis light years ahead of any other trading technique.

 

 

COMBINE WITH MOVING AVERAGES

 

Traders can combine simple moving averages with candlestick analysis for additional confirmation and information on trade entry and exit points. The 50-period simple moving average (SMA) and the 200-period simple moving average are important technical indicators that act as powerful support and resistance levels. Global money managers monitor those two key longer-term moving averages closely and often base long-term investing decisions at these price levels. Candle analysis helps reveal what types of decisions are being made near or at these key moving averages.

 

Visually analyzing investor sentiment through candle analysis at important technical levels creates the platform to enter or exit positions at the most opportune times. Applying simple rules for the use of moving averages, in conjunction with candlestick signals, greatly improves the probabilities of being in or out of a trade at the correct time.

 

First, a little background on moving averages. The moving averages have a tendency to act as support and resistance. They also act as magnets for a price trend. Money managers may not have the inclination to buy during a downtrend until the price hits a support level. They may not want to sell until a price has reached the potential target, the resistance level. Another simple rule of thumb, if a price moves away from important moving averages too quickly, the price has a tendency to come back to the moving averages.

 

 

RULES IN ACTION

 

Using these simple rules with candlestick signals makes for a high-probability trade. As illustrated in Figure 1, a candlestick buy signal forms at Point A, which is known as a bullish engulfing pattern. This signal formed after indecisive trading (a doji and a small hammer signal).

 

 

This combination of signals illustrates a strong reversal situation. Add in the fact that it all occurred at the 50-day moving average, and the technical evidence is strengthened that the next uptrend is in progress.

 

 

SHORTER MOVING AVERAGES, TOO

 

Traders can also combine candles with the eight-period exponential moving average (EMA). This moving average is effective for pinpointing entries and exits, as well as signaling the continuation of an uptrend or downtrend.

 

How can this be used? When a candlestick buy signal is confirmed with a close above the eight-period EMA, the uptrend should continue until the formation of a candlestick sell signal and a close below the eight-period EMA. The opposite is true for a downtrend. A candlestick sell signal and a close below the eight-period EMA indicates a downtrend is in progress until a candlestick buy signal is followed with a settlement above that moving average.

 

 

TAKING IT A STEP FURTHER

 

Day traders can improve their daily trading results with additional fine-tuning of candlestick analysis with moving averages. Short-term trades can be implemented when the two-period EMA crosses the eight-period EMA following a candlestick signal. This dramatically reduces the number of times a trader will enter a trade that immediately fails or closes a winning trade before the full price move is over.

 

See Figure 2 for an example of how the moving averages were used effectively while trading soybeans on a 10-minute chart. Point A shows a bearish engulfing pattern signal forming when stochastics revealed overbought conditions. These are signals to take profits after the recent uptrend. Also note how the two-period EMA moved a great distance away from the eight-period EMA. This was additional evidence that price was ready to pullback. The first viable target would be a test of the eight-period EMA.

 

 

Will price use the eight-period EMA as support and move

back up? A trader does not know that when taking profits at the bearish engulfing signal. When it pulls back to that level, the candlestick formations illustrate what investor sentiment is doing at that time. In this case, the price did not find support at the eight-period EMA. Additionally, the two-period EMA continued down through the eight-period EMA, indicating it was not time to buy.

 

Point B shows a potential reversal. However, there were two indications that this was not a trend reversal. First, stochastics were still heading down, not yet at the oversold conditions. Also, the two-period EMA did not move up through the eight-period EMA. This lack of confirmation keeps an investor from getting into a bad trade.

 

 

PATIENCE IS A VIRTUE

 

It was not until Point C in Figure 2 that it became time to buy. The piercing pattern was followed by a bullish moving average confirmation. That confirmation came when the two-period EMA moved higher through the eight-period EMA; also stochastics were in an uptrend. Utilizing the combination of technical signals greatly improves a trader’s odds of being in the right trade at the right time.

 

 

STAY IN YOUR WINNERS

 

The two-period and eight-period EMA combination also prevents a trade from being closed too early. Additionally, the moving average pair can signal when to re-enter a trending price move if a trade were closed too early. As illustrated in Figure 3, although candlestick sell signals appeared in the uptrend, the two-period EMA did not cross down through the eight-period EMA. This allowed a trader to remain in a position that was moving to much higher levels.

 

 

The candlestick sell signal at Point A might have indicated a time to take profits. However, the eight-period EMA was not that far away. Each time the price tested that level, a bullish candlestick signal formed and the two-period EMA could not make its way down through that level. Without the confirmation of the sell signals, traders could have more confidence to remain in the position.

 

 

KNOW YOUR MARKET’S PERSONALITY

 

Different moving average combinations work more effectively on various underlying markets. Although the two-period and eight-period EMA work well for trading forex or the E-minis, a 13-period and 34-period EMA combination might work better on coffee and cocoa 15-minute charts. For those trading the U.S. dollar, I have found that using the eight-period EMA and the 50-period SMA on the hourly chart to be a successful combination.

 

The success of trading any market starts with a proven trading method such as candlestick analysis. From there, adding the appropriate confirming indicators can be easily tested for enhancing profitable trading programs.

 

 

PUT THE ODDS ON YOUR SIDE

 

Traders who use candlestick signals and then incorporate confirming indicators, such as moving averages, can increase their probabilities in spotting trend changes and their odds for profits. Ignoring the information contained within the candlestick signals could mean that a trader is leaving profits on the table. Mastering the various signals and patterns within candlestick analysis can allow traders to spot fear and greed and help identify high-probability trading opportunities.

 

Stephen W. Bigalow is author of Profitable Candlestick Investing: Pinpointing Market Turns to Maximize Profits and High Profit Candlestick Patterns.

&

High Profit Candlestick Patterns

 

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THE BASICS

 

 

Reversal points were identified by Japanese rice traders in the 1600s using simple charting techniques. The traders used the same information found on a standard bar chart. The difference is that they put more weight on the open and closing prices, as well as the high and the low for a period.

 

As illustrated in Figure A, an open that is lower than the closing price creates a white (bullish) candle. An open that is higher than the close creates a dark (bearish) candle. The positioning of these candles, with analysis of the colors, provides valuable information.

 

Edited April 2, 2009 by brownsfan019

[brownsfan019 17]

My thoughts... Bigalow does a lot of work w/ candlesticks and in my newer days, I would spend time at his site.

 

I would highly recommend his books if you want to learn more about using candlesticks in your trading.

 

Profitable Candlestick Trading: Pinpointing Market Opportunities to Maximize Profits

 

High Profit Candlestick Patterns

And he presents a good article here for someone to work w/ using candlesticks and moving averages, which we have also discussed here in a few threads.

[Blu Bull 10]

Thanks for sharing this

[bathrobe 10]

Great info, thanks for posting

[brownsfan019 17]

No problem guys. I read the article in SFO and thought it would be a good fit here in the CC.

 

Bigalow has some good work on candlesticks.

[SunTrader 10]

I read the article when it came in the mail. And I use candles all the time but the opening sentence struck me as very bold and more importantly unsubstantiated "...... more powerful than all other methods of technical analysis".

 

Otherwise Bigelow does know candlesticks.

[brownsfan019 17]

I read the article when it came in the mail. And I use candles all the time but the opening sentence struck me as very bold and more importantly unsubstantiated "...... more powerful than all other methods of technical analysis".

 

Otherwise Bigelow does know candlesticks.

 

I agree Sun. It's his opinion and nothing more. There are so many ways to trade it's not even funny. In his eyes, candles work. Others would say they are a farce.

 

In the end, requires the end user to put in the time and work to get it done.

[artrading 10]

Interesting article Browns, thanks for highlighting!

[Dinerotrader 10]

I am new to candlesticks so may be a silly question but they seem very much intended to be used on a daily chart with real open and close prices. How does arbitrary open and close prices used in candles on a 5 minute chart of the ES mean anything? The actual close of the market really does affect the way millions of investor's trading strategies since being out or in the market during close hours bears risks so it makes sense to me that daily candles would visualize price action/sentiment/etc. appropriately. I just don't get candles on smaller time frames yet.

I would greatly appreciate your thoughts.

[brownsfan019 17]

As I've said many times here, the lower the timeframe, the less reliable candle patterns by themselves are. You MUST use them in conjunction with other tools - I would recommend defining support/resistance and then use candles to aid in your trading.

 

For example - if you see a hammer and just a hammer randomly on a chart, that's nothing IMO. Now if you see a hammer at the previous day high or low, along w/ some other support/resistance, then you might have something there.

 

In the article referenced in this thread, the author uses moving averages to use w/ candlesticks.

[Dinerotrader 10]

brownsfan019-

Do you still use volume candles at all? I was reading some posts from back in 2007 in which you seemed very positive on using candles based on volume instead of the passage of time. I really value your opinion on candle reading and you normally mention 5minutes candles currently so did you decide after time that volume candles just didn't add value to your setups? Thanks.

[ensoniq 10]

I am new to candlesticks so may be a silly question but they seem very much intended to be used on a daily chart with real open and close prices. How does arbitrary open and close prices used in candles on a 5 minute chart of the ES mean anything? The actual close of the market really does affect the way millions of investor's trading strategies since being out or in the market during close hours bears risks so it makes sense to me that daily candles would visualize price action/sentiment/etc. appropriately. I just don't get candles on smaller time frames yet.

I would greatly appreciate your thoughts.

 

I would tend to agree with the point you make here. Not many people seem to realise that a five minute candle is a completely arbitrary timeframe that they are trying to impose on the market. Shift the five minute 'ruler' two minutes one way, and you get an entirely different picture, though still a five minute candle chart. Shift it three minutes the other way, and you get a different picture again . . .

 

Daily (cash session) candles are different in that they represent a distinct unit of time, both preceded and followed by a period in which no trading occurs.

 

I hope that's helpful.

[ensoniq 10]

In your thread you make the following statement:

 

The 50-period simple moving average (SMA) and the 200-period simple moving average are important technical indicators that act as powerful support and resistance levels.

 

I feel I should point out that this cannot be the case. A moving average can only be calculated after the price action has occured. It cannot provide support or resistance during a trading period because it cannot be calculated until after that trading period is over.

 

If I ask you 'at what level can we expect resistance at the 200SMA tomorrow?' you cannot offer a reply because you cannot know where tomorrow's 200SMA will be until after tomorrow's close. You cannot give me any information that will be useful to me in advance. This is (part of) why such indicators are said to be 'lagging'.

 

A further point to make is that, because a moving average is by its very nature an average of price action, price can be expected to spend as much time above the MA as below it - hence the probabilty of it providing support in any given instance is pretty much a coin toss (and likewise with resistance).