JAPANESE CANDLESTICK CHARTING TECHNIQUES

~-Y?~L&B~E!% L

?ABWt

"Candles Exhaust Themselves to Give Light to Men"

JAPANESE CANDLESTICK CHARTING TECHNIQUES
A Contemporary Guide to the Ancient Investment Techniques of the Far East

STEVE NISON

NEW YORK INSTITUTE OF FINANCE
NewYork London Toronto Sydney Tokyo Singapore

Library of Congress Cataloging-in-Publication Data Nison, Steve. Japanese candlestick charting techniques : a contemporary guide to the ancient investment technique of the Far East I Steve Nison. p. cm. Includes bibliographical references and index. ISBN 0-13-931650-7 1. Stocks-Charts, diagrams, etc. 2. Investment analysis. I. Title. HG4638.N57 1991 90-22736 332.63'22-dc20 CIP This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.

From a Declaration of Principles Jointly Adopted by a Committee of the American Bar Association and a Committee of Publishers and Associations
01991 by Steve Nison All rights reserved. No part of this book may be reproduced in any form or by any means without permission in writing from the publisher. New York Institute of Finance Simon & Schuster Printed in the United States of America 1 0 9 8 7

Acknowledgements
Like having ice cream after a tonsillectomy, this section is my treat after the book's completion. Some of those who deserve recognition for their help are addressed in Chapter 1 in my discussion of my candlestick education. There are many others whom I would like to thank for their help along my candlestick path. Candles might help light the way, but without the assistance and insights of many others it would have been almost impossible to do this book. There were so many who contributed in one way or another to this project that if I have forgotten to mention anyone I apologize for this oversight. The Market Technicians Association (MTA) deserves special mention. It was at the MTAfs library that I first discovered candlestick material written in English. This material, albeit scant, was extremely difficult to obtain, but the marvelously complete MTA library had it. This information provided the scaffolding for the rest of my candlestick endeavors. Besides the two English references on candlesticks I mention in Chapter 1, I also obtained a wealth of information from books published in Japanese. I would like to thank the following Japanese publishers and authors for these books that I used as references:

Kabushikisouba no Technical Bunseki (Stock Market Technical Analysis) by Gappo Ikutaro, published by Nihon Keizai Shinbunsha Kabuka Chato no Tashikana Yomikata ( A Sure W a y to Read Stock Charts) by Katsutoshi Ishii, published by Jiyukokuminsha Keisen Kyoshitsu Part 1 (Chart Classroom Part I ) , published by Toshi Rader Hajimete Kabuka Chato w o Yomu Hito no Hon ( A Book for Those Reading Stock Charts for the First Time) by Kazutaka Hoshii, published by Asukashuppansha

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Acknowledgements

Nihon Keisenshi (The History o Japanese Charts), Chapter 2 by Kenji f Oyama, published by Nihon Keisai Shimbunsha Shinpan Jissen Kabushiki Chart Nyumon (Introduction to Stock Charts) by Okasan Keisai Kenkyusho, published by Diamond-sha a Sakata Goho W Furinkazan (Sakata's Five Rules are Wind, Forest, Fire and Mountain), published by Nihon Shoken Shimbunsha Yoshimi Toshihiko no Chato Kyoshitsu (Toshihiko Yoshimi's Chart Classroom) by Toshihiko Yoshimi, published by Nihon Chart Then there's the team at Merrill Lynch who were so helpful in looking over the manuscript, making suggestions, and providing ideas. John Gambino, one of the best colleagues anyone can work with provided all the Elliott Wave counts in this book. Chris Stewart, Manager of Futures Research, not only read the entire manuscript but provided valuable suggestions and finely dissected the many, many charts I used. I also want to thank Jack Kavanagh in compliance who also read the manuscript. Yuko Song provided extra insights by conveying some of my candlestick questions to her Japanese customers who use candlesticks. I have included hundreds of charts in this book from various services. Before I thank all the services that have generously provided use of their candlestick charts, I want to give plaudits to Bloomberg L.P. and CQG (Commodity Quote Graphics). Bloomberg L.P. was among the first on-line services to provide candlestick charts on the American markets. It's too bad I didn't discover this earlier. I was drawing candlestick charts on my own for years before I found out about Bloomberg. CQG, an on-line futures charting service, was also among the first to see the potential of candlestick charts. Within a few weeks of my first candlestick article, they sent me an alpha test (this is a high-tech term for the very early stages of software prototype testing) of their candlestick software for my CQG System One T". Once I had this software, my candlestick research progressed exponentially. Most of the charts in this book are courtesy of CQG. Besides Bloomberg L.P. and CQG, other services that were kind enough to provide charts are: Commodity Trend Service Charts (North Palm Beach, FL), CompuTrac " (New Orleans, LA), Ensign Software (Idaho Falls, ID), FutureSource " (Lombard, Ill), and Quick 10-E Financial Information System (New York, N.Y.).
T T

I want to thank those who took time from their busy schedules to review the introductions for Part Two of the book. These are: Dan

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Acknowledgements

vii

Gramza for the chapter on Market Profile@; Korzenik for the chapters Jeff on options and hedging; John Murphy for the chapter on volume and open interest; once again, John Gambino for the chapter on Elliott Wave; Charles LeBeau for the chapter on oscillators; Gerard Sanfilippo and Judy Ganes for the chapter on hedging; and Bruce Kamich for the English language glossary. The Nippon Technical Analysts Association (NTAA) deserves utmost praise for their assistance. Mr. Kojiiro Watanabe at the Tokyo Investment Information Center helped me to contact NTAA members who have been especially helpful. They are: Mr. Minoru Eda, Manager, Quantative Research, Kokusai Securities Co.; Mr. Yasushi Hayashi, Senior Foreign Exchange Trader at Sumitomo Life Insurance; and Mr. Nori Hayashi, Senior Analyst, Fidelity Management and Research (Far East). When I asked them questions via fax I expected just brief answers. But these three NTAA members took their valuable time to write pages of explanations, complete with drawings. They were wonderful about sharing their candlestick experiences and insights with me. I also want to thank them for reading over and providing information for Chapter 2 on the history of Japanese technical analysis. If there are any mistakes that remain, they are those that I failed to correct. I want to thank again "idea a day" Bruce Kamich. Bruce is a friend and a fellow futures technician. Throughout our 15-year friendship he has provided me with many valuable ideas and suggestions. Probably two of the most important were his suggestion that I join the MTA and his constant haranguing until I agreed to write a book about candlesticks. Then there's the publishing staff of the New York Institute of Finance. They were all great, but those with whom I worked most closely deserve extra praise. Susan Barry and Sheck Cho patiently, skillfully and affably guided a neophyte author through the labyrinth of the book publishing business. Of course there is my family. At the time that I was writing this book, our newborn son Evan entered the picture (with all the excitement about candlesticks, I came close to calling him Candlesticks Nison). Try writing a book with a newborn and a rambunctious four-year-old daughter, Rebecca, and you start to get an idea of how much my wife, Bonnie, contributed to this book. She cared for the children while I maladroitly pummeled away at the keyboard. Obviously, she had the harder job. For each chapter's heading, and throughout the book, I used Japanese proverbs or sayings. Many times proverbs in the United States are considered trite and are rarely used. This is not so in Japan where proverbs are respected. Besides being enjoyable to read, the Japanese proverbs offer insights into Japanese beliefs and perspectives. I would like to

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Acknowledgements

thank the following publishers for the use of their material for the proverbs and sayings used in this book: University of Oklahoma Press, Charles E. Tuttle, and Kenkyusha Ltd. Finally, I must give proper and legal acknowledgements to many of the services I relied upon during my writing and research. Tick Volume and LiquidProfile " is a registered trademark of CQG. Market Profile@ ity Data Bank@ registered trademarks of the Chicago Board of Trade. are The CBOT holds exclusive copyrights to the Market ProfileB and Liquidity Data Bank@graphics. Graphics reproduced herein under the permission of the Chicago Board of Trade. The views expressed in this publication are solely those of the author and are not to be construed as the views of the Chicago Board of Trade nor is the Chicago Board of Trade in any way responsible for the contents thereof.
T

PREFACE
" A clever hawk hides his claws"

W o u l d you like to learn a technical system refined by centuries of use, but virtually unknown here? A system so versatile that it can be fused with any Western technical tool? A system as pleasurable to use as it is powerful? If so, this book on Japanese candlestick charting techniques is for you. You should find it valuable no matter what your background in technical analysis. Japanese candlestick charts are older than bar charts and point and figure charts. Candlesticks are exciting, powerful, and fun. Using candlesticks will help improve your market analysis. My focus will be mainly on the U.S. markets, but the tools and techniques in this book should be applicable to almost any market. Candlestick techniques can be used for speculation and hedging. They can be used for futures, equities, options, or anywhere technical analysis is applied. By reading this book you will discover how candlesticks will add another dimension of analysis. Do not worry if you have never seen a candlestick chart. The assumption of this book is that they are new to you. Indeed, they are new to the vast majority of the American and European trading and investing community. If you are a seasoned technician, you will discover how joining Japanese candlesticks with your other technical tools can create a powerful synergy of techniques. The chapters on joining Japanese candlestick techniques with Western technical tools will be of strong interest to you. If you are an amateur technician, you will find how effective candlestick charts are as a stand alone charting method. To help guide you, I

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Preface

have included a glossary of all the western and Japanese candlestick terms used. The Japanese technicals are honed by hundreds of years of evolution. Yet, amazingly, we do not know how the Japanese analyze our markets with their traditional technical tool called candlesticks. This is disconcerting if you consider that they are among the biggest players in the financial markets. The Japanese are big technical traders. Knowing how the Japanese use candlestick charts to analyze both our markets and theirs may help you answer the question "What are the Japanese going to do?" The Japanese use a combination of western chart and candlestick techniques to analyze the markets. Why shouldn't we do the same? If you do not learn about Japanese candlestick charts, your competition will! If you like reading about colorful terminology like "hanging-man lines," "dark-cloud covers," and "evening stars" then this book is for you. If you subscribe to one of the multitude of services now providing candlestick charts and would like to learn how to use these charts, then this book is for you. In the first part of the book, you learn how to draw and interpret over 50 candlestick lines and formations. This will slowly and clearly lay a solid foundation for the second part where you will learn to use candlesticks in combination with Western technical techniques. This book will not give you market omniscience. It will, however, open new avenues of analysis and will show how Japanese candlesticks can "enlighten" your trading.

Contents
Preface Chapter ix 1

1

INTRODUCTION
Some background, 1 How I learned about candlestick charts, 1 Why have candlestick charting techniques captured the attention of traders and investors around the world?, 4 What is in this book, 5 Some limitations, 7 The importance of technical analysis, 8

Chapter

2

A HISTORICAL BACKGROUND

PART ONE: THE BASICS
Chapter

3
4

CONSTRUCTING THE CANDLESTICKS
Drawing the candlestick lines, 21

Chapter

REVERSAL PATTERNS
Hammer and hanging-man lines, 28 Engulfing pattern, 38 Dark-cloud cover, 43 Piercing pattern, 48

xii

Contents

Chapter

5

STARS
The morning star, 56 The evening star, 59 The morning and evening doji stars, 64 The shooting star and the inverted hammer, 70 The inverted hammer, 75

55

Chapter

6

MORE REVERSAL PATTERNS
The harami pattern, 79 Harami Cross, 85 Tweezers tops and bottoms, 88 Belt-hold lines, 94 Upside-gap two crows, 98 Three black crows, 101 The counterattack lines, 103 Three mountains and three rivers, 107 The importance of the number three in candlesticks, 112 Dumpling tops and fry pan bottoms, 113 Tower tops and tower bottoms, 115

Chapter

7

CONTINUATION PATTERNS
Windows, 119 Upward- and downward-gap tasuki, 129 High-price and low-price gapping plays, 131 Gapping side-by-side white lines, 134 Rising and falling three methods, 135 Three advancing white soldiers, 143 Separating lines, 147

Chapter

8

THE MAGIC DOJI
The importance of the doji, 149 Doji at tops, 150 Doji after a long white candlestick, 154 The long-legged doji and the rickshaw man, 154 The gravestone doji, 159 Doji as support and resistance, 161 The tri-star, 162

Chapter

9

PUTTING IT ALL TOGETHER

.

165

xiv

Contents

Chapter

16 CANDLESTICKS WITH ELLIOTT WAVE
Elliott wave basics, 253 Elliott wave with candlesticks, 254

Chapter

17 CANDLESTICKS WITH MARKET PROFILE"
Market profile" with candlesticks, 261

Chapter

18 CANDLESTICKS WITH OPTIONS
Options basics, 268 Options with candlesticks, 269

Chapter Chapter

19 HEDGING WITH CANDLESTICKS
20 HOW I HAVE USED CANDLESTICKS
CONCLUSION

Glossary Glossary

A CANDLESTICK TERMS AND VISUAL GLOSSARY

B

AMERICAN TECHNICAL TERMS BIBLIOGRAPHY INDEX

Contents

xiii

PART TWO: THE RULE OF MULTIPLE TECHNICAL TECHNIQUES
Chapter Chapter

10 A CONFLUENCE OF CANDLESTICKS

11 CANDLESTICKS WITH TRENDLINES
Support and resistance lines with candlesticks, 185 Springs and upthrusts, 193 The change of polarity principle, 201

Chapter Chapter

12 CANDLESTICKS WITH RETRACEMENT LEVELS

13 CANDLESTICKS WITH MOVING AVERAGES
The simple moving average, 215 The weighted moving average, 216 The exponential moving average and the MACD, 216 How to use moving averages, 217 Dual moving averages, 220

Chapter

14 CANDLESTICKS WITH OSCILLATORS
Oscillators, 227 The relative strength index, 228 How to Compute the RSI, 228 How to Use RSI, 229 Stochastics, 232 How to Compute Stochastics, 232 How to Use Stochastics, 233 Momentum, 236

Chapter

15 CANDLESTICKS WITH VOLUME AND OPEN INTEREST
Volume with candlesticks, 242 On balance volume (OBV), 244 OBV with candlesticks, 245 Tick volume '" 245 , Tick Volume '"with candlesticks, 246 Open interest, 248 Open interest with candlesticks, 249

241

CHAPTER

1

INTRODUCTION lAS i
"The beginning is most important"

SOME BACKGROUND
Some of you may have already heard of candlecharts. Probably, many more of you have not. In December 1989, I wrote an introductory article on candlesticks that precipitated an immediate groundswell of interest. It turned out that I was one of the few Americans familiar with this centuries-old Japanese technique. I wrote follow-up articles, gave numerous presentations, taught classes, and was interviewed on television and by newspapers across the country. In early 1990, I wrote a short reference piece for my Chartered Market Technician thesis about candlestick charts. It contained very basic introductory material, but it was the only readily available information on candlestick charts in the United States. This handout became very popular. Within a few months, Merrill Lynch, the publisher of the booklet, received over 10,000 requests.

HOW I LEARNED ABOUT CANDLESTICK CHARTS
"Why," I have often asked myself, "has a system which has been around so long almost completely unknown in the West?" Were the Japanese trying to keep it secret? Was it the lack of information in the United States? I don't know the answer, but it has taken years of research to fit all the pieces together. I was fortunate in several ways.

2

Introduction

Perhaps my perseverance and serendipity were the unique combination needed that others did not have. In 1987, I became acquainted with a Japanese broker. One day, while I was with her in her office, she was looking at one of her Japanese stock chart books (Japanese chart books are in candlestick form). She exclaimed, "look, a window." I asked what she was talking about. She told me a window was the same as a gap in Western technicals. She went on to explain that while Western technicians use the expression "filling in the gap" the Japanese would say "closing the window." She then used other expresions like, "doji" and "dark-cloud cover." I was hooked. I spent the next few years exploring, researching, and analyzing anything I could about candlestick charts. It was not easy. There are scant English publications on the subject. My initial education was with the help of a Japanese broker and through drawing and analyzing candlestick charts on my own. Then, thanks to the Market Technicians Association (MTA) library, I came across a booklet published by the Nippon Technical Analysts Association called Analysis of Stock Price i n Japan. It was a Japanese booklet which had been translated into English. Unfortunately, there were just ten pages on interpreting candlestick charts. Nonetheless, I finally had some English candlestick material. A few months later, I borrowed a book that has had a major influence on my professional life. The MTA office manager, Shelley Lebeck, brought a book entitled The Japanese Chart of Charts by Seiki Shimizu and translated by Greg Nicholson (published by the Tokyo Futures Trading Publishing Co.) back from Japan. It contains about 70 pages on candlestick charts and is written in English. Reading it was like finding an oasis in a desert. As I discovered, while the book yielded a harvest of information, it took some effort and time to get comfortable with its concepts. They were all so new. I also had to become comfortable with the Japanese terminology. The writing style was sometimes obscure. Part of this might have resulted from the translation. The book was originally written in Japanese about 25 years ago for a Japanese audience. I also found out, when I had my own material translated, that it is dreadfully difficult to translate such a specialized subject from Japanese to English. Nonetheless, I had some written reference material. This book became my "Rosetta Stone." I carried the book with me for months, reading and rereading, taking copious notes, applying the candlestick methods to the scores of my hand-drawn candlestick charts. I chewed and grinded away at the new ideas and terminology. I was fortunate in another sense. I had the help

Introduction

3

of the author, Seiki Shimizu, to answer my many questions. Although Mr. Shimizu does not speak English, the translator of the book, Greg Nicholson, graciously acted as our intermediary via fax messages. The Japanese Chart of Charts provided the foundation for the rest of my investigation into candlesticks. Without that book, this book would not have been possible. In order to continually develop my abilities in candlestick charting techniques, I sought out Japanese candlestick practitioners who would have the time and inclination to speak with me about the subject. I met a Japanese trader, Morihiko Goto who had been using candlestick charts and who was willing to share his valuable time and insights. This was exciting enough! Then he told me that his family had been using candlestick charts for generations! We spent many hours discussing the history and the uses of candlestick charts. He was an invaluable storehouse of knowledge. I also had an extensive amount of Japanese candlestick literature translated. Obtaining the original Japanese candlestick information was one problem. Getting it translated was another. Based on one estimate there are probably fewer than 400 full-time Japanese-to-English translators in America (this includes part-time translators)' I had to find a translator who could not only translate routine material, but also the highly specialized subject of technical analysis. In this regard I was lucky to have the help of Languages Services Unlimited in New York. The director, Richard Solberg, provided indispensable help to this project. He was a rarity. He was an American fluent in Japanese who understood, and used, technical analysis. Not only did Richard do a wonderful job of translating, but he helped me hunt down and obtain Japanese candlestick literature. Thanks to his help I might have the largest collection of Japanese books on candlesticks in the country. Without Richard this book would have been much less extensive. Before my introductory article on candlestick charts appeared in late 1989, there were few services offering candlestick charts in the United States. Now a plethora of services offer these charts. These include: Bloomberg L.P. (New York, NY); Commodity Trend Service Charts (North Palm Beach, FL); CompuTrac '"(New Orleans, LA); CQG (Glenwood Springs, CO); Ensign Software (Idaho Falls, ID); Futuresource '"(Lombard, IL); and Knight Ridder-Commodity Perspective (Chicago, L).

4

Introduction

By the time you read this book, there probably will be additional services providing candlestick charts. Their popularity grows stronger every day. The profusion of services offering the candlestick charts attests to both their popularity and their usefulness.

WHY HAVE CANDLESTICK CHARTING TECHNIQUES CAPTURED THE ATTENTION OF TRADERS AND INVESTORS AROUND THE WORLD?
I have had calls and faxs from around the world requesting more information about candlestick techniques. Why the extensive interest? There are many reasons and a few are:
1. Candlestick charts are flexible. Users run the spectrum from first-time chartists to seasoned professionals. This is because candlestick charts can be used alone or in combination with other technical analysis techniques. A significant advantage attributed to candlestick charting techniques is that these techniques can be used in addition to, not instead of, other technical tools. I am not trying to convince veteran technicians that this system is superior to whatever else they may be using. That is not my claim. My claim is that candlestick charting techniques provide an extra dimension of analysis.
2. Candlestick charting techniques are for the most part unused in the

United States. Yet, this technical approach enjoys a centuries-old tradition in the Far East, a tradition which has evolved from centuries of trial and error.
3. Then there are the picturesque terms used to describe the patterns. Would the expression "hanging-man line" spark your interest? This is only one example of how Japanese terminology gives candlesticks a flavor all their own and, once you get a taste, you will not be able to do without them.

4. The Japanese probably know all the Western methods of technical analysis, yet we know almost nothing about theirs. Now it is our turn to benefit from their knowledge. The Japanese use a combination of candlestick charting techniques along with Western technical tools. Why shouldn't we do the same?

5. The primary reason for the widespread attention aroused by candlestick charts is that using them instead of, or in addition to, bar charts is a win-win situation.

Introduction

5

As we will see in Chapter 3 on drawing candlestick lines, the same data is required in order to draw the candlestick charts as that which is needed for our bar charts (that is, the open, high, low, and close). This is very significant since it means that any of the technical analysis used with bar charting (such as moving averages, trendlines, Elliott Wave, retracements, and so on) can be employed with candlestick charts. But, and this is the key point, candlestick charts can send signals not available from bar charts. In addition, there are some patterns that may allow you to get the jump on those who use traditional Western charting techniques. By employing candlestick charting instead of bar charting you have the ability to use all the same analyses as you would with bar charting. But candlestick charts provide a unique avenue of analysis not available anywhere else.

WHAT IS IN THIS BOOK?
Part I of the book reveals the basics on constructing, reading, and interpreting over 50 candlestick chart lines and patterns. Part I1 explains how to meld candlestick charts with Western technical analysis techniques. This is where the true power of candlecharts is manifested. This is how I use them. I have drawn illustrations of candlestick patterns to assist in the educational process. These illustrations are representative examples only. The drawn exhibits should be viewed in the context that they show certain guidelines and principles. The actual patterns do not have to look exactly as they do in the exhibits in order to provide the reader with a valid signal. This is emphasized throughout the book in the many chart examples. You will see how variations of the patterns can still provide 'mportant clues about the state of the markets. Thus, there is some subjectivity in deciding whether a certain candlestick formation meets the guidelines for that particular formation, but this subjectivity is no different than that used with other charting techniques. For instance, is a $400 support area in gold considered broken if prices go under $400 intra-day, or do prices have to close under $400? Does a $.I0 penetration of $400 substantiate broken support or is a larger penetration needed? You will have to decide these answers based on your trading temperment, your risk adversity, and your market philosophy. Likewise, through text, illustrations and real examples I will provide the general principles and guidelines for recognizing the candlestick formations. But you should not expect the real-world examples to always match their ideal formations.

6

Introduction

I believe that the best way to explain how an indicator works is through marketplace examples. Consequently, I have included many such examples. These examples span the entire investment spectrum from futures, fixed-income, equity, London metal markets and foreign exchange markets. Since my background is in the futures markets, most of my charts are from this arena. I also look at the entire time spectrumfrom intra-day to daily, weekly, and monthly candlestick charts. For this book, when I describe the candlestick lines and patterns, I will often refer to daily data. For instance, I may say that in order to complete a candlestick pattern the market has to open above the prior day's high. But the same principles will be valid for all time frames. Two glossaries are at the end of the text. The first includes candlestick terms and the second Western technical terms used in the book. The candlestick glossary includes a visual glossary of all the patterns. As with any subjective form of technical analysis, there are, at times, variable definitions which will be defined according to the users' experience and background. This is true of some candlestick patterns. Depending on my source of information, these were instances in which I came across different, albeit usually minor, definitions of what constitutes a certain pattern. For example, one Japanese author writes that the open has to be above the prior close in order to complete a dark-cloud cover pattern (see Chapter 4). Other written and oral sources say that, for this pattern, the open should be above the prior high. In cases where there were different definitions, I chose the rules that increased the probability that the pattern's forecast would be correct. For example, the pattern referred to in the prior paragraph is a reversal signal that appears at tops. Thus, I chose the definition that the market has to open above the prior day's high. It is more bearish if the market opens above the prior day's high and then fails, then it would be if the market just opens above the prior day's close and then failed. Much of the Japanese material I had translated is less than specific. Part of this might be the result of the Japanese penchant for being vague. The penchant may have its origins in the feudal ages when it was acceptable for a samurai to behead any commoner who did not treat him as expected. The commoner did not always know how a samurai expected him to act or to answer. By being vague, many heads were spared. However, I think the more important reason for the somewhat ambigtlous explanations has to do with the fact that technical analysis is more of an art than a science. You should not expect rigid rules with most forms of technical analysis-just guideposts. Yet, because of this uncertainty, some of the ideas in this book may be swayed by the author's trading philosophy. For instance, if a Japanese author says that a candlestick line has to be "surpassed to signal

Introduction

7

the next bull move, I equate "surpassed" with "on a close above." That is because, to me, a close is more important than an intra-day move above a candlestick line. Another example of subjectivity: In the Japanese literature many candlestick patterns are described as important at a high-price area or at a low-price area. Obviously what constitutes a "high-price" or "low-price" area is open to interpretation.

SOME LIMITATIONS
As with all charting methods, candlestick chart patterns are subject to the interpretation of the user. This could be viewed as a limitation. Extended experience with candlestick charting in your market specialty will show you which of the patterns, and variations of these patterns, work best. In this sense, subjectivity may not be a liability. As you gain experience in candlestick techniques, you will discover which candlestick combinations work best in your market. This may give you an advantage over those who have not devoted the time and energy in tracking your markets as closely as you have. As discussed later in the text, drawing the individual candlestick chart lines requires a close. Therefore, you may have to wait for the close to get a valid trading signal. This may mean a market on close order may be needed or you may have to try and anticipate what the close will be and place an order a few minutes prior to the close. You may also prefer to wait for the next day's opening before placing an order. This aspect may be a problem but there are many technical systems (especially those based on moving averages of closing prices) which require a closing price for a signal. This is why there is often a surge in activity during the final few minutes of a trading session as computerized trading signals, based on closing prices, kick into play. Some technicians consider only a close above resistance a valid buy signal so they have to wait until the close for confirmation. This aspect of waiting for a close is not unique to candlestick charts. On occasion, I can use the hourly candlestick charts to get a trade signal rather than waiting for the close of that day. For instance, there could be a potentially bullish candlestick pattern on the daily chart. Yet, I would have to wait for the close before the candlestick pattern is completed. If the hourly charts also show a bullish candlestick indicator during that day, I may recommend buying (if the prevalent trend is up) even before the close. The opening price is also i.mportant in the candlestick lines. Equity traders, who do not have access to on-line quote machines, may not be

8

Introduction

able to get opening prices on stocks in their newspapers. I hope that, as candlestick charts become more common, more newspapers will include openings on individual stocks. Candlestick charts provide many useful trading signals. They do not, however, provide price targets. There are other methods to forecast targets (such as prior support or resistance levels, retracements, swing objectives, and so on). Some Japanese candlestick practitioners place a trade based on a candlestick signal.and stay with that trade until another candlestick pattern tells them to offset. Candlestick patterns should always be viewed in the context as to what occurred before and in relation to other technical evidence. With the hundreds of charts throughout this book, do not be surprised if you see patterns that I have missed within charts. There will also be examples of patterns that, at times, did not work. Candlesticks will not provide an infallible trading tool. They do, however, add a vibrant color to your technical palette. Candlestick charts allow you to use the same technical devices that you use with bar charts. But the candlestick charts give you signals not available with bar charts. So why use a bar chart? In the near future, candlestick charts may become as standard as the bar chart. In fact, I am going to make a bold prediction: A s more technicians become comfortable with candlestick charts, they will no longer use bar charts. I have been a technical analyst for nearly 20 years. And now, after discovering all their benefits, I only use candlestick charts. I still use all the traditional Western technical tools, but the candlesticks have given me a unique perspective into the markets. Before I delve into the topic of candlestick charts, I will briefly discuss the importance of technical analysis as a separate discipline. For those of you who are new to this topic, the following section is meant to emphasize why technical analysis is so important. It is not an in-depth discussion. If you would like to learn more about the topic, I suggest you read John Murphy's excellent book Technical Analysis of the Futures Markets (The New York Institute of Finance). If you are already familiar with the benefits of technical analysis, you can skip this section. Do not worry, if you do not read the following section, it will not interfere with later candlestick chart analysis information.

THE IMPORTANCE OF TECHNICAL ANALYSIS
The importance of technical analysis is five-fold. First, while fundamental analysis may provide a gauge of the supplyidemand situations,

Introduction

9

pricelearnings ratios, economic statistics, and so forth, there is no psychological component involved in such analysis. Yet the markets are influenced at times, to a major extent, by emotionalism. An ounce of emotion can be worth a pound of facts. As John Manyard Keynes stated, "there is nothing so disastrous as a rational investment policy in an irrational ~ o r l d . " ~ Technical analysis provides the only mechanism to measure the "irrational" (emotional) component present in all markets. Here is an entertaining story about how strongly psychology can . takes place at the affect a market. It is from the book The New G a t ~ b y sIt ~ Chicago Board of Trade.
Soybeans were sharply higher. There was a drought in the Illinois Soybean Belt. And unless it ended soon, there would be a severe shortage of beans. . . . Suddenly a few drops of water slid down a window. "Look," someone shouted, "rain!". More than 500 pairs of eyes [the traderseditor's note] shifted to the big windows. . . . Then came a steady trickle which turned into a steady downpour. It was raining in downtown Chicago. Sell. Buy. Buy. Sell. The shouts cascaded from the traders' lips with a roar that matched the thunder outside. And the price of soybeans began to slowly move down. Then the price of soybeans broke like some tropic fever. It was pouring in Chicago all right, but no one grows soybeans in Chicago. In the heart of the Soybean Belt, some 300 miles south of Chicago the sky was blue, sunny and very dry. But even if it wasn't raining on the soybean fields it was in the heads of the traders, and that is all that counts [emphasis added]. To the market nothing matters unless the market reacts to it. The game is played with the mind and the emotions [emphasis added].

In order to drive home the point about the importance of mass psychology, think about what happens when you exchange a piece of paper called "money" for some item like food or clothing? Why is that paper, with no intrinsic value, exchanged for something tangible? It is because of a shared psychology. Everyone believes it will be accepted, so it is. Once this shared psychology evaporates, when people stop believing in money, it becomes worthless. Second, technicals are also an important component of disciplined trading. Discipline helps mitigate the nemesis of all traders, namely, emotion. As soon as you have money in the market, emotionalism is in the driver's seat and rationale and objectivity are merely passengers. If you doubt this, try paper trading. Then try trading with your own funds. You will soon discover how deeply the counterproductive aspects of tension, anticipation, and anxiety alter the way you trade and view

10

Introduction

the markets-usually in proportion to the funds committed. Technicals can put objectivity back into the drivers seat. They provide a mechanism to set entry and exit points, to set riskheward ratios, or stoplout levels. By using them, you foster a risk and money management approach to trading. As touched upon in the previous discussion, the technicals contribute to market objectivity. It is human nature, unfortunately, to see the market as we want to see it, not as it really is. How often does the following occur? A trader buys. Immediately the market falls. Does he take a loss. Usually no. Although there is no room for hope in the market, the trader will glean all the fundamentally bullish news he can in order to buoy his hope that the market will turn in his direction. Meanwhile prices continue to descend. Perhaps the market is trying to tell him something. The markets communicate with us. We can monitor these messages by using the technicals. This trader is closing his eyes and ears to the messages being sent by the market. If this trader stepped back and objectively viewed price activity, he might get a better feel of the market. What if a supposedly bullish story is released and prices do not move up or even fall? That type of price action is sending out volumes of information about the psychology of the market and how one should trade in it. I believe it was the famous trader Jesse Livermore who expressed the idea that one can see the whole better when one sees it from a distance. Technicals make us step back and get a different and, perhaps, better perspective on the market. Third, following the technicals is important even if you do not fully believe in their use. This is because, at times, the technicals are the majon reason for a market move. Since they are a market moving factor, they should be watched. Fourth, random walk proffers that the market price for one day has no bearing on the price the following day. But this academic view leaves out an important component-people. People remember prices from one day to the next and act accordingly. To wit, peoples' reactions indeed affect price, but price also affects peoples' reactions. Thus, price, itself, is an important component in market analysis. Those who disparage technical analysis forget this last point. Fifth, and finally, the price action is the most direct and easily accessible method of seeing overall supplyldemand relationships. There may be fu.ndamenta1 news not known to the general public but you can expect it is already in the price. Those who have advance knowledge of some market moving event will most likely buy or sell until current prices reflect their information. This knowlehge, at times, consequently,

Introduction

11

may be discounted when the event occurs. Thus, current prices should reflect all available information, whether known by the general public or by a select few.

NOTES
'Hill, Julie Skur. "That's Not What I Said," Business Tokyo, August 1990, pp. 4 6 4 7 'Smith, Adam. The Money Game, New York, NY: Random House, 1986, p. 154. 3Tamarkin, Bob. The New Gatsbys, Chicago, IL:Bob Tamarkin, 1985, pp. 122-123.

CHAPTER

2

A HISTORICAL BACKGROUND
"Through Inquiring of the Old We Learn the New"

T h i s chapter provides the framework through which Japanese technical analysis evolved. For those who are in a rush to get to the "meat" of the book (that is, the techniques and uses of candlesticks), you can skip this chapter, or return to it after you have completed the rest of the book. It is an intriguing history. Among the first and the most famous people in Japan to use past prices to predict future price movements was the legendary Munehisa Homma.' He amassed a huge fortune trading in the rice market during the 1700s. Before I discuss Homma, I want to provide an overview of the economic background in which Homma was able to flourish. The time span of this overview is from the late 1500s to the mid-1700s. During this era Japan went from 60 provinces to a unified country where commerce blossomed. From 1500 to 1600, Japan was a country incessantly at war as each of the daimyo (literally "big name" meaning "a feudal lord") sought to wrestle control of neighboring territories. This 100-year span between 1500 and 1600 is referred to as "Sengoku Jidai" or, literally, "Age of Country at War." It was a time of disorder. By the early 1600s, three extraordinary generals-Nobunaga Oda, Hideyoshi Toyotomi, and Ieyasu Tokugawa-had unified Japan over a 40-year period. Their prowess and achievements are celebrated in Japanese history and folklore.

14

A Historical Background

There is a Japanese saying: "Nobunaga piled the rice, Hideyoshi kneaded the dough, and Tokugawa ate the cake." In other words, all three generals contributed to Japan's unification but Tokugawa, the last of these great generals, became the shogun whose family ruled Japan from 1615 to 1867. This era is referred to as the Tokugawa Shogunate. The military conditions that suffused Japan for centuries became an integral part of candlestick terminology. And, if you think about it, trading requires many of the same skills needed to win a battle. Such skills include strategy, psychology, competition, strategic withdrawals, and yes, even luck. So it is not surprising that throughout this book you will come across candlestick terms that are based on battlefield analogies. There are "night and morning.attacks", the "advancing three soldiers pattern", "counter attack lines", the "gravestone", and so on. The relative stability engendered by the centralized Japanese feudal system lead by Tokugawa offered new opportunities. The agrarian economy grew, but, more importantly, there was expansion and ease in domestic trade. By the 17th century, a national market had evolved to replace the system of local and isolated markets. This concept of a centralized marketplace was to indirectly lead to the development of technical analysis in Japan. Hideyoshi Toyotomi regarded Osaka as Japan's capital and encouraged its growth as a commercial center. Osaka's easy access to the sea, at a time where land travel was slow, dangerous, and costly, made it a national depot for assembling and disbursing supplies. It evolved into Japan's greatest city of commerce and finance. Its wealth and vast storehouses of supplies provided Osaka with the appellation the "Kitchen of Japan." Osaka contributed much to price stability by smoothing out regional differences in supply. In Osaka, life was permeated by the desire for profit (as opposed to other cities in which money making was despised). The social system at that time was composed of four classes. In descending order they were the Soldier, the Farmer, the Artisan, and the Merchant. It took until the 1701)s for merchants to break down the social barrier. Even today the traditional greeting in Osaka is "Mokarimakka" which means, "are you making a profit?". In Osaka, Yodoya Keian became a war merchant for Hideyoshi (one of the three great military unifiers). Yodoya had extraordinary abilities in transporting, distributing, and setting the price of rice. Yodoyals front yard became so important that the first rice exchange developed there. He became very wealthy-as it turned out, too wealthy. In 1705, the Bakufu (the military government led by the Shogun) confiscated his entire fortune on the charge that he was living in luxury not befitting his

A Historical Background

15

social rank. The Bakufu was apprehensive about the increasing amount of power acquired by certain merchants. In 1642, certain officials and merchants tried to corner the rice market. The punishment was severe: their children were executed, the merchants were exiled, and their wealth was confiscated. The rice market that originally developed in Yodoya's yard was institutionalized when the Dojima Rice Exchange was set up in the late 1600s in Osaka. The merchants at the Exchange graded the rice and bargained to set its price. Up until 1710, the Exchange dealt in actual rice. After 1710, the Rice Exchange began to issue and accept rice warehouse receipts. These warehouse receipts were called rice coupons. These rice receipts became the first futures contracts ever traded. Rice brokerage became the foundation of Osaka's prosperity. There were more than 1,300 rice dealers. Since there was no currency standard (the prior attempts at hard currency failed due to the debasing of the coins), rice became the defacto medium of exchange. A daimyo needing money would send his surplus rice to Osaka where it would be placed in a warehouse in his name. He would be given a coupon as a receipt for this rice. He could sell this rice coupon whenever he pleased. Given the financial problems of many daimyos, they would also often sell rice coupons against their next rice tax delivery (taxes to the daimyo were paid in rice-usually 40% to 60% of the rice farmer's crop). Sometimes the rice crop of several years hence was mortgaged. These rice coupons were actively traded. The rice coupons sold against future rice deliveries became the world's first futures contracts. The Dojima Rice Exchange, where these coupons traded, became the world's first futures exchange. Rice coupons were also called "empty rice" coupons (that is, rice that was not in physical possession). To give you an idea of the popularity of rice futures trading, consider this: In 1749, there were a total of 110,000 bales (rice used to trade in bales) of empty-rice coupons traded in Osaka. Yet, throughout all of Japan there were only 30,000 bales of ricea2 Into this background steps Homma, called "god of the markets." "Munehisa Homma was born in 1724 into a wealthy family. The Homma family was considered so wealthy that there was a saying at that time, "I will never become a Homma, but I would settle to be a local lord." When Homma was given control of his family business in 1750, he began trading at his local rice exchange in the port city of Sakata. Sakata was a collections and distribution area for rice. Since Homma came from Sakata, you will frequently come across the expression "Sakata's Rules" in Japanese candlestick literature. These refer to Homma.

16

A Historical Background

When Munehisa Homma's father died, Munehisa was placed in charge of managing the family's assets. This was in spite of the fact that he was the youngest son. (It was usually the eldest son who inherited the power during that era.) This was probably because of Munehisa's market savvy. With this money, Homma went to Japan's largest rice exchange, the Dojima Rice Exchange in Osaka, and began trading rice futures. Homma's family had a huge rice farming estate. Their power meant that information about the rice market was usually available to them. In addition, Homma kept records of yearly weather conditions. In order to learn about the psychology of investors, Homma analyzed rice prices going back to the time when the rice exchange was in Yodoya's yard. Homma also set up his own communications system. At prearranged times he placed men on rooftops to send signals by flags. These men stretched the distance from Osaka to. Sakata. After dominating the Osaka markets, Homma went to trade in the regional exchange at Edo (now called Tokyo). He used his insights to amass a huge fortune. It was said he had 100 consecutive winning trades. His prestige was such that there was the following folk song from Edo: "When it is sunny in Sakata (Homma's town), it is cloudy in Dojima (the Dojima Rice Exchange in Osaka) and rainy at Kuramae (the Kuramae exchange in Edo)." In other words when there is a good rice crop in Sakata, rice prices fall on the Dojima Rice Exchange and collapse in Edo. This song reflects the Homma's sway over the rice market. In later years Homma became a financial consultant to the government and was given the honored title of samurai. He died in 1803. Homma's books about the markets (Sakata Senho and Soba Sani No Den) were said to have been written in the 1700s. His trading principles, as applied to the rice markets, evolved into the candlestick methodology currently used in Japan.

-

-

A Historical Background

17

NOTES
'His first name is sometimes translated as Sokyu and his last name is sometimes translated as Honma. This gives you an idea of the difficulty of translating Japanese into English. The same Japanese symbols for Homma's first name, depending on the translator, can be Sokyu or Munehisa. His last name, again depending on the translator, can be either Homma or Honma. I chose the English translation of Homma's name as used by the Nippon Technical Analysts Association. 'Hirschmeier, Johannes and Yui, Tsunehiko. The Development of Japanese Business 1600-1973, Cambridge, MA: Harvard University Press, 1975, p. 31.

PART

I

THE BASICS
"Even a Thousand Mile Journey Begins with the First Step"

CHAPTER

3

CONSTRUCTING THE CANDLESTICKS wwm < T A T W I ~
"Without Oars You Cannot Cross in a Boat"

A comparison between the visual differences of a bar chart and a candlestick chart is easy to illustrate. Exhibit 3.1 is the familiar Western bar chart. Exhibit 3.2 is a candlestick chart of the same price information as that in the bar chart. On the candlestick chart, prices seem to jump off the page presenting a stereoscopic view of the market as it pushes the flat, two-dimensional bar chart into three dimensions. In this respect, candlecharts are visually exciting.

DRAWING THE CANDLESTICK LINES
Since candlestick charts are new to most Western technicians, the most common Western chart, the bar chart, is used throughout this chapter as an instructional tool for learning how to draw the candlestick lines. Drawing the daily bar chart line requires open, high, low, and close. The vertical line on a bar chart depicts the high and low of the session. The horizontal line to the left of the vertical line is the opening price. The horizontal line to the right of the vertical line is the close. Exhibit 3.3 shows how the same data would be used to construct a bar chart and a candlestick chart. Although the daily bar chart lines and candlestick chart lines use the same data, it is easy to see that they are drawn differently. The thick part of the candlestick line is called the real

22
8 : 13

The Basics

CCHO DAILY BAR

0 1989 CQG INC.

- H= L=
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o=

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-

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127

ti=

. .
'Dec 1 4

'Jan
111 118 126 11 12 1 8 115 122 129

'Feb 1 5

112

120

126

1

EXHIBIT 3.1. Cocoa-March, 1990, Daily Bar Chart
C H DAILY B R CO A

@

1989 CQG INC.

EXHIBIT 3.2. Cocoa-March, 1990, Daily Candlestick Chart

Constructing the Candlesticks
Time Period 1 2 3 4 5 Open 20 25 30 45 25

23

High 30 25 35 50 40

Low 15 10 15 35 25

Close 25 15 20 40 35 Candlestick Chart

I

1

2 3 4 Time Period

5

1

2 3 4 Time Period

5

EXHIBIT 3.3 Bar Chart and Candlestick Chart

body. It represents the range between that session's opening and closing. When the real body is black (i.e., filled in) it means the close of the session was lower than the open. If the real body is white (i.e., empty), it means the close was higher than the open. The thin lines above and below the real body are the shadows. These shadows represent the session's price extremes. The shadow above the real body is called the upper shadow and the shadow under the real body is known as the lower shadow. Accordingly, the peak of the upper shadow is the high of the session and the bottom of the lower shadow is the low of the session. It is easy to see why these are named candlestick charts since the individual lines often look like candles and their wicks. If a candlestick line has no upper shadow it is said to have a shaven head. A candlestick line with no lower shadow has a shaven bottom. To the Japanese, the real body is the essential price movement. The shadows are usually considered as extraneous price fluctuations. Exhibits 3.4 through 3.7 demonstrate some common candlestick lines. Exhibit 3.4 reveals a long black candlestick reflecting a bearish period in which the market opened near its high and closed near its low. Exhibit 3.5 shows the opposite of a long black body and, thus, represents a bullish period. Prices had a wide range and the market opened near the low and closed near the high of the session. Exhibit 3.6 shows candlesticks having small real bodies and, as such, they represent a tug of war between the bulls and the bears. They are called spinning tops and are neutral in lateral trading bands. As shown later in this book (in the sec-

24

The Basics

EXHIBIT 3.4. Black Candlestick

EXHIBIT 3.5. White Candlestick

High 1

_,High

Close-Low , ------

J

Close
LOW'

Open

EXHIBIT 3.6. Spinning Tops

EXHIBIT 3.7. Doji Examples

tions on stars and harami patterns), these spinning tops do become important when part of certain formations. The spinning top can be either white or black. The lines illustrated in Exhibit 3.6 have small upper and lower shadows, but the size of the shadows are not important. It is the diminutive size of the real body that makes this a spinning top. Exhibit 3.7 reveals no real bodies. Instead, they have horizontal lines. These are examples of what are termed doji lines. A doji occurs when the open and close for that session are the same or very close to being the same (e.g., two- or three-thirty-seconds in bonds, a Yi cent in grains, and so on.). The lengths of the shadows can vary. Doji are so important that an entire chapter is devoted to them (see Chapter 8 The Magic Doji). Candlestick charts can also be drawn more colorfully by using the classical Japanese candlestick chart colors of red and black. Red can be used instead of the white candlestick. (This could be especially useful for computer displays of the candlestick charts.) The obvious problem with this color scheme is that photo copies and most computer printouts will not be useful since all the real bodies would come out as black. Some readers may have heard the expression yin and yang lines. These are the Chinese terms for the candlestick lines. The yin line is another name for the black candlestick and the yang line is equivalent to the white candlestick. In Japan, a black candlestick is called in-sen (black line) and the white candlestick is called yo-sen (white line). The Japanese place great emphasis on the relationship between the open and close because they are the two most emotionally charged

Constructing the Candlesticks

25

points of the trading day. The Japanese have a proverb that says, "the first hour of the morning is the rudder of the day." So is the opening the rudder for the trading session. It furnishes the first clue about that day's direction. It is a time when all the news and rumors from overnight are filtered and then joined into one point in time. The more anxious the trader, the earlier he wants to trade. Therefore, on the open, shorts may be scrambling for cover, potential longs may want to emphatically buy, hedgers may need to take a new or get out of an old position, and so forth. After the flurry of activity on the open, potential buyers and sellers have a benchmark from which they can expect buying and selling. There are frequent analogies to trading the market and fighting a battle. In this sense, the open provides an early view of the battlefield and a provisional indication of friendly and opposing troops. At times, large traders may try to move the market on the open by executing a large buy or sell order. Japanese call this a morning attack. Notice that this is another military analogy. The Japanese use many such military comparisons as we shall see throughout the book.

CANDLESTICK TERMINOLOGY AND MARKET EMOTION
Technicals are the only way to measure the emotional component of the market. The names of the Japanese candlestick charts make this fact evident. These names are a colorful mechanism used to describe the emotional health of the market at the time these patterns are formed. After hearing the expressions "hanging man" or "dark-cloud cover," would you think the market is in an emotionally healthy state-of course not! These are both bearish patterns and their names clearly convey the unhealthy state of the market. While the emotional condition of the market may not be healthy at the time these patterns form, it does not preclude the possibility that the market will become healthy again. The point is that at the appearance of, say, a dark-cloud cover, longs should take defensive measures or, depending on the general trend and other factors, new short sales could be initiated. There are many new patterns and ideas in this book, but the descriptive names employed by the Japanese not only make candlestick charting fun, but easier to remember if the patterns are bullish or bearish. For example, in Chapter 5 you will learn about the "evening star" and the "morning star." Without knowing what these patterns look like or what they imply for the market, just by hearing their names which do you think is bullish and which is bearish? Of course, the evening star which comes out before darkness sets in, sounds like the bearish signal-and so it is! The morning star, then, is bullish since the morning star appears just before sunrise.

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:

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:

:
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i

i

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26

The Basics

The other pivotal price point is the close. Margin calls in the futures markets are based on the close. We can thus expect heavy emotional involvement into how the market closes. The close is also a pivotal price point for many technicians. They may wait for a close to confirm a breakout from a significant chart point. Many computer trading systems (for example, moving average systems) are based on closes. If a large buy or sell order is pushed into the market at, or near, the close, with the intention of affecting the close, the Japanese call this action a night attack. Exhibits 3.4 to 3.7 illuminate how the relationship between a period's open, high, low, and close alters the look of the individual candlestick line. Now let us turn our attention to how the candlestick lines, alone or in combination, provide clues about market direction.

CHAPTER

4

REVERSAL PATTERNS
--%%ImJ
"Darkness Lies One Inch Ahead"

Technicians watch for price clues that can alert them to a shift in market psychology and trend. Reversal patterns are these technical clues. Western reversal indicators include double tops and bottoms, reversal days, head and shoulders, and island tops and bottoms. Yet the term "reversal pattern" is somewhat of a misnomer. Hearing that term may lead you to think of an old trend ending abruptly and then reversing to a new trend. This rarely happens. Trend reversals usually occur slowly, in stages, as the underlying psychology shifts gears. A trend reversal signal implies that the prior trend is likely to change, but not necessarily reverse. This is very important to understand. Compare an uptrend to a car traveling forward at 30 m.p.h. The car's red brake lights go on and the car stops. The brake light was the reversal indicator showing that the prior trend (that is, the car moving forward) was about to end. But now that the car is stationary will the driver then decide to put the car in reverse? Will he remained stopped? Will he decide to go forward again? Without more clues we do not know. Exhibits 4.1 through 4.3 are some examples of what can happen after a top reversal signal appears. The prior uptrend, for instance, could convert into a period of sideways price action. Then a new and opposite trend lower could start. (See Exhibit 4.1.) Exhibit 4.2 shows how an old uptrend can resume. Exhibit 4.3 illustrates how an uptrend can abruptly reverse into a downtrend. It is prudent to think of reversal patterns as trend change patterns. I was tempted to use the term "trend change patterns" instead of "reversal patterns" in this book. However, to keep consistent with other tech-

28

The Basics

EXHIBIT 4.1. Top Reversal

EXHIBIT 4.2. Top Reversal

EXHIBIT 4.3. Top Reversal

nical analysis literature, I decided to use the term reversal patterns. Remember that when I say "reversal pattern" it means only that the prior trend should change but not necessarily reverse. Recognizing the emergence of reversal patterns can be a valuable skill. Successful trading entails having both the trend and probability on your side. The reversal indicators are the market's way of providing a road sign, such as "Caution-Trend in Process of Change." In other words, the market's psychology is in transformation. You should adjust your trading style to reflect the new market environment. There are many ways to trade in and out of positions with reversal indicators. We shall discuss them throughout the book. An important principle is to place a new position (based on a reversal signal) only if that signal is in the direction of the major trend. Let us say, for example, that in a bull market, a top reversal pattern appears. This bearish signal would not warrant a short sale. This is because the major trend is still up. It would, however, signal a liquidation of longs. If there was a prevailing downtrend, this same top reversal formation could be used to place short sales. I have gone into detail about the subject of reversal patterns because most of the candlestick indicators are reversals. Now, let us turn our attention to the first group of these candlestick reversal indicators, the hammer and hanging-man lines.

HAMMER AND HANGING-MAN LINES
Exhibit 4.4 shows candlesticks with long lower shadows and small real bodies. The real bodies are near th.e top of the daily range. The variety of candlestick lines shown in the exhibit are fascinating in that either line can be bullish or bearish depending on where they appear in a trend. If either of these lines emerges during a downtrend it is a signal that the downtrend should end. In such a scenario, this line is labeled a hammer,

These Lines Can Be Either Bullish or Bearish

1T

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White or Black

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Reversal Patterns

29

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Source. C o r n p u ~ r a c ~ ~

I

EXHIBIT 10.1. Crude Oil-October 1989, Daily (Confluence of Candlesticks)

of a bearish shooting star. This line's small real body (being within the previous day's real body) makes it a harami. Finally, the top of the upper shadow (that is, the high of the day) on the shooting star day was also a failure at the February 1600 highs. Exhibit 10.4 shows that within a period of a few weeks, this market formed a tweezers bottom, a bullish engulfing pattern, and a hammer. Exhibit 10.5 shows that from mid to late July, a series of bearish candlestick indications occurred including a doji star followed by three hanging-man lines (as shown by 1, 2 and 3). In between hanging-man 1 and 2, a shooting star formed. Exhibit 10.6 is a bearish candlestick signal within a bearish candlestick signal. The peak of the rally in December was touched by a hanging-man session. This hanging-man session was also the star portion of an evening star formation. Exhibit 10.7 shows that May 9 through 11 delivered a series of top reversal candlestick signals at the $1.12 area. The tall white candlestick on May 9 was followed by a small real body candlestick. This second candlestick was a hanging man. It also, when

A Confluence of Candlesticks 179

Resistance

Shooting Star and Harami Pattern
I

'3
11

1/16

1 -

Dl3

iZ6

342

3a5

4'9

443

Source: Quick 10- E Informative System

EXHIBIT 10.3. Fujitsu-1990, Daily (Confluence of Candlesticks)

180

The Rule of Multiple Technical Techniques

I

I

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1

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30DEC88

24FEB89

28APR

3OJUN

25AUG

270CT

29DEC

Source: Bloomberg L.P.

EXHIBIT 10.4. Exxon-Weekly (Confluence of Candlesticks)

l Jun
Source: CompuTracTM

IJul

EXHIBIT 10.5. Sugar-October 1989, Daily (Confluence of Candlesticks)

A Confluence of Candlesticks

181

. . . . . .
. . . . . . .

Hanging

.

.

Man.

Line

. m- .

. . . . .
Evening star Pattern

. . .

. .

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November
Source: Ensign Software

December

EXHIBIT 10.6. Wheat-March 1990, Daily (Confluence of Candlesticks)
14:02 CPUO D A I L Y BAR @ 1990 CQG INC. .0=11650 .H=11885 .......................................................................................................................................... 12000 L=11640 .L=11820~ . . . . . A = +215

.

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11500

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11000

10500

.

7 i 6/90 O= 11650 -H= 11885 , L= 11640 -C= 11820 ,a 1 2 1 9

:

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.

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,

116

123

,Mar 130

Jun
1 7
114 121 128
1 4

.Jul
111 118 125 (2

-

EXHIBIT 10.7. Copper-September 1990, Daily (Confluence of Candlesticks)

182

The Rule of Multiple Technical Techniques

EXHIBIT 10.8. British Pound-Weekly (Confluence of Candlesticks)

joined to the prior candlestick, completed a harami pattern. On May 11, another assault at the $1.12 highs occurred. This assault failed via a shooting star line. These three sessions had nearly the same highs. This constructed a short-term top. Thus, within three sessions there were four bearish indications: a hanging man; a harami; a shooting star; and tweezers top. The market backed off from these highs. The $1.12 price became significant resistance as evidenced by the bulls' failure to punch above it during mid-June's rally. This $1.12 level was important for another reason. Once broken on the upside on June 28, it converted to pivotal support. Observe the doji star that arose after the June 28 long white candlestick. We know a doji after a long white candlestick is a top reversal. This means the prior uptrend should end. For two days after the doji, the market showed it was running out of breath since there were two black candlesticks locked in a lateral band. The market had run out of steam-or so it had appeared. Remember the May 9 through 11 resistance area? The lows of the two black candlestick sessions of July 2 and 3 held that old resistance as support. The bears had tried to break the

A Confluence of Candlesticks

183

market but they could not. Until that support broke, the back of the short-term bull market which commenced June 26 would not be broken. In this scenario, the confluence of candlesticks which was so important as a top on May 9 through 11 became influential again a few months later as important support. Exhibit 10.8 illustrates how, in mid-1987, a series of candlestick signals intimated a top. Specifically, within a month there was a hanging man, a doji, and a dark-cloud cover. After the dark-cloud cover, the market sold off and, in the process, opened a window. This window became resistance on the brief rally just before the next leg lower. The selloff finally ended with the tweezers bottom and the bullish belt-hold line (although the white candlestick had a lower shadow it was small enough to view this line as a bullish belt hold).

CHAPTER

11

CANDLESTICKS WITH TRENDLINES
"Make Use of Your Opportunities"

T h i s chapter examines candlestick techniques in conjunction with trendlines, breakouts from trendlines, and old support and resistance areas. There are many ways to determine a trend. One method is with the technician's most basic tool-the trendline.

1

SUPPORT AND RESISTANCE LINES WITH CANDLESTICKS
Exhibit 11.1 shows an upward sloping support line. It is made by connecting at least two reaction lows. This line demonstrates that buyers are more aggressive than sellers since demand is stepping in at higher lows. This line is indicative of a market that is trending higher. Exhibit 11.2 shows a downward sloping resistance line. It is derived by joining at least two reaction highs. It shows that sellers are more aggressive than buyers as evidenced by the sellers willingness to sell at lower highs. This reflects a market that is trending lower. The potency of a support or resistance line depends on the number of times the line has been successfully tested, the amount of volume at each test, and the time the line has been in force. Exhibit 11.3 has no candlestick indicators that are worth illustrating. It does represent one of the major advantages of candlesticks, though. Whatever you can do with a bar chart, you can do with a candlestick chart. Here we see how a basic

186

The Rule of Multiple Technical Techniques

Upward Sloping Support Line

Downward Sloping Resistance Line

EXHIBIT 11.1. Upward Sloping Support Line

EXHIBIT 11.2. Downward Sloping Resistance Line

head and shoulders neckline could be drawn on the candlestick chart just as easily as with the bar chart. However, as we will see in the rest of this chapter, the candlesticks provide added depth to trendline analysis. Exhibit 11.4 illustrates that the lows in late March (near $173) formed a support area that was successfully tested in late April. This successful April test of support had an extra bullish kicker thanks to the candlesticks. Specifically, the three sessions on April 20 to 22 formed a bullish morning star pattern.

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EXHIBIT 11.3. Crude OilJuly 1990, Intra-day (Trendlines on Candlestick Charts)

Candlesticks with Trendlines

187

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6APR

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Source: Bloomberg L.P.

EXHIBIT 11.4. CBS1990, Daily (Support Line with Candlesticks)

Exhibit 11.5 has a wealth of information about using trendlines with candlestick indicators. That includes: The emergence of support line 1 (late January-early February) shows that the two lows on January 29 and 31 were the initial two points of this line. A third test of this line of February 7 was also a bullish hammer. The combination of these two factors gave a bottom reversal signal. For those who bought at this area, the hammer's low could be used as a protective stop out level. The emergence of support line 2 (mid-January-early March) is more important than support line 1 since it was in effect longer. On March f 2, the third test s this line was made by way of a bullish hammer. Since the major trend was up (as shown by the upward sloping support line 2), the bullish hammer and the successful test of support conformed to a buy signal for March 2. Protective sell stops could be positioned under the hammer's low or under the upward sloping support line 2. A puncture of this support line would be a warning that the prior uptrend had stalled. The harami gave the first inkling of trouble. This example illuminates the importance of stops. As discussed previously, there were numerous reasons to believe that the market was going higher when it tested support line 2 via a hammer. Yet, the mar-

188

The Rule of Multiple Technical Techniques

10: 16 O= 2016

CLMO D R I L Y ERR

@

1989 CQG INC.

support Line 2
3/21/90 O 2016 = -H= 2024 , , , , , , .... , , , L= 2004 C= 2013 H 118 126

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1900

'Jan 11 12

'Feb
1 8 115 122 129 1 5 112 120

'Mar 126 1 5

112

119

EXHIBIT 11.5. Crude Oil-June 1990, Daily (Support Line with Candlesticks)

ket pulled back. You should be confident when the trade is placed, but always take into account doubt and uncertainty. One of the most important concepts in trading--especially futures, is risk control. The use of stops is synonymous to risk control. Exhibit 11.6 shows dark-cloud covers 1 and 2 produced a resistance line. Dark-cloud cover 3 intersected at this resistance line and thus confirmed this line's importance as a supply area. Exhibit 11.7 shows that there was a rally (not shown) that stopped at A. This area provided a preliminary resistance area at .6419. A long-legged doji arose at B. The fact that this doji also surfaced near the resistance level set by A was a reason to be cautious. Points A and B gave the first two points of a resistance line. Traders who use hourly charts would thus look for failed rallies near this line to take appropriate action-especially if they got a confirmatory bearish candlestick indicator. At C, there was a long-legged doji (like the one at B) near the resistance line. The market then backed off. At D, the white candlestick with a long upper shadow was a shooting star. It failed at the resistance line. This white candlestick was immediately followed by a black candlestick that engulfed it. These two candles constituted a bearish engulfing pattern. Exhibit 11.8 shows two engulfing patterns where pattern 1 was a

Candlesticks w t Trendlines ih

189

................................................................................
THE IMPORTANCE OF PROTECTIVE STOPS
Technicals should be used to set up risklreward parameters. As such they will provide the analyst with a mechanism for a risk and money management approach to trading. Defining risk means using protective stops to help protect against unanticipated adverse price movements. If stops are not used, the analyst is not taking advantage of one of the most powerful aspects of technical analysis. A stop should be placed at the time of the original trade; this is when one is most objective. Stay in the position only if the market performs according to expectations. If subsequent price action either contradicts or fails to confirm these expectations, it is time to exit. If the market moves opposite to the chosen position you may think, "why bother with a stop-it is just a short-term move against me." Thus you stubbornly stay with the position in the hope the market will turn in your direction. Remember two facts:
1. all long-term trends begin as short-term moves; and 2. there is no room for hope in the market. The market goes its own way without regard to you or your position.

The market does not care whether you own it or not. The one thing worse than being wrong is staying wrong. Lose your opinion, not your money. Be proud of the ability to catch mistakes early. Getting stopped out concedes a mistake. People hate to admit mistakes since pride and prestige get involved. Good traders will not hold views too firmly. It has been said that famous private investor Warren Buffet has two rules:
1. capital preservation; and 2. don't forget rule 1.

Stops are synonymous with rule 1. You have limited resources. These resources should be maximized, or at a minimum, preserved. If you are in a market that has moved against your position, it is time to exit and find a better opportunity. Think of a stop as a cost of doing business. Since so much of the Japanese candlestick terminology is grounded on military terminology, we will look at stops in this context as well. Each trade you make is a battle. And you will have to do what even the greatest generals have to do-make temporary, tactical retreats. A general's goal is to preserve troops and munitions. Yours is to save capital and equanimity. Sometimes you must lose a few battles to win the war. The Japanese have a saying, "a hook's well lost to catch a salmon." If you are stopped out, think of it as you would a lost hook. Maybe with the next hook you will catch your prize.

190
8 : 17 o=

The Rule of Multiple Technical Techniques

PL MONTHLY BAR

@

1990 CQG INC.

. L=
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EXHIBIT 11.6. Platinum-Monthly (Resistance Line with Candlesticks)
8:07 JYMO 60 MINUTE BRR

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EXHIBIT 11.7. Japanese YenJune, 1990 Intra-day (Resistance Line with Candlesticks)

Candlesticks w t Trendlines ih

191

Jul
--

Oct

Jan 1989

Apr

Jul

Source: OCopyr~ght 1990 Commodity Trend Servlcea

EXHIBIT 11.8. Orange Juice-Weekly (Resistance Line with Candlesticks)

warning to longs. A few weeks later, the second bearish engulfing pattern emerged. The highs on engulfing pattern 2 also were a failure at a resistance line. Exhibit 11.9 shows an upward sloping resistance line. It is a trendline that connects a series of higher highs. While not as popular as the downward sloping resistance line in Exhibit 11.1, it can be a useful device for longs. When the market approaches this kind of line, longs should take defensive measures in anticipation of a pullback. These protective measures could include taking some profits on long positions, moving up a protective stop, or selling calls. Although pullbacks should be temporary (since the major trend is up), the failure from this line could be an early and very tentative indication of the beginning of a new downtrend. Exhibit 11.10 is a downward sloping support line. This is another type of line not used very often, but can occasionally be valuable for those who are short. Specificaliy, the downward sloping support line is

192

The Rule of Multiple Technical Techniques

Upward Sloping Resistance Line

Downward Sloping Support Line

EXHIBIT 11.9. Upward Sloping
Resistance Line

EXHIBIT 11.10. Downward Sloping
Resistance Line

indicative of a downtrend (as gauged by the negative slope). Yet, when the market successfully holds this kind of support line, shorts should take defensive measures in preparation of a price bounce. In looking at Exhibit 11.11, our first focus is on the downward sloping support line (line A) as previously illustrated on Exhibit 11.10. Connecting lows L, and L, provides a tentative support line. Candlestick L, almost touches this line before prices rebounded. This proved the validity of the support line. The lows at L, were not just a successful test of this downward sloping support line, but they formed a bullish piercing pattern. It was time to cover shorts-or at least take defensive measures such as lowering stops or selling puts. It was not time to buy because the major trend was down (as reflected by the bear channel defined by downward sloping line A and the dashed resistance line above line A). In this case, it turned out that the low at L, was the start of a powerful bull move that only ended with the appearance, a few months later, of the long-legged doji (a rickshaw man since the opening and closing were in the middle of the range) and the hanging man. Note the second piercing pattern on October 19 and 20. Next, still looking at Exhibit 11.11, let us look at the upward sloping resistance line (line B) as previously shown in Exhibit 11.9. The price activity from January 15 reflects a market that is creating a series of higher highs. Based on this (and the dashed support line), one can see that there is a bull trend in force. The failure on March 6 at a upward sloping resistance line gave a signal for longs to take protective measures. Notice this third test at this resistance line was a shooting star line with its attendant very long upper shadow and small real body. The three days following the shooting star were hanging-man lines or variations thereof. This combination of factors, a pullback from a resistance line, the shooting star and the hanging-man lines gave clear warnings that the market would soon correct.

Candlesticks w t Trendlines ih

193

EXHIBIT 11.11. Cotton-May, 1990, Daily (Upward Sloping Resistance Line and Downward Sloping Support Line with Candlesticks)

SPRINGS AND UPTHRUSTS
Most of the time, the markets are not in a trending mode but rather in a lateral range. On such occasions, the market is in a relative state of harmony with neither the bulls nor the bears in charge. The Japanese word for tranquility and calm is "wa." I like to think of markets that are bounded in a horizontal trading zone as being in a state of "wa." It is estimated that markets are in a nontrending mode as much as 70% of the time.' As such, it would be valuable to use a trading tool that provides attractive entry points in such circumstances. There is a set of tools which are effective in such environments. They are called upfhrusts and springs. They may be especially useful concepts when employed with candlestick techniques. Upthrusts and springs are based on concepts popularized by Richard Wyckoff in the early 20th century. As previously mentioned, when the markets are in a state of "wa" they will trade in a quiet, horizontal band. At times, however, the bears

194 The Rule of Multiple Technical Techniques
Price Objective

Unsustained

Price Objective Upthrust Spring

t

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Unsustained New Lows (Spring)

EXHIBIT 11.12. Upthrust

EXHIBIT 11.13. Spring

or bulls may assault a prior high or low level. Trading opportunities can arise on these occasions. Specifically, if there is an unsustained breakout from either a support or resistance level, it can present an attractive trading opportunity. In such a scenario there is a strong probability there will be a return to the opposite side of the congestion band. There is an unsustained penetration of resistance in Exhibit 11.12. Prices then return back under the old highs which had been "penetrated." In such a scenario, one could short and place a stop above the new high. The price target would be a retest of the lower end of the congestion band. This type of false upside breakout is called an upthrust. If an upthrust coincides with a bearish candlestick indicator it is an appealing opportunity to short. The opposite of an upthrust is the spring. The spring develops when prices pierce a prior low. Then prices spring back above the broken support area (see Exhibit 11.13). In other words, new lows could not hold. Buy if prices push back above the old lows. The objective would be for a retest of the congestion zone's upper band. The stop would be under the lows made on the day of the spring. Trading springs and upthrusts is so effective because they provide a clear target (the opposite end of the trading range) and protective stop (the new high or low made with the "false breakout"). Exhibit 11.14 is a good example of upthrusts with candlesticks. Day A marked the high for the move and a resistance level (notice how the hanging-man line the prior day gave warning of the end of the uptrend). The dual lows at L, and L, defined the lower end of the trading band. There was an upthrust on day B. That is, the prior highs at A were breached, but the new highs did not hold. The failure of the bulls to maintain the new highs at B was a bearish signal. Another negative sign was that day B was also a shooting star. Shooting stars are sometimes part of an upthrust. At such times, it is a powerful incentive to sell. As if a bearish upthrust and a shooting star were not enough to send chills down a bull's back, the day after B a hanging man appeared! With the

Candlesticks with Trendlines

195

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1989 CQG INC.

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EXHIBIT 11.14. Dow Jones Industrials-1990, Daily (Upthrust with Candlesticks)

bearish upthrust at B we have a target of the lower end of the lateral band, that is, the lows made by L, and L,. Exhibit 11.15 shows that on May 1, a new high for the move as the CRB touched 248.44. On May 10, the bulls managed to nudge above this level by about 25 ticks. They were unable to sustain these new highs. This failure was an upthrust. May 10 was also a shooting star. It spelled an end to the prior minor uptrend. Thus, a short sale with a stop above May 10 highs would have been warranted. The objective would be a retest of the lower end of the recent trading range near 245.00. As shown in Exhibit 11.16, the highs of April 5 overran the early March highs near $5.40. However, the bulls could not defend the new higher territory. This was an upthrust. Verification of the bearish aspect of this upthrust came via the hanging man in the next session. Exhibit 11.17 shows in July 1987, the CRB found a base near 220 via a harami pattern. The lows made by this harami were successfully tested by the following week's long white line which was also a bullish belt hold. In the third quarter of that year, the 220.00 level was temporarily broken. The market then sharply rebounded and, in the process, created a hammer and a spring. The objective based on this spring was a retest of the prior highs near 235.

196

The Rule of Multiple Technical Techniques

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EXHIBIT 11.15. CRB-Cash,

Daily, 1990 (Upthrust with Candlesticks)

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EXHIBIT 11.16. Silver-September, 1990, Daily (Upthrust with Candlesticks)

Candlesticks with Trendlines

197

Source: 8Copyright 1990 Commodity Trend Serv~ce"

EXHIBIT 11.17. CRB-Cash-Weekly (Spring with Candlesticks)

Exhibit 11.18 indicates that the early January lows were perforated in late February. The failure to hold the lows meant that this was a bullish spring. The day of the spring was also a hammer. This union of bullish signals gave plenty of warning to the technician to look for a return move to the upper end of the JanuaryJFebruary band near $78. Interestingly, the rally stopped in mid-March near $78 at an evening doji star formation. Exhibit 11.19 shows that after a harami, the market slid. It stabilized at hammer 1. This hammer was also a successful test of the prior support near $.50. Another slight pullback occurred on hammer 2. With this bullish hammer, the market nudged marginally under the summer lows (by 25 ticks) but the bears could not maintain these new lows. Thus a spring, complimented by a hammer and a tweezers bottom created noteworthy bullish evidence. Exhibit 11.20 reveals that during the week of March 12, soybeans touched a low of $5.96 formed a bullish engulfing

198 The Rule of Multiple Technical Techniques

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Source: Bloomberg L.P.

EXHIBIT 11.18. Live Cattle-April, 1990, Daily (Spring with Candlesticks)

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1990 CQG INC.

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(Spring with Candlesticks)

Candlesticks with Trendlines

199

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EXHIBIT 11.20. Soybeans-July, 1990, Intra-day (Spring with Candlesticks)

pattern and rallied. On April 3, prices broke this level and made new lows. These new lows failed to hold and created a spring. Furthermore, the lows on that session constructed a bullish engulfing pattern. Why do springs and upthrusts work so well? To answer this, refer to Napoleon's response when asked which troops he considered best. His View the market as a terse response was, "those which are victori~us."~ battlefield between two sets of troops-the bulls and the bears. The territory they each claim is especially evident when there is a lateral trading range. The horizontal resistance line is the bears' terrain to defend. The horizontal support line is the bulls domain to defend. At times there will be "scouting parties" (this is my term and not a candlestick expression) sent by big traders, commercial accounts, or even locals to test the resolve of the opposing troops. For instance, there might be a push by the bulls to try to move prices above a resistance line. In such a battle, we have to monitor the determination of the bears. If this bullish scouting party can set up camp in enemy territory (that is, close above resistance for a few days) then a beachhead is made. New, fresh attacking bull troops should join the scouting party. The market should move higher. As long as the beachhead is maintained (that is, the market should hold the old resistance area as new support), the bull
1

200

The Rule of Multiple Technical Techniques

,15: 15 UZO DAILY B R A @ 1989 CQG INC. .O= 3514 ................................................................................................................... ti- 3922 L- 3476 L= 3 4 8 2 ~ A= -34

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H= 3522 L= 3476 C= 3482 112

'Apr

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119

126

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116

123

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1 7

114

121

129

1 4

11 1

EXHIBIT 11.21. Wheat-December 1990, Daily (Upthrusts and "Scouting Parties")

troops will have control of the market. An example of a "scouting party" is presented in Exhibit 11.21. In late May, there were highs made at $3.54. Numerous bull scouting parties tried to get a foothold into the bear's terrain above $3.54. They only succeeded in pushing prices above $3.54 intra-day. The bulls could not get a beachhead, that is, a close, into the bears terrain. The bulls then went into retreat. The result? A return to the bottom end of the congestion band near $3.45. A candlestick sign that the bears still had control of the market was the bearish engulfing pattern made in early June. The shooting stars on June 12 and 13 did not help the picture either. A bullish scouting party also transpired in early April. By failing to hold above the mid-March highs, the bulls had to retreat. The result was a retest of the late March lows. This failure was confirmed by a bearish shooting star.

Candlesticks with Trendlines

201

THE CHANGE OF POLARITY PRINCIPLE
The Japanese have a saying that, "a red lacquer dish needs no decoration." This concept of simple beauty is the essence of a technical principle I frequently use with candlestick charting. It is as simple as it is powerful-old support becomes new resistance; old resistance becomes support. This is what I call the "change of polarity" principle. Exhibit 11.22 shows support converting to resistance. Exhibit 11.23 illustrates prior resistance becoming new support. The potency of this change of polarity is proportional to:
1. the number of times the old support/resistance levels have been tested; and 2. the volume and/or open interest on each test.

The concept behind the change of polarity principle (although not traditionally called that) is an axiom discussed in any basic book on technical analysis. Yet, it is an under utilized gem. To see how universally well this rule works let us briefly look at some examples across the various time horizons and markets. Exhibit 11.24 shows four occasions in which old resistance converted to new support. Exhibit 11.25 shows how the lows from late 1987 and mid-1988 became an important resistance zone for all of 1989. Exhibit 11.26 illustrates how the old resistance level near 27,000 in 1987, once penetrated, becomes significant support in 1988. To round out the time horizon (we saw this rule in the prior examples with a daily, weekly and monthly chart) let us look at an intra-day chart (see Exhibit 11.27). From early to mid-July, it was obvious where at the resistance level set in- $.72. Once penetrated on July 23, this $.72 immediately converted to support. Once the July 24 and 25 highs of $.7290 were breached, that level also converted to support. Exhibit 11.28 shows the usefulness of the change of polarity principle. In late 1989 to early 1990 there was a substantial rally. For the first half of 1990, the market traded in a lateral band with support shown as

Converted to

Old Resistance

Converted t o New Support

EXHIBIT 11.22. Change of Polarity-Support
Converting to Resistance

EXHIBIT 11.23. Change of Polarity-Resistance
Converting to Support

202

The Rule of Multiple Technical Techniques

12 : 33 O= 2706

CZO DAILY BAR

@

1989 CQG INC.

Resistance

a

t= 57G

v 'Dec 'Jan 'Feb 'Mar 'Flpr 'May 13016 11312012714 111118 12612 1 11512212915 1 2 12012615 11211912612 I 11612313017 8 1 9

1

EXHIBIT 11.24. Corn-December 1990, Daily (Change of Polarity)
8:07

. 0= 6361 . H= 6371
,

JY WEEKLY BAR

@

1989 CQG INC.

.L= 6360 ......................................................................................................................................... .- 9000 L= 6365v A= -27

:
,
'

-H= 6420

4/16/90 0= 6280 L= 6254 C= 6365 Oc t

'Jan
11988

Apr

Ju 1

Oct

'Jan
11989

Apr

Ju 1

Oct

'Jan
11990

Apr

EXHIBIT 11.25. Japanese Yen Futures, Weekly (Change of Polarity)

Candlesticks with Trendlines

203

8:08 .0=26193 . H=26788 L=25949 L=26672
-A=.

NKIC MONTHLY BAR

@

1990 CQG INC.

+?.%. ...................... : .....................................................................I.. .....................I................. : : .~40000

EXHIBIT 11.26. Nikkei-Monthly (Change of Polarity)
15 : 22

O= 7322 . , H= 7350 . ,L=7301. -L= 73484. . a = +12 .

. . . . . . . . . . . . . . . . . . . . . . .............................................................. . ...... ........................... Resistance . . ...... . ................... . . . . . . . . . . . . . .

. . . . .

SFUO 60 MINUTE BAR

.

.

.

. . . . . .

. . . .

@

1990 CQG INC.

......

7300

.

. . .

. .

. .

. .

. .

. .

. .

- ...........
.

. . . .

. . . .

.

.

. .

.- 7200

.

..... ...... ................

.

.
. .

...... ...... ...... ...... ...... .......... 7100 . . . .

.

O= H= .L= . C= rn 7/30 13120 . . . . . . . 7325 . . . . . . . . . . 7350 . . . . . . . 7324 ...................... ............................................................................................................... . . .- 7000 7348 . . . 17/5 17/9 1 7/16 1 7/73 1 7/m

.

.

.

. .

. .

EXHIBIT 11.27. Swiss Franc-September 1990, Intra-day (Change of Polarity)

204

The Rule of Multiple Technical Techniques

EXHIBIT 11.28. Orange Juice-Weekly (Change of Polarity)

a dotted line near $1.85. When this level was breached in June 1990, what was next support? The price action from $1.25 to $2.05 was essentially straight up so there was no support evident based on the late 1989 to early 1990 rally. Yet, when $1.85 broke, support was expected near $1.65. Where did I get that figure? Two reasons. The first was that a 50% correction of the prior $.80 rally was near $1.65. The second, and more important reason, was the prior resistance at area A was also near $1.65. That should mean it will now be support. A series of limit-down days comprised the June selloff. This selloff stopped at $1.66. Pick up just about any chart, be it intra-day, daily, weekly, or longer and the chances are high that you will see examples of this change of polarity in action. Why is something so simple so good? The reason has to do with the raison d'@treof technical analysis; to measure the emotions and actions of the trading and investing community. Thus, the better a technical tool measures behavior, the better that tool should work. And the change of polarity principle is so successful because it is based on sound trading psychological principles. What are these principles? It has to do with how people react when the market goes against their position or when they believe they may miss a market move. Ask yourself what is the most important price on any chart? Is the

Candlesticks w t Trendlines ih

205

highs made for move? The lows? Yesterday's close? No. The most important price on any chart is the price at which you entered the market. People become strongly, keenly and emotionally attached to the price at which they bought or sold. Consequently, the more trading that transpires at a certain price area the more people are emotionally committed to that level. What does this have to do with the fact that old resistance becomes support and old support becomes resistance? Let us look at the Exhibit 11.29 to answer this. In late December, a steep selloff culminated at $5.33 (at A). On another test of this level, there are at least three groups who would consider buying. Group 1 would be those who were waiting for the market to stabilize after the prior selloff and who now have a point at which the market found support-$5.33 (the December 28 lows at area A). A few days later, a successful test (at B) of this support probably pulled in new longs. Group 2 would be those who were previously long but were stopped out during the late December selloff. On rally B to B1, in mid-January, some of these old longs who were stopped out would say to themselves that they were right about silver being in a bull market. They just timed there original purchase incorrectly. Now is the time to buy. They want to be vindicated in their original view. They wait for a pullback to support at C to go long again. Group 3 would be those who bought at points A and B. They also see the B to B, rally and may want to add to their position if they get a "good price." At area C, they have their good price since the market is at support. Thus more buyers come in at C. Then for good measure another pullback to D draws in more longs. Then the problems start for the longs. In late February, prices puncture support areas A, B, C, and D. Anyone who bought at this old support area is now in a losing trade. They will want to get out of their trade with the least damage. Rallies to where the longs bought (around $5.33), will be gratefully used by them to exit their longs. Thus, the original buyers at areas A, B, C, and D may now become sellers. This is the main reason why old support becomes new resistance. Those who decided not to liquidate their losing long positions on the minor rallies in early March then had to go through the pain of watching the market fall to $5. They used the next rally, in early April (Area E), to exit. Exhibit 11.29 illustrates how support can become resistance. The same rationale, but in reverse, is the reason why resistance often becomes support. Do not let the simplicity of the rule fool you. It works-especially when melded with candlestick indicators. For example look at area E. Notice how the doji after a tall white real body meant

206

The Rule of Multiple Technical Techniques
@

8 : 44 O 4815 =

SIN0 DAILY B R A

1989 CQG INC.

. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

- ................................................................................................................................................... . . 6000 t . . : . . . . . . : . . . . : . . . . : . . . .:. . . . . . . : . . . . : . . . . : . . . .: . . . . :. . .
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . B1 ... ................... ................... : .. . . . . . . . . . . ;oji.. . . . . . . . . . 1 .: . - ................. . Doji. . . . . . . : Resistance ' E j . . . . .
. . . Support . . . . . . . . . . ................... .................... . . . . . . . . . . . . . . . ................. . . . . . . . . . . . . . . . . . . . . . . : . . . . : . .
5500

:

:

:

.

.

.

.
5000

.

:

. . . . . . . . . . . . . : . . . .: . . .
I

L,O= 4815 / 9 0 , :, 6/22

-:= 47;;
' C = 4810

. . . 1 . . . .: . . . . :. . . .......:. ..................... .................:. ................................................................ :. :. ................... 4500
. . . .
. . .

:.

1.

'Jan

rn

118 126 1 1 2 8

'Feb 'Mar 'Apr 115 122 129 1 112 120126 1 112 119 126 1 1 5 5 2 9

'May
I16 123 130 1 7

'Jun
114 121 12914 111 1\18

EXHIBIT 11.29. Silver-July 1990, Daily (Change of Polarity)

trouble. This candlestick signal coincided with the resistance line. The same scenario unfolds at F. In Exhibit 11.30, the highs at A and B then became support in late 1986 and then in 1989. Note how the strength of this support was confirmed twice in 1989 by two consecutive hammer lines. In September and early October, at areas A and B in Exhibit 11.31, the market maintained a support level near $1,230. Once the bears pulled the market under that level on October 9, this $1,230 then converted to a band of resistance. After the first failure at this new resistance, at C, prices descended until the bullish engulfing pattern. A minor rally then followed. This rally stalled, once again, at the $1,230 level. In addition, there was a dark-cloud cover.

Candlesticks w t Trendlines ih

207

EXHIBIT 11.30. Swiss Franc-Monthly (Change of Polarity with Candlesticks)
9:43 C Z DAILY BAR CO @ 1990 CQG I N C . -' .0=1165 , ,H= 1165 , L = 1150 ' , L= 1150v h= -24 ..................................................................................................................................................... 1400

-

:

-

Dark Cloud Cover

Bullish

-

.10/30/90"' 1165 1165 1150 1150 130
' ' '

Engulfing ............................................................................................................ pattern

1100

'O= 'H= 'L= ' C=

'Aug

1 6

113

120

127

'Sep 1 3

110

117

124

'Oc t 1 1

1 8

115

122

129

EXHIBIT 11.31. Cocoa-December 1990, Daily (Change of Polarity with Candlesticks)

208

The Rule of Multiple Technical Techniques

Notes lColby, Robert W. and Meyers, Thomas A. The Encyclopedia of Technical Market Indicators, Homewood, I : L Dow Jones-Irwin, 1988, p. 159. 'Kroll, Stanley. Kroll on Futures Trading, Homewood, IL:Dow Jones-Irwin, 1988, p. 20.

CHAPTER

12

CANDLESTICKS WITH RETRACEMENT LEVELS
%?1%WWB$Uh! I
"All things come to those who wait"

Markets usually do not trend straight up, nor do they fall vertically downward. They usually retrace some of the advance, or decline, before resuming the prior trend. Some of the more popular retracement levels are the 50% level and the Fibonacci figures of 38% and 62% (see Exhibits 12.1 and 12.2). Fibonacci was a 13th century mathematician who derived a special sequence of numbers. Without getting into too much detail, by comparing these numbers to one another one could derive what is called-not surprisingly-the Fibonacci ratios. These ratios include 61.8% (or its inverse of 1.618) and 38.2% (or its inverse of 2.618). This is why the 62% (61.8% rounded off) and the 38% (38.2% rounded off) corrections are so popular. The popular 50% correction is also a Fibonacci ratio. The 50% retracement is probably the most widely monitored level. This is because the 50% retracement is used by those who use Gann, Elliott Wave, or Dow Theory. Exhibit 12.3 illustrates how well retracements can help predict resistance areas in a bear market. The 50% retracements in gold over the past few years have become significant resistance levels. Let us look at three instances on this chart where 50% retracements melded with candlestick techniques to provide important top reversal signals. Xetracement 1The highs at A in late 1987 ($502) were made by a bearish engulfing pattern. The selloff which began in late 1987 ended with a piercing pattern at B at $425. Based on a 50% retracement of this selloff from A to B, resistance should occur at $464 (this is figured by taking half the difference between the high at A and the low at B and

210

The Rule of Multiple Technical Techniques

B

"'I a / llI @

I

- 3 8 % Retracernent of A- B
-

I

@

5 0 % Retracernent of A-B 6 2 % Retracement of A-B

EXHIBIT 12.1. Popular Retracement Levels in an Uptrend

A

EXHIBIT 12.2. Popular Retracement Levels in a Downtrend

.s;
\

a

- 3 8 % Retracement of A-B
5 0 % Retracernent of A- B 6 2 % Retracernent of A-B

@ -

@\ @
\

a,, \;
\\

B

\\

adding this onto the low at B). Thus, at $464 you look for resistance and confirmation of resistance with a bearish candlestick indicator. A bearish engulfing pattern formed at C. At C, the high was $469 or within $5 of the 50% correction. The market began its next leg lower. Retracement 2The selloff which began at C ended at the morning star pattern at D. Taking a 50% correction from C's high at $469 to D's low at $392 gives a resistance area of $430. Thus, at that level, bearish candlestick confirmation should appear. Gold reached $433 at area E. During this time (the weeks of November 28 and December 5 (at E)) gold came within $.50 of making a bearish engulfing pattern. Another decline started from E. Retracement 3From the high at E to the low at F in 1989 (at $357), prices fell $76. (Interestingly, all three selloffs, A to B, C to D, and E to F fell about $77.) There were no candlestick indicators that called the lows on June 5. The second test of these lows in September came via a hammerlike line. The next resistance level, a 50% retracement of the decline from E to F, is $395. Not too surprisingly gold surpassed this level. Why wasn't this a surprise? Because, in late 1989, gold pierced a two-year resistance

Candlesticks w t Retracement Levels ih

211

EXHIBIT 12.3. Gold-Weekly (Retracements with Candlesticks)

line. In addition, gold built a solid base in 1989 by forming a double bottom at the $357 level. Thus, we have to look out farther to a 50% retracement of the larger move. This means a 50% retracement of the entire decline from the 1987 high (area A) to the 1989 low (area F). This furnishes a resistance level of $430. Near this $430 level, at $425 on the week of November 20 at area G, the market gave two signs that the uptrend was in trouble. Those signs were a harami pattern and, as part of this pattern, a hanging man. A few weeks later, on the week of January 22, the highs for this move were touched at $425. The following week's price action created another hanging man. Gold declined from there. Look at Exhibit 12.4. The combination tweezers and harami bottom at $18.58 (A) was the start of a $3.50 rally. This rally terminated at $22.15 (B) with a bearish engulfing pattern. A 50% correction of the A- thrust B would mean support near $20.36. At area C, a bullish piercing pattern formed at $20.15. The market then had a minor rally from C. This rally ran into problems because of the dark-cloud cover at D. Interestingly, D's high at $21.25 was within 10 ticks of a 50% bounce from the prior downleg K C . Exhibit 12.5 reveals that a Fibonacci 62% retracement of rally A- is B

212
12 :44

The Rule of Multiple Technical Techniques

. O= 1836 .H= 1845 . . . . . . . . . . . L= 1752 L= 17954
,

CLKO D A I L Y BAR

A=

-11

B (Bearish Engulfing Pattern)

. . . . . .
D ark-cloud

..................... ................ :

. . . . . . . . . . . . . ...........
...................

.

.

.

. .

.......

. . . . . . . . . . . . . . . . . . . . . .
.................................... (Tweezers and Hararni)

A

,

: I -:= ......................................................................................................................................... ~~~~ :
4/20/90
L = 1752 C= 1795
'Nov

1600

'Dec

'Jan

'Feb

'Mar

'Apr

m

1 6 1 3 (30 1 1 3 1 0 1 7 1 111 1 8 1 6 1 1 1 5 1 2 1 9 1 1 2 120126 1 1 2 1 9 1 6 1 1 1 2 6 1 2 2 4 1 2 2 8 1 2 2 5 1 5 1 1 2 2 9

16 1

EXHIBIT 12.4. Crude OilMay 1990, Daily (Retracements with Candlesticks)
14:43 O= 6430 -H= 6530 L= 6400 L = 65164 -A= +82 SNO D A I L Y BAR

@

1990 CQG I N C .

. . . .
'

.

.

.

..

.

.

.
6600

. . .
. . .
. . . . . .

.
.

.
.

6300

.
.

.
.

.
.

.
.

B

..

...................................................................
Hararni

. .. ..

6000

5/ 2/90 O= 6430 . H= 6530 ........................................................................................................................................ -L= 6400 - 5700 , C = 6516 Feb Mar .Apr Mar , 19 19 2 1 5 1 2 119 1 16 2 1 5 112 I26 I2 IP (16 13 2 10 3
,

.A

. .

1

EXHIBIT 12.5. Soybeans-July 1990, Daily (Retracements with Candlesticks)

Candlesticks with Retracement Levels
0

213

9:09

CLZO DAILY BAR
, ,

1990 CPG INC.

. O= 3400 . H= 3420
,

L= 3385 -L=34,15A.:. A= -39 ,

.

.

.

:. . . .

:

.

.

.

,:,

.

.

.

:

.

.

.

:
H

.

.

.

.

...........................

- . . . . . . .........................................................................................

.........

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

Hammer

.

- .....).+

+.

rm.l?lr.mrrtn*?~~.*,*.,~tt*

...................................................................................
L
1

9:07 CLZO 60 MINUTE BAR 0 1990 CQG INC. -o= 3400 ........................................................................................................................................... 3750 H= 3420 -L= 3385 . L= 3400v .A= - 4 . . 5,

TY

- ..................................................................................................................................................... - 3250

10/31 8:45 -0= 3400 H= 3420 -L= 3385 C= 3400 rn 3000

.

Hammer

11 0/22

110/29

EXHIBIT 12.6. Crude Oil-(a) December 1990 and (b) December 1990 Intra-day

214

The Rule of Multiple Technical Techniques

$5.97. This also coincides closely with the old resistance level from late January and February at $5.95. That old resistance converted to support. On the pullback to this level, on April 2 and 3, this $5.97 held as support. These sessions formed a harami pattern that signaled an end to the prior minor downmove. Then, just for good measure, there was an additional test of this support in mid-April, and away went the beans! Exhibit 12.6a shows from crude oil's July low at L, to its October high at H, there was a $21.70 rally. A 50% retracement of this rally would be at $29.05. Thus, based on the theory that a 50% retracement level from a rally should be support, we should look for a bullish candlestick indicator near that $29.05 area on the brisk selloff from October's high. This is what unfolded. On October 23, after prices touched a low of $28.30, a hammer developed on the daily chart. The market rallied over $5 from that hammer. On the intra-day chart of the price action on October 23 (see Exhibit 12.6b) we see the first hour's action also formed a hammer. Thus, the daily candlestick chart on October 23 and the first hour on the intra-day candlestick chart on October 23 both had hammers. This is a rare, and as we see, significant occurrence. Note how, on the intra-day chart, the brisk rally that began with the hammer ran out of force with the emergence of the hanging man on October 26.

CANDLESTICKS WITH MOVING AVERAGES
+At-$
"Ten Men, Ten Tastes"

T h e moving average is one of the oldest and most popular tools used by technicians. Its strength is as a trend-following device which offers the technician the ability to catch major moves. Thus, it is utilized most effectively in trending markets. However, since moving averages are lagging indicators they can catch a trend only after it has turned.

THE SIMPLE MOVING AVERAGE
The most basic of the moving averages is, as the name implies, the simple moving average. This is the average of all the price points used. For example, let us say that the last five gold closing prices were $380, $383, $394, $390, and $382. The five-day moving average of these closes would be

The general formula is:

where P1 = the most recent price P2 = the second most recent price and so on n = the number of data points

216

The Rule of Multiple Technical Techniques

The term "moving" in moving average is applicable because, as the newest data is added to the moving average, the oldest data is dropped. Consequently, the average is always moving as the new data is added. As seen in the simple moving average example above, each day's gold price contributed 1 , to the total moving average (since this was a five-day moving average). A nine-day moving average means that each day will only be % of the total moving average. Consequently, the longer the moving average, the less impact an individual price will have on it. The shorter the term of the moving average, the closer it will "hug" prices. This is a plus insofar as it is more sensitive to recent price action. The negative aspect is that it has a greater potential for whipsaws. Longer-term moving averages provide a greater smoothing effect, but are less responsive to recent prices. The more popular moving averages include the four- , nine- , and 18-day averages for shorter-term traders and the 13- , 26- , and 40-week moving averages for position players. The 13- and 40-week moving averages are popular in Japan. The spectrum of moving average users runs from the intra-day trader, who uses moving averages of real-time trades, to the hedger who may focus on monthly, or even yearly, moving averages. Other than the length of the average, another avenue of analysis is based on what price is used to compute the average. Most moving average systems use, as we did in our gold example, closing prices. However, moving averages of highs, lows, and the mid-point of the highs and lows have all been used. Sometimes, moving averages of moving averages are even used.

THE WEIGHTED MOVING AVERAGE
A weighted moving average assigns a different weight to each price used to compute the average. Almost all weighted moving averages are front loaded. That is, the most recent prices are weighted more heavily than older prices. How the data is weighted is a matter of preference.

THE EXPONENTIAL MOVING AVERAGE AND THE MACD
The exponential moving average is a special type of weighted moving average. Like the basic weighted moving average, the exponential moving

Candlesticks w t Moving Averages ih

217

average is front weighted. Unlike other moving averages, though, the exponential moving average incorporates all prior prices used in the data. This type of moving average assigns progressively smaller weights to each of the past prices. Each weight is exponentially smaller than the previous weight, hence, the name exponential moving average. One of the most popular uses of the exponential moving average is for use in the MACD (Moving Average Convergence-Divergence). The MACD is composed of two lines. The first line is the difference between two exponential moving averages (usually the 26- and 12-period exponential moving averages). The second line of the MACD is made by taking an exponential moving average (usually a 9 period) of the difference between the two exponential moving averages used to make the first line. This second line is called the signal line. More about the MACD in Exhibits 13.7 and 13.8.

HOW TO USE MOVING AVERAGES
Moving averages can provide objective strategies with clearly defined trading rules. Many of the computerized technical trading systems are underpinned on moving averages. How can moving averages be used? The answer to this is as varied as there are different trading styles and philosophies. Some of the more prevalent uses of the moving average include:
1. Comparing the price versus the moving averages as a trend indicator. For instance, a good gauge to see if a market is in an intermediateterm uptrend could be that prices have to be above the 65-day moving average. For a longer-term uptrend prices would have to be higher than the 40-week moving average.
2. Using the moving average as support or resistance levels. A close

above the specified moving average would be bullish. A close below the moving average would be bearish. 3. Monitoring the moving average band (also known as envelopes). These bands are a certain percentage above or below the moving average and can serve as support or resistance. 4. Watching the slope of the moving average. For instance, if the moving average levels off or declines after a period of a sustained rise, it may be a bearish signal. Drawing trendlines on the moving averages is a simple method of monitoring their slope. 5. Trading with a dual moving average system. This is addressed in detail later in this chapter.

218

The Rule of Multiple Technical Techniques

The examples that follow use various moving averages. They are not based on optimum moving averages. An optimum moving average today might not be the optimum one tomorrow. The moving averages used in this text are widely monitored along with some which are not as widely used but which are based on such tools as Fibonacci numbers. The moving averages used here are not the important point. What is meaningful is how moving averages can be melded with candlesticks. I like using the 65-day moving average as a broad spectrum moving average. From my experience, it seems to work well in many of the futures markets. Exhibit 13.1 illustrates a 65-day moving average that offered support to the market at areas 1, 2, and 3. Beside the moving average shoring up the market at these points, we see a bullish engulfing pattern at area 1, a hammer and harami at 2, and another hammerlike line at 3. Exhibit 13.2 reveals that a confluence of technical factors joined on April 2 and 3 to warn alert eyes of trouble ahead. Let us take a look at the specifics:
1. In early March, prices broke under the 65-day moving average. From

that point, the moving average became resistance.

10: 10 O= 6510 -H= 6520
L= 6452

S O DAILY B R N A

@

1990 CQG INC.

<

. .

.

.

.

..

L=
.A=

646%~ . -52 65 SIM (CLI 0 SIM (CLI 0 SIM (CL)

.

.

.

.

.

.

. .

. .

. .

.

.

.

\

Average
O = H= .L= C=
-. -. . 6510 . 6520 6452 ,. 6464 129

6055.91...................................................................................................................

-

Mar
1 5 112 119 126 1 5 112 I19 126

Apr

MUY 1 9 (16

1 2

13 2

10 3

J

EXHIBIT 13.1. Soybeans-July 1990, Daily (Simple Moving Average with Candlesticks)

Candlesticks with Moving Averages
14 : 09 O= 1935 H= 1947 L= 1892 L= 1902A = -5 65 SIM (C1 0 SIM (C) 0 SIM (C) C M DQILY BAR L O

219

@

1989 CQG INC.

.
'

.

.

:
A
'

..........................
Dark-cloud Cover 65- day Moving Average

..........................

EXHIBIT 13.2. Crude Oil-June 1990, Daily (Simple Moving Average with Candlesticks)

2. The two candlesticks on April 2 and 3 formed a dark-cloud cover. This dark-cloud cover was also a failure at the moving average's resistance area.
3. April 3 was not only a dark-cloud cover and a failure at a moving average, but it was also within 7 ticks of a 50% retracement of price decline A-B.

Exhibit 13.3 shows that late February's test of the 65-day moving average support line was confirmed with a hammer. The market retested these lows a few days later and, in the process, formed a tweezers bottom.

220
7:33

The Rule of Multiple Technical Techniques
@

o=
H=
A=

..
65 SIM [C)

SUKO DGILY BAR

.

.

.

.

.

.

1989 CQG INC.

L= L=

............

;

....................................... ...................................................

:

4....

...

............

.

.

Hammer
. .

Moving Average

.

.

.

.

,

.

0=
H=
I

.................................................
'Jan 11 12

1

....................................... ......................
'Feb 1 5

1

L=

c=

18 1

16 2

1 8

15 1

122

19 2

112

10 2

16 2

'Mar 1 5

I
112

EXHIBIT 13.3. Sugar-May 1990, Daily (Simple Moving Average with Candlesticks)

DUAL MOVING AVERAGES
There are many ways two moving averages can be used. One way is as an overbought/oversold indicator or oscillator. This indicator is obtained by subtracting the shorter-term moving average from the longer-term moving average. This indicator has plus or minus values. Thus a value above 0 means the shorter-term moving average is above the longer-term moving average. Anything under 0 means the shorter-term moving average is less than the longer-term moving average. In doing this, we are comparing the short-term momentum to a longer-term momentum. This is because, as discussed earlier, the short-term moving average is more responsive to recent price activity. If the short-term moving average is relatively far above (or below), the longer-term moving average, the market is said to be overbought (or oversold). Another use of two moving averages is to monitor crossovers between the short-term and longer-term moving averages. If the shorterterm moving average crosses the longer-term moving average, it could be an early warning of a trend change. An example would be if a shorter-term moving average crosses above a longer-term moving aver-

Candlesticks with Moving Averages

221

age. This is a bullish signal. In Japan, such a moving average crossover is called a golden cross. Thus, if the three-day moving average crosses above the nine-day moving average it is a golden cross. A dead cross in Japan is the opposite. It is a bearish indication which occurs when the shorter-term moving average crosses under the longer-term moving average. For a short-term overbought/oversold indicator, some technicians monitor the current close in relation to the five-day moving average. (See Exhibit 13.4.) For instance, if copper's five-day moving average is $1.10 and today's close is $1.14, copper would be $.04 overbought. In this example, the lower graph's line is made up of the five-day moving average subtracted from the current close. As can be seen from this chart, when this dual moving average line gets about 400 points (that is, $.04) overbought the market become vulnerable-especially with bearish candlestick confirmation. At time period 1, an overbought reading coincided with a harami; at period 2, it hit another harami; at 3, it hit a doji; and at 4, it hit another harami. A market can relieve its overbought condition by selling off or by trading sideways. In this example, time periods 1 and 3 relieved the overbought situation by easing into a lateral band. Periods 2 and 4 saw selloffs. Overbought markets usually should not be shorted.

,

: 0= . H= - L=
L=

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CPUO D A I L Y BAR

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1990 CQG INC.

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EXHIBIT 13.4. Copper-September 1990, Daily (Dual Moving Averages with Candlesticks)

222

The Rule of Multiple Technical Techniques

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EXHIBIT 13.5. Deutschemark-September 1990, Daily (Dual Moving Averages with Candlesticks)

Instead, they should be used by longs to take defensive measures. The reverse is true in oversold markets. Two moving averages can be plotted as two lines overlaid on a price chart. As previously mentioned, when the shorter-term moving average crosses above a longer-term moving average it is called a golden cross by the Japanese and is a bullish indication. Exhibit 13.5 has a bullish golden cross and a fry pan bottom. The fry pan bottom was confirmed by the window on July 2. Note how the window became support in the first half of July and how the shorter-term moving average became support as the market rallied. Dual moving average differences are also used as a divergence vehicle. As prices increase, the technician wants to see the short-term moving average increase relative to the longer-term moving average. This would mean increasing positive values for the moving average difference line. If prices advance and the difference between the short- and longterm moving averages narrows, the market is indicating that the shorterterm momentum is running out of steam. This suggests an end to the price advance. In Exhibit 13.6, we have a histogram between two moving averages. During time periods 1 and 2, advancing prices were echoed by a

Candlesticks with Moving Averages
14:Ol C M DAILY B R , L O A

223

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1989 COG INC.

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EXHIBIT 13.6. Crude Oil-June 1990, Daily (Dual Moving Averages with Candlesticks)

widening differential between the short- and long-term moving averages. This means the shorter-term moving average is increasing more quickly than the longer-term moving average. This bodes well for a continuation of the uptrend. Time period 3 is where the market experienced problems. The $.50 rally, which began February 23, was mirrored by a narrowing of the moving average differential. This reflects a weakening of the short-term momentum. Add to this the dark-cloud cover and you have a market vulnerable to a price pullback. The histogram also displays when the short-term moving average crosses above or below the longer-term moving average. When the histogram is below 0, the short-term moving average is under the long-term average. When it is above 0, the short-term average is above the longterm moving average. Thus, an oscillator reading under 0 represents a bearish dead cross; above 0 would be a bullish golden cross. There was a golden cross at time frame A. A few days before this golden cross there was a bullish inverted hammer. At B, there was a dead cross. At time frame C, prices had rallied but the short-term moving average could not get back above the longer-term moving average (that is, the oscillator remained under 0). In addition, a bearish signal was sent when the dark-cloud cover formed on April 2 and 3.

224
15:07

The Rule of Multiple Technical Techniques

L= 8902 .L= 89144 .A= -9

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Bearish Engulfing Pattern

BDUO DAILY BAR

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1990 CQG INC.

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OSCILLATOR BDUO OPILY BAR

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0.150 EXP (CL) - 0.075 EX P (CL)

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EXHIBIT 13.7. Bonds-September 1990, Daily (MACD with Candlesticks)

EXHIBIT 13.8. Coffee-September 1990, Daily (MACD with Candlesticks)

Candlesticks with Moving Averages

225

The MACD has two lines. They are shown on the lower chart in Exhibit 13.7. The more volatile solid line is the signal line. A sell signal occurs when this signal line crosses below the dashed, less volatile line. In this example, the bearish implications of the two bearish engulfing patterns were corroborated by the bearish crossovers of the MACD indicators (see arrows). In Exhibit 13.8, the signal line of the MACD pushed above the slower moving line in early July (see arrow). This was a notable clue that the market might be bottoming. Shifting to the candlesticks shows that the first morning star's bullish implications were voided by the dark-cloud cover. The price decline from this dark-cloud cover ended with another morning star. After a temporary set back with the hanging man, the market's upward force gained steam.

CANDLESTICKS WITH OSCILLATORS f#+e-rtFlB h if
"Let every bird sing its own note"

Pattern recognition techniques are often subjective (this includes candlestick techniques). Oscillators are mathematically derived techniques which offer a more objective means of analyzing the market. They are widely used and are the basis of many computerized trading systems.

OSCILLATORS
Oscillators include such technical tools as the relative strength index, stochastics, and momentum. As discussed in greater depth later in this chapter, oscillators can serve traders in at least three ways:
1. Oscillators can be used as divergence indicators (that is, when the price and the oscillator move in different directions). They can warn that the current price trend may be stalling. There are two kinds of divergence. A negative, or bearish, divergence occurs when prices are at a new high, but the oscillator is not. This implies the market is internally weak. A positive, or bullish, divergence is when prices are at a new low but the oscillator does not hit a new low. The implications are that the selling pressure is losing steam.

228 The Rule of Multiple Technical Techniques
2. As overboughtloversold indicators, oscillators can notify the trader if

the market has become overextended and, thus, vulnerable to a correction. Using an oscillator as an overbought/oversold indicator requires caution. Because of how they are constructed, oscillators are mainly applied in lateral price environments. Using an oscillator as an overboughtloversold indicator when a new major trend is about to commence can cause problems. If, for example, there is a break above the top of a congestion band, it could indicate the start of a new bull leg and the oscillator could stay overbought while prices ascend. 3. Oscillators can confirm the force behind a trend's move by measuring the market's momentum. Momentum measures the velocity of a price move by comparing price changes. In theory, the velocity should increase as the trend is underway. A flattening of momentum could be an early warning that a price move may be decelerating. Use oscillator signals to place a position in the direction of the dominant trend. Thus, a bullish oscillator indication should be used to buy, if the major trend is up, and to cover shorts, if the major trend is down. The same idea applies to a sell signal vis-a-vis an oscillator. Do not short on a bearish oscillator signal unless the prevailing trend is heading south. If it is not, a bearish oscillator signal should be used to liquidate longs.

THE RELATIVE STRENGTH INDEX
The Relative Strength Index (RSI)' is one of the most popular technical tools used by futures traders. Many charting services plot the RSI and many traders closely monitor it. The RSI compares the relative strength of price advances to price declines over a specified period. Nine and 14 days are some of the most popular periods used. How to Compute the RSI The RSI is figured by comparing the gains of up sessions to the losses of the down sessions over a given time frame. The calculations used are dependent only on closing prices. The formula is: RSI
=

100

-

(1 %S)

where RS = average up points for periodlaverage down points for period

Candlesticks with Oscillators

229

Thus, computing a 14-day RSI entails adding the total gains made on the up days over the last 14 days (on a close-to-close basis) and dividing by 14. The same would be done for the down days. These figures provide the relative strength, (RS). This RS is then put into the RSI formula. This RSI formula converts the RS data so that it becomes an index with a range between 0 and 100.

How to Use RSI
The two main uses of RSI are as an overbought/oversold indicator and as a tool to monitor divergences. As an overbought/oversold indicator, the RSI implies that the market is overbought if it approaches the upper end of this band (that is, above 70 or 80). At that point, the market may be vulnerable to a pullback or could move into a period of consolidation. Conversely, at the lower end of the RSI range (usually below 30 or 20), it is said to reflect an oversold condition. In such an environment, there is a potential of a short covering move. As a divergence tool, RSI calculations can be helpful when prices make a new high for the move and the RSI fails to make a concurrent high. This is called a negative divergence and is potentially bearish. A positive divergence occurs when prices make a new low, but the RSI does not. Divergences are more meaningful when RSI oscillator readings are in overbought or oversold regions. Exhibit 14.1 displays both a bullish positive and a bearish negative RSI divergence which helped these candlestick readings. At the time of the January 24 price low, the RSI was 28%. On January 31, a new price low for the move occurred. The RSI then was 39%. This was noticeably higher than the 28% RSI value of January 24. New price lows and a higher RSI level created a bullish positive divergence. Besides the positive divergence, the white line of January 31 engulfed the prior black candlestick. This built a bullish engulfing pattern. A doji star arose on March 14. The next session created a candlestick similar to a hanging man. (The lower shadow was not long enough for it to be a classic hanging man, though.) At the time of these potentially bearish candlestick indicators, the RSI was also sending out a warning alert. Specifically, the new price peaks of March 15 and 16 were mirrored by lower RSI readings. This is bearish negative divergence. The market made another price surge on March 21, and although this was a new price high, RSI levels continued to decline. The result was a pullback to the March support area of $1.11. In Exhibit 14.2 the decline that began with the bearish engulfing pat-

230
. 1= :1 1

The Rule of Multiple Technical Techniques
CPKO

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EXHIBIT 14.1. Copper-May, 1990, Daily (RSI with Candlesticks)

tern stopped at the piercing pattern. The constructive outlook implied by this piercing pattern was reinforced by the positive divergence of the RSI. Some technicians also use trendlines with RSI. In this case, the RSI uptrend support line held in spite of new price lows on March 29. Exhibit 14.2 illustrates another reason to use candlesticks as a compliment to the RSI. Candlesticks may give a bullish or bearish signal before the additional confirmation sometimes needed by the RSI. Specifically, some technicians will view the RSI as giving a bullish signal if two steps occur. The first is the aforementioned positive divergence. The next is that the RSI has to move above its prior high. In this example, that would mean a move above the April 20 RSI level (A). Based on this procedure the bullish signal would have been given at point B. However, by joining the bullish candlestick indication (the engulfing line) with the RSI's positive divergence, the bullish signal would have been apparent a few days earlier. Doji are a warning signal during uptrends. But, like all technical clues, they can sometimes mislead you. One way to filter out the misleading clues is to add other technical tools. Exhibit 14.3 illustrates the use of the RSI as a tool of confirmation. A bearish shooting star and a set of doji lines appeared in the middle of May (time frame A). These sig-

Candlesticks with Oscillators

231

EXHIBIT 14.2. Wheat-May 1990, Daily (RSI with Candlesticks)
7 . O=: 5 4 : H= .L= DJI5 DAILY BQR

@ 1990 COG INC. Hanging

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EXHIBIT 14.3. Dow Jones Industrial Average (RSI with Candlesticks)

232

The Rule of Multiple Technical Techniques

naled the end of the prior uptrend, at least temporarily, as the market moved into a lateral range for the next few weeks. After this respite, a rally pushed prices to new highs at time frame B. These highs were 100 points above where they were at time frame A. Yet, at time frame B, the RSI was where it was at A. This reflected a flagging of the markets internal strength. The harami at B sounded more warning sirens. After a 100-point setback from the highs at time frame B, another rally ensued. This rally touched the 3000 level at time frame C. These new highs were sharply above prices at time frame B but the RSI was noticeably less. This bearish divergence at time frame C accompanied with the shooting star, the doji, and the hanging man indicated the internally weak structure of the market, even though prices touched new highs.

STOCHASTICS
The stochastic oscillator is another popular tool used by futures technicians. As an oscillator, it provides overbought and oversold readings, signals divergences, and affords a mechanism to compare a shorter-term trend to a longer-term trend. The stochastic indicator compares the latest closing price with the total range of price action for a specified period. Stochastic values are between 0 and 100. A high-stochastic reading would mean the close is near the upper end of the entire range for the period. A low reading means that the close is near the low end of the period's range. The idea behind stochastics is that, as the market moves higher, closes tend to be near the highs of the range or, as the market moves lower, prices tend to cluster near the lows of the range.

How to Compute Stochastics
The stochastic indicator is comprised of two lines; the %K and the %D lines. The %K line, called the raw stochastic or the fast %K, is the most sensitive. The formula for the %K line is: (Close) - (Low of N) x 100 (High of N) - (Low of N)
=

%K

where Close = current close Low of N = low of the range during the period used High of N = high of the range during the period used

Candlesticks with Oscillators

233

The "100" in the equation converts the value into a percentage. Thus, if the close today is the same as the high for the period under observation, the fast %K would be 100%. A period can be in days, weeks, or even intra-day (such as hourly). Nineteen, fourteen, and twenty-one periods are some of the more common periods. Because the fast %K line can be so volatile, this line is usually smoothed by taking a moving average of the last three %K values. This lw three-period moving average of %K is called the so %K. .Most technicians use the slow %K line instead of the choppy fast %K line. This slow %K is then smoothed again using a three-day moving average of the slow %K to get what is called the %D line. This %D is essentially a moving average of a moving average. One way to think of the difference between the %K and %D lines is too view them as you would two moving averages with the %K line comparable to a short-term moving average and the %D line comparable to a longer-term moving average.

How to Use Stochastics
As mentioned previously, stochastics can be used a few ways. The most popular method is to view it as a tool for showing divergence. Most technicians who monitor stochastics use this aspect of divergence in conjunction with overbought/oversold readings. Some technicians require another rule. That rule is to have the slow %K line cross under the %D line for a sell signal, or for the slow %K to move above the %D for a busy signal. This is comparable to the bullish (bearish) signal of a faster moving average crossing over (under) the slower moving average. For instance, to get a buy signal, the market must be oversold (25% or less for %D), there is a positive divergence and, the %K line is crossing above the %D line. Looking at Exhibit 14.4, the doji session of January 3 should give you pause. A doji following a long white candlestick "ain't pretty." The doji session made new price highs as they pushed above the December highs. But stochastics did not echo these price highs with concomitant highs, so this was bearish negative divergence. It was an important affirmation of the bearish signal sent on the doji day. Besides the divergence, some technicians look for crossovers of the %K and %D lines. See Exhibit 14.5. In mid-1989, copper based out via a hammer. Another series of hammer lines materialized in early 1990. Was this a sign of another base? The answer was more than likely yes because of what the stochastic evidence told us. Hammer B made new lows as it broke under the lows from hammer A. Yet, at hammer B there was a higher stochastic reading than at hammer A. This was a positive divergence. The implications were an abating of selling pressure.

234

The Rule of Multiple Technical Techniques
@
1989 CQG INC.

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.

. .

EXHIBIT 14.4. Dow Jones Industrial Average, 1989-1990 (Stochastics with Candlesticks)

EXHIBIT 14.5. Copper-Weekly (Stochastics with Candlesticks)

Candlesticks with Oscillators

235

There was also a positive crossover as the more volatile, solid %K line crossed above the dotted %D line (see arrow). This crossover is considered more significant if it is from oversold readings (that is, under 25%). That is what occurred here. So, in early 1990, there were a series of hammerlike lines and a positive divergence with a positive crossover during an oversold market. A confluence of technical indicators that were strong clues that the prior downtrend had ended. As illustrated by Exhibit 14.6, April 12 and 16 formed a dark-cloud cover. The black candlestick session on April 16 pushed prices above the former highs in March. Thus prices were at a new high, but stochastics were not. The dark-cloud cover and the negative divergence were two signs to be circumspect about further rallies. The next downleg was corroborated by a negative crossover when the faster %K line crossed under the slower %D line (as shown by the arrow). I do not often use candlesticks with British Pound futures because, as can be seen in Exhibit 14.7, many sessions are small real bodies or doji. This is in addition to the frequent gaps induced by overnight trading (this is also true of other currency futures). Nonetheless, at times, there are candlestick signals that bear watching especially when confirmed with other indicator^.^

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EXHIBIT 14.6. S&P-June

1990, Daily (Stochastics with Candlesticks)

236

The Rule of Multiple Technical Techniques

10 :26 BPNO DAILY BAR @ 1989 CQG INC. O=16020 . . . . . . -H=16088. . ' 1L=16012.. .......:.... ....................................... . 1 ................................................................................17000 1 .: L=16074A . . . . . . -A= + 6 4 :.

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1 5

EXHIBIT 14.7. British Pound-June 1990, Daily (Stochastics with Candlesticks)

During the week of March 19, a variation of a morning star arose. Normally, it is best if the third white candlestick of the morning star pattern pushes well into the first session's black body. This white candlestick did not. Before deciding how much importance to place on a variation of a pattern, scan the other technical evidence. At the time of the morning star (or actually its variation), prices touched new price lows; stochastics did not. This was a bullish positive divergence which was soon confirmed when the %K line crossed over the %D line. Consequently, the fact that the morning star pattern was less than ideal should have only given you temporary pause about calling for a bottom. Stochastic indicators provided plenty of added proof to this outlook.

MOMENTUM
Momentum, also called price velocity, is a measurement of the difference between the closing price today and the closing price a specified number of days ago. If we use a ten-day momentum we compare today's close to that of ten days ago. If today's close is higher, the momentum is a

Candlesticks with Oscillators

237

positive number on the momentum scale. If today's close is lower than that of ten days ago, the momentum is a minus figure. Using the momentum index, price differences (the difference between today's close and that of whatever period you pick) should rise at an increasing rate as a trend progresses. This displays an uptrend with increasingly greater momentum. In other words, the velocity of the price changes is increasing. If prices are rising and momentum begins to flatten, a decelerating price trend is in effect. This could be an early warning that a prior price trend could end. If the momentum crosses under the 0 line, it could be construed as a bearish sign, above the 0 line, as bullish. Momentum is also handy as an overbought/oversold indicator. For instance, when the momentum index is at a relatively large positive value the market may be overbought and vulnerable to a price pullback. Momentum usually hits its peak before prices. Based on this, a very overbought momentum oscillator could be presaging a price peak. In Exhibit 14.8, the long-legged doji in January was a warning for the longs to be careful. Further reason for caution was that prices produced new highs on this doji session, yet the momentum was noticeably lower than at the prior high in late November (A). More proof that a downtrend could start was apparent when the momentum fell under 0in early February.

EXHIBIT 14.8. Gold-June 1990, Daily (Momentum with Candlesticks)

238

The Rule of Multiple Technical Techniques

EXHIBIT 14.9. Heating Oil-July 1990, Daily (Momentum with Candlesticks)

Another use of momentum is to provide a yardstick for overbought or oversold levels (see Exhibit 14.9). In this heating oil chart, observe how an oscillator reading of around +200 (that is, the current close is $.02 above the close ten days ago) represents an overbought environment. An oversold state exists for this market when the momentum oscillator is -400 points or $.04 under the close of ten days prior. At the 200-point overbought level, continuation of the prior rally is unlikely and the market should either trade sideways or backoff. The odds of a top reversal with an overbought momentum reading are increased if there is bearish candlestick confirmation. In this regard, in February an overbought momentum level is coupled with an evening star and then a harami cross. Another overbought oscillator in early April joined another evening star pattern. Hammers A and B accompanied the oversold momentum levels in March and April. At these points, further selloffs were unlikely and either sideways action or rallies could unfold to relieve the oversold nature of the market.

Candlesticks w t Oscillators ih

239

Notes
'This RSI is different than the relative strength used by equity technicians. The relative strength used by equity technicians compares the relative strength performance of a stock, or a small group of stocks, to the performance of broader market index such as the Dow Jones or the S&P 500. 'To help follow the 24-hour foreign exchange markets some Japanese candlestick users will draw a candlestick based on the Tokyo trading session and draw another candlestick line on the U.S. trading session. Thus, for each 24-hour period, there will be two candlesticks. For those who follow the currency futures, the weekly candlestick charts may decrease some of the problems caused by overnight trading.

CANDLESTICKS WITH VOLUME AND OPEN INTEREST
"A single arrow is easily broken, but not ten in a bundle"

T h e theory behind volume states that the greater the volume, the greater the force behind the move. As long as volume increases, the current price trend should continue. If, however, volume declines as a price trend progresses, there is less reason to believe that the trend will continue. Volume can also be useful for confirming tops and bottoms. A light volume test of a support level suggests a diminution of selling force and is, consequently, bullish. Conversely, a light volume test of a previous high is bearish since it demonstrates a draining of buying power. Although volume can be a useful auxiliary medium to measure the intensity of a price move, there are some factors with volume, especially as they pertain to futures, that somewhat limit their usefulness. Volume is reported a day late. Spread trading may cause aberrations in volume figures-especially on individual contract months. With the increasing dominance of options in many futures markets, volume figures could be skewed because of option arbitrage strategies. Nonetheless, volume analysis can be a useful tool. This chapter examines some ways volume and candlestick charting techniques can be merged.

242

The Rule of Multiple Technical Techniques

VOLUME WITH CANDLESTICKS
Exhibit 15.1 shows how volume and candlestick techniques can help confirm double tops or bottoms. On March 22 (line I), the market pushed up to the late February highs near 94. Volume at line 1 was 504,000 contracts (all volume figures are total volume for all contract months). For the next few sessions, prices tried to push above this 94 level. The small white real bodies on these days reflected the bulls' lack of fervor. The low volume figures on these small candlestick sessions echoed this. The bulls finally surrendered after a week. In late March, within two days, the market fell two full points. Next we turn our attention to the tall white candlestick of April 4 (line 2). Could this strong session presage gathering strength by the bulls? The answer is probably not. First, we note the volume on this rally session was a relatively light 300,000 contracts. The long black candlesticks a few sessions before (March 29 and 30) had larger volume. Another sign of trouble appeared with the action following line 2. The next day (line 3) a small real body appeared. Lines 2 and 3 constituted a harami pattern. The implications were that the prior upmove was over. Note also that this small real body day was also a variation on a bearish hanging

EXHIBIT 15.1. Bonds-June 1990, Daily (Volume with Candlesticks)

-

-

Candlesticks with Volume and Open Interest

243

man (an ideal hanging-man line is at the top of a trading range or an uptrend). The next day, (line 4) there was a final surge to 94. This was a portentous rickshaw man day. In addition, this price push had relatively little force behind it as reflected by the lighter volume (379,000 contracts) compared to the volume on March 22 (504,000 contracts). The light volume test at an old high increased the chance this was a double top. The move under the March 30 low confirmed this as a double top. This double top gave a minimum measured target of 90. We saw how a light volume test of a high could signal a top, especially when joined with bearish candlestick indications. On this chart we also have a volume/candlestick signal of a bottom. On April 27, there is a doji line. For reasons discussed in Chapter 8, doji days are usually more significant as reversals in uptrends than in downtrends. Yet, with verification, they also should be viewed as a bottom trend reversal. This unfolded in bonds. The importance of the doji on April 27 became amplified when, three days later, another doji appeared. Two doji in themselves are significant, but look at what else occurred during these two doji days. First, there was a tweezers bottom (that is, the lows were nearly the same). Note also the volume on these days. On April 27 volume was 448,000. Volume on May 2, the second doji, was almost half at 234,000 contracts. A light volume test of a support area is bullish. We see the results. The bullish engulfing pattern, shown in Exhibit 15.2, shows that late April had a white candlestick with the largest volume in the last few months. This forcibly proved the conviction of the bulls. A light volume retest of these lows by a candlestick similar to a hammer confirmed a solid base. There are many specialized technical tools based on volume. Two of the more popular are on balance volume and tick volumeT".

244
. 3 :15

The Rule of Multiple Technical Techniques

EDMO DAILY BAR

@

1987 CQG INC.

,

C= 9168

70000 65000 1..

ED DAILY VOL/OI

,

.. ..
........:. ........: .........: . .......,:. ........1 , . ..

..

. .

. .
OOC

EXHIBIT 15.2. '~urodollars-~une1990, Daily (Volume with Candlesticks)

ON BALANCE VOLUME
On balance volume (OBV) is a net volume figure. When the market closes higher compared to the prior close the volume figure for that day is added to the cumulative on balance volume figure. When the close is lower, the volume for that day is subtracted from the cumulative on balance volume figure. OBV can be used in a few ways. One way is to confirm a trend. OBV should be moving in the direction of the prevailing price trend. If prices are ascending along with OBV, increased volume is reflected by the buyers, even at higher price levels. This would be bullish. If, conversely, price and OBV are declining, it reflects stronger volume from the sellers and lower prices should continue. OBV is also used in lateral price ranges. If OBV escalates and prices are stable (preferably at a low price area) it would exhibit a period of accumulation. This would bode well for advancing prices. If prices are moving sideways and OBV is declining it reflects distribution. This would have bearish implications, especially at high price levels.

Candlesticks with Volume and Open Interest

245

EXHIBIT 15.3. Silver-July1990, Daily (OBV with Candlesticks)

OBV with Candlesticks

As illustrated in Exhibit 15.3, the June 13 heavy selloff of silver was followed by a small real body. This harami pattern converted the strong downtrend into a lateral trend. The market traded sideways for the next few weeks. During that time, OBV was ascending reflecting a bullish accumulation. June 25 saw new price lows. These lows did not hold as evidenced by the hammer line formed on that session. The positive divergence in OBV, the failure of the bears to hold the new lows, and the hammer line supplied signs of a near-term bottom.

TICK VOLUME '"
In the futures market, volume is reported a day late. As a way to circumvent this problem, many technicians use tick volumeTM to get a "feel" for volume on an intra-day basis. Tick volumeTM shows the number of trades per intra-day period. It does not show the number of contracts per trade.

246

The Rule of Multiple Technical Techniques

It would indicate, for instance, a tick volume of 50 trades per hour. We do not know how many contracts were in each trade. They could have been 50 single-lot orders or 50-100 lot orders. In this sense, tick volume is not a true volume figure. It is useful, though, because it is the only means of measuring the volume on a more timely, albeit less accurate, basis. Tick VolumeTM with Candlesticks The hourly intra-day chart in Exhibit 15.4 shows the usefulness of tick volumeTM. After a bullish hammer late in the session on May 4, prices moved higher. However, these advancing prices were made on declining tick volumeTM. This was one sign of lack of conviction by buyers. The other was the short white real bodies. In the first three hours of May 8, there was a sharp price break. These made new lows for the move. The intra-day action late on May 8 provided clues this early morning selloff was to be short lived. After the third hour's long black line, a doji materialized. These two lines formed a harami cross. Then a white body appeared a few hours later which engulfed the prior two black bodies.

EXHIBIT 15.4. Cocoa-July 1990, Intra-day (Tick Volume with Candlesticks)
TM

Candlesticks with Volume and Open Interest

247

This was a bullish engulfing pattern that had extra significance since it engulfed two black bodies. The lows made by the white engulfing line also formed a tweezers bottom. Just in case, another hint of a bottom was needed, tick volume " substantiated that the buyers were taking control. Prices rose after the aforementioned bullish engulfing pattern. During this rally, volume expanded as did the height of the real bodies. A shooting star and resistance near $1,340 from the prior week, temporarily put a damper on the price ascent. Once the market pushed above the $1,340 resistance level via a window, there was no doubt the bulls were in control. In Exhibit 15.5, the hammer hour on June 19 furnished a sign that the market may be searching for a bottom. The first hour of June 20 made a new low at $16.62 (line 1). Tick volumeTM on this hour was a brisk 324 trades. Another move down to that level, via a long black candlestick (line 2), was made later that session. This time tick volumeT" was only 262 trades. The next session, June 21, is the one of the most interest. On the third hour of trading, prices made a new low for the move at $16.57. This new low was made on lighter tick volumeT" (249 trades) then the prior two tests (lines 1 and 2). This meant selling pressure was easing. Prices then sprung back and made an hourly hammer line. (From the
T

EXHIBIT 15.5. Crude Oil-August 1990, Intra-day (Tick VolumeTM with Candlesticks)

248

The Rule of Multiple Technical Techniques

previous discussion on springs in Chapter 11, you know to look for a retest of the recent high near $17.24.)

OPEN INTEREST
In the futures markets, a new contract is created when a new buyer and a new short seller agree to a trade. Because of this, the number of contracts traded in the futures market can be greater than the supply of the commodity which underlies that futures contract. Open interest is the total number of long or short contracts, but not a total of both, which remain outstanding. Open interest assists in gauging, as does volume, the pressure behind a price move. It does this by measuring if money is entering or exiting the market. Whether open interest rises or falls is contingent on the amount of new buyers or sellers entering the market as compared to old traders departing. In this section, our focus will be on the importance of price trends accompanied by rising open interest. The major principle to keep in mind is that open interest helps confirm the current trend if open interest increases. For example, if the market is trending higher and open interest is rising, new longs are more aggressive than the new shorts. Rising open interest indicates that both new longs and new shorts are entering the market, but the new longs are the more aggressive. This is because the new longs are continuing to buy in spite of rising prices. A scenario such as building open interest and falling prices reflects the determination of the bears. This is because rising open interest means new longs and shorts entering the market, but the new short sellers are willing to sell at increasingly lower price levels. Thus, when open interest rises in an uptrend, the bulls are generally in charge and the rally should continue. When open interest increases in a bear trend, the bears are in control and the selling pressure should continue. On the opposite side, if open interest declines during a trending market it sends a signal the trend may not continue. Why? Because for open interest to decline traders with existing positions must be abandoning the market. In theory, once these old positions are exited, the driving force behind the move will evaporate. In this regard, if the market rallies while open interest declines, the rally is due to short covering (and old bulls liquidating). Once the old shorts have fled the market, the force behind the buying (that is, short covering) should mean the market is vulnerable to further weakness. As an analogy, let's say that there is a hose attached to a main water

Candlesticks with Volume and Open Interest

249

line. The water line to the hose can be shut off by a spigot. Rising open interest is like fresh water pumped from the main water line into the hose. This water will continue to stream out of the hose while the spigot remains open (comparable to rising open interest pushing prices higher or lower). Declining open interest is like closing the spigot. Water will continue to flow out of the hose (because there is still some water in it), but once that water trickles out, there is no new source to maintain the flow. The flow of water (that is, the trend) should dry up. There are other factors to bear in mind (such as seasonality), which we have not touched upon in this brief review of open interest.

Open Interest with Candlesticks
Exhibit 15.1 on June bonds showed a wealth of information about volume. It also illustrates the importance of rising open interest to confirm a trend. Look again at this bond chart, but this time focus on open interest. Refer to Exhibit 15.1 for the following analysis. A minor rally in bonds started March 13 and lasted until March 22. Open interest declined during this rally. The implication was that short covering caused the rally. When the short covering stopped, so would the rally. The rally stalled at line 1. This was a rickshaw man session that saw prices fail at the late February highs near 94. Open interest began to rise with the selloff that began on April 9. A rising open interest increase meant that new longs and shorts were entering the market. The bears, however, were the more aggressive in their desire since they were still selling at progressively lower prices. Open interest continued higher throughout the late April decline. When the two doji, on April 27 and May 2, emerged at the 88 V2 level, open interest began to level off. This reflected a diminution of the bears' selling pressure. Ascending open interest and prices throughout May were a healthy combination as seen in Exhibit 15.6. Not so healthy was the fact that June's rising prices were being mirrored by declining open interest. The implication is that June's rally was largely short covering. This scenario does not bode well for a continuation of higher prices. The shooting star spelled a top for the market and the market erased in four sessions what it had made in about a month. If there is unusually high open interest coinciding with new price highs it could presage trouble. This is because rising open interest means new short and longs are entering the market. If prices are in a gradual uptrend, stop losses by the new longs will be entered along the price move at increasingly higher prices. If prices suddenly fall, a chain reaction of triggered sell stop loss orders can cause a cascade of prices.

250

The Rule of Multiple Technical Techniques

CTZO DAILY BAR O 1990 CQG INC. 5 ,5..'.. ..................................................................................................................................... 8000 1 7 . .. ..

. H= 7355
-L=

-:O= 7/12/90 7215
7207 LC= 7349

......l.+. ....................................................................................................................... r.:.................

.

.
.

.. ..
..
CT DAILY VOL/OI

..

..
..

..
.

C

EXHIBIT 15.6. Cotton-December 1990, Daily (Open Interest with Candlesticks)

EXHIBIT 15.7. Sugar-July 1990, Daily (Open Interest with Candlesticks)

Candlesticks with Volume and Open Interest

251

Exhibit 15.7 is a good case in point. Sugar traded in the $. 15 to $.I6 range for two months from early March. Open interest noticeably picked up from the last rally that commenced in late April. It reached unusually high levels in early May. As this rally progressed, sell stops by the new longs were placed in the market at increasingly higher levels. Then a series of doji days gave a hint of indecisiveness and a possible top. Once the market was pressed on May 4, stop after stop was hit and the market plummeted. The second aspect of this open interest level was that new longs who were not stopped out were trapped at higher price levels. This is because as open interest builds, new longs and shorts are entering the market. However, with the precipitous price decline, prices were at a two-month low. Every one who had bought in the prior two months now had a loss. The longs who bought anywhere near the price highs are in "pain." And judging from the high open interest figures at the highs near $.16, there were probably many longs in "pain." Any possible rallies will be used by them in order to exit the market. This is the scenario that unfolded in mid-May as a minor rally to $.I5 meet with heavy selling.

CANDLESTICKS WITH ELLIOTT WAVE
$a,iQ$ki~3+tf ~ f t u a
"Like both wheels of a cart"

T h e Elliott Wave Theory of market analysis is employed by a broad spectrum of technical analysts. It is as applicable to intra-day charts as it is to yearly charts. In this introductory section I only scratch the surface of Elliott. Describing Elliott Wave methodology can be, and is, a book in itself.

ELLIOTT WAVE BASICS
The Wave principle was discovered by R. N. Elliott early in this century. He noted that, among other aspects, price movements consists of a fivewave upmove followed by a corrective three-wave downmove. These eight waves form a complete cycle as illustrated in Exhibit 16.1. Waves 1, 3, and 5 are called impulse waves while waves 2 and 4 are called corrective waves. Although Exhibit 16.1 reflects an Elliott Wave count in a rising market, the same concepts would hold in a falling market. Thus, the impulse waves on a downtrending market would be sloping downward and the corrective waves would be upward bounces against the main trend. Another major contribution of Elliott was his use of the Fibonacci series of numbers in market forecasting. Wave counts and Fibonacci

254

The Rule of Multiple Technical Techniques

EXHIBIT 16.1. The Basic Elliott Wave Form

ratios go hand in hand since these ratios can be used to project price targets for the next wave. Thus, for example, wave 3 could be projected to move 1.618 times the height of wave 1; a wave 4 could correct 38.2% or 50% of the wave 3 move; and so on.

Elliott Wave with Candlesticks
This chapter illustrated how candlesticks can lend verification to Elliott Wave termination points. The most important waves to trade are waves 3 and 5. Wave 3 usually has the most powerful move. The top of wave 5 calls for a reversal of positions. The wave counts below are with the help of my colleague, John Gambino, who focuses closely on Elliott. Elliott Wave counts are subjective (at least until the wave is over) and as such the wave counts below may not be the same as derived by someone else. A five-wave count (see Exhibit 16.2a) is discussed wave by wave in the following text. Impulse wave 1 started with the dark-cloud cover in late February. Wave 1 ended at the harami pattern in mid-March. This harami implied that the prior downward pressure was abating. A minor bounce unfolded. Corrective wave 2 was a bounce that ended with another dark-cloud cover. Impulse wave 3 is the major leg down. The extent of this move can be estimated by using a Fibonacci ratio and the height of wave 1. This gives a wave 3 target of $17.60. At $17.60, look for a candlestick signal to confirm a bottom for this wave 3 count. This occurred on April 11. For visual details about April 11, refer to Exhibit 16.2(b) which is the intra-day chart of crude. On April 11, crude broke in the first hour as it falls $1 from the prior close. At that point, the selloff looks unending. Then some interesting price events occur. The selloff abruptly stops at $17.35-very close to the Elliott count of $17.60. Second, the hourly chart (see Exhibit 16.2(b)) shows that the first hour of trading on this selloff ended as a classic hammer. This potentially bullish indicator is immediately followed by a

Candlesticks with Elliott Wave

255

7:38 o= H= L= . L=
A=

CLMO DAILY BAR

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1990 CQG ItIC.

.

.

.

..

Dark-cloud Cover

Cover

,

..
(a) Shooting

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Harami

.............

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....................

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(c) Harami and Tweezers .. Top

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..................................................................... .............

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Piercing Morning

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.

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. Star . (b)

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EXHIBIT 16.2. Crude Oil-June 1990: (a) Daily and (b) Intra-day (Elliott Wave with Candlesticks)

256

The Rule of Multiple Technical Techniques

series of strong long white bodies. On this hourly chart the bullish hammer and the ensuing white lines confirmed a bottom for the wave 3 count. The daily chart also provided a bottom reversal signal with a piercing pattern based on the price action of April 10 and 11. We now look for a wave 4 rally. Corrective wave 4's top should rally but should not move above the bottom of the prior wave 1 according to Elliott Wave theory. In this example, that would be the $19.95. Approaching that level, look for a bearish candlestick cue. That is, indeed, what unfolded. On May 14 and 15, the market stalled under $20 via the harami cross and tweezers top. The wave 4 top was hit. Interestingly, by breaking wave 4 into its (a), (b), and (c) subcompon e n t ~ ,corroboration by candlestick indicators is apparent. At (a), a shooting star whose highs stopped at a window from early April appears. A morning star at (b) called the bottom. Subcomponent (c) was also the top of wave 4 with its attendant bearish harami cross and tweezers top. Exhibit 16.3 illustrates that the five impulse waves down began in late December 1989 from 100.16. The wave counts are shown. The bottom of wave 1 formed a harami pattern. The top of wave 2 formed a

9:39 O= 9407

CI=9 1C:.. 4

.

.

.

BDMO DAILY BAR " . .

0 ' . ' . "

1989 CQG INC. . .

-

, ,

Doji and Tweezers ' L= 9406 . C= 9414 Dec Jan Feb Mar Jun rn 1 7 1 111 1 8 1 6 1 1 1 5 1 2 1 9 1 1 2 120126 1 1 2 1 9 1 6 1 1 1 6 1 3 1 0 1 1 4 1 1 1 9 2 4 1 2 2 8 1 2 2 5 1 5 1 1 2 2 9 1 2 3 7 1 2 2

'

EXHIBIT 16.3. Bonds-June 1990, Daily (Elliott Wave with Candlesticks)

Candlesticks with Elliott Wave

257

dark-cloud cover. Wave 3 did not give a candlestick indication. Wave 4 constituted a harami. The most interesting aspect of this Elliott pattern is the fifth and final downwave. The fifth wave target is derived by taking the height of the third wave and a Fibonacci ratio. This provides a target of 88.08. At the end of April, the low of the move was 88.07. At this low, the candlesticks sent a strong bullish signal based on a tweezers bottom and two doji at this tweezers bottom. Volume also confirmed this bottom. Please refer to Exhibit 15.1 to receive a more detailed description of what happened at this low vis-a-vis the candlesticks and volume.

CANDLESTICKS WITH MARKET PROFILE@
?m%%
"Existing together, thriving together" Market Profile@,used by many futures traders, presents information about the markets that was previously only available to those in the trading pits. Market Profile@helps technicians understand the internal structure of the markets. It offers a logical, statistically based analysis of price, time, and volume. This section examines only a few of the many tools used by followers of the Market Profile@. Topics such as different types of profile days (that is, normal, trend, neutral, long-term market activity charts, and so on), or the Liquidity Data Bank@will not be discussed here. The goal of this brief introduction is to alert the reader to a few of the unique insights of the Market Profile@and how it can be used in conjunctionwith candlesticks. A few of the elements underlying the Market Profile@ are:
1. The purpose of all markets is to facilitate trade. 2. The markets are self regulating. The regulating constraints include price, time, and volume.

3. The markets, as they attempt to facilitate trade, will use price probes to "advertise" for sellers or buyers. The reaction to these probes provides valuable clues about the strength or weakness of the market.

organizes daily action into half-hour periods and The Market Profile@ assigns a letter to each half-hour period. Thus the " A period is from

260

The Rule of Multiple Technical Techniques

B

9
B

Selling Extreme

Initial Balance

Selling Range Extension

. .

Area

:

:.
EXHIBIT 17.1. Example of the Market Profile@

:) Buying Extreme
L

Source: Market Profile is a registered trademark of the Chicago Board of Trade Copyright Board of Trade of the City of Chicago 1984. A L L RI G HT S R ES ERVED

8:00 to 8:30 A . M . (Chicago time), "B" is from 8:30 to 9:00 A.M., and so forth. For markets that open before 8:00 A.M. (such as bonds, currencies, and metals), the first half hours are usually designated "y" and "z." Each letter is called a TPO (Time-Price Opportunity). The half-hour segment represents the price range that developed over that time period. This is displayed in Exhibit 17.1. The first hour of trading is labeled as the initial balance. This is the time period when the market is exploring the range of trading. In other words, it is the market's early attempt to find value. A range extension is any new high or low made after the first hour's initial balance. Exhibit 17.1 establishes a selling range extension, but since there are no new highs after the initial balance, there is no buying range extension. Value, to those who follow Market ProfileB, is defined as the market's acceptance of price over time and is reflected in the amount of volume traded at that price. Thus, time and volume are the key ingredients in determining value. If the market trades briefly at a price, the market is indicating rejection of that price. That is, the market has not found "value." If prices are accepted for a relatively extended time with good volume, it connotes market acceptance. In such a scenario, the market found value. The market's acceptance of price is where 70% of the day's volume occurred (for those familiar with statistics, it is one standard deviation which has been rounded up to 70%). This is defined as the day's value area. Thus, if 70% of the volume for trading wheat took place in a $3.30 to $3.33 range, that range would be its value area.

Candlesticks with Mavket Profile@

261

A price probe is the market's search for the boundaries of value. How the trading and investing community acts on such price probes can send out important information about the market to Market Profile@users. One of two actions occur after a price probe. Prices can backtrack to the value area or value can relocate to the new price. Acceptance of a new price as value would be confirmed by increased volume and the time spent at that level. If prices backtrack to value, the market shows a rejection of those prices that are considered unfairly high or low. Quick rejection of a price can result in what is called an extreme. An extreme is defined as two or more single TPOs at the top or bottom of the profile (except for the last half hour). Normally, an extreme at the top of the profile is caused by competition among sellers who were attracted by higher prices and a lack of buyers. A bottom extreme is caused by an influx of buyers attracted by lower prices and a dearth of sellers. Buying and selling extremes are noted in Exhibit 17.1. How the market trades compare to the prior value area also discloses valuable information. Market Profile followers monitor whether there is initiating buying or selling, or responsive buying or selling. This is identified by determining where the current day's extreme and range extensions are occurring with respect to the prior day's value area. Specifically, buying below the prior day's value area is deemed responsive buying because prices are below value and buyers are responding to what they perceive to be undervalued prices. These buyers expect that prices will return to value. Sellers at prices below the prior day's value area are said to be initiating sellers. This means they are aggressive sellers since they are willing to sell at prices under value. The implication of this is that they believe value will move down. Buying above the prior session's value area is initiating buying. These aggressive buyers are convinced that value will move up to price. Otherwise why buy above what is now perceived is as value? Sellers at prices above the prior day's value area are responsive sellers. They are responsive to higher prices and expect prices to return to value. Trading should go in the direction of the initiating group unless price is quickly rejected. Thus, if there is initiating selling activity (extremes and/or range extension), under the previous day's value area on expanding volume, it should have bearish implications.
Q

Market Profile@ with Candlesticks
Exhibit 17.2 reveals how a doji on July 2 and a hanging man during the next session were candlestick alerts of a top. What did the Market Pro-

262

The Rule of Multiple Technical Techniques

9: 47 BDUO DAILY BAR @ 1990 CQG INC. O= 9103 H= 9105 ........................................................................................................................................ L= 9003 9600 L= 9OliA A= -24 I

Source: Market Profile is a registered trademark of the Chicago Board of Trade Copyright Board of Trade of the City of Chicago 1984. ALL RIGHTS RESERVED

EXHIBIT 17.2. Bonds-June 1990, Daily (Market Profile@ with Candlesticks)

Candlesticks with Market Profile@

263

file@ during this time period? July 2 had a relatively small value area say as compared to the prior session. It was also a light volume session (132,000 contracts as compared to 303,000 the prior session). This hinted that price was having trouble being accepted at these higher rates. In other words, there was lack of trade facilitation. It is also a profile with range extension to both sides. This indicates a tug of war between the bulls and bears. July 3 was another light-volume session (109,000 contracts) which significantly discounts the bullish developments-an upside range extension and a close at the highs of the day. The next day, July 5, is where the weakness of the market materializes. During the early part of the session, new highs were made for the move. In the process, upside range extensions were also formed. With these range extensions, the market was advertising for sellers. They got them. The market sold off toward the latter part of the session (the J, K, and L periods) to close near the low of the day. The open of July 6 saw initiating selling on the opening since the market opened under the prior day's value area. This showed immediate selling activity. July 6 also displayed increased volume and an initiating selling extreme (that is, single prints at the top of the profile) during the "y" period. This confirmed the market was in trouble. In this example, we see an important aspect about the hanging man previously addressed; it is only what happens after that line that makes it a bearish indicator. July 3 was the hanging-man day. Here we see the Market Profile@picture of the hanging-man line was giving some positive indications about the market. It was only on the following session, July 5 and especially the morning of July 6, that a top was also verified via Market ProfileB. Exhibit 17.3 shows that July 5 was a very evident shooting star. After this line appeared, cotton plunged for three sessions. Was there anything prior to the shooting star a la Market Profile@which gave signs of trouble? Yes, there was. From June 29 to July 3 prices advanced but by way of a shrinking value area. This meant less trade facilitation at higher prices. The market was having trouble accepting these new highs as value. In addition, volume, as gauged by the total number of those session's TPO counts, was decreasing (actual volume was light on these sessions. However, since volume is not released until the following day, the TPO count can be used as a gauge of volume). Notice of a top was provided by the shooting star of July 5. The Market Profile@ that seson sion showed a range toward the upside failed to get buying followthrough. Additionally, the entry of sellers attracted by these higher prices drove the market down as indicated by the range extension down and the weak close. These were bearish signs.

264
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The Rule of Multiple Technical Techniques

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Source: Market Profile is a registered trademark of the Chicago Board of Trade Copyright Board of Trade of the City of Chicago 1984. ALL RIGHTS RESERVED

EXHIBIT 17.3. Cotton-December, 1990, Daily (Market ProfileB with Candlesticks)

Candlesticks with Market Profile@

265

If more proof was needed, all one had to do was wait until the opening of July 6. An initiating selling extreme developed on the opening under the previous day's value area. This confirmed the presence of sellers and difficulty ahead. Thus, the Market Profile@tools confirmed the bearish implications of the shooting star. conThere are some interesting similarities between Market Profile@ cepts and candlesticks. Wider value areas in Market Profile@ usually represent facilitation of trade and, as such, increase the probability for price trend continuation. Thus, in an uptrend, one would like to see widening value areas. Likewise, with the candlesticks, one would like to see a rally via a series of longer and longer white real bodies in order to confirm the power behind the move. Shrinking value areas in Market Profile@reflect less facilitation of trade and thus less certainty of a continuation of the price move. So it is with the candlestick's advance block or stalled patterns. In those formations, the trend is still up but it takes place by means of shrinking white real bodies. These formations indicate that the prior momentum is running out of steam. What about a star in candlesticks? A short real body in an uptrend or downtrend would be a sign of decreasing vigor by the bulls (a star in an uptrend) or the bears (a star in a downtrend). So would a small value area after a strong advance (or decline). The small value area would reflect a lack of trade facilitation. They could be a harbinger of a trend change. A hammer's lower shadow might be formed due to a buying extreme in which lower prices induce an influx of buyers. A shooting star's long upper shadow could be the result of a selling extreme in which higher prices attracted strong selling.

CANDLESTICKS WITH OPTIONS
+?ha%& h b i f Q i % th 9
"If there is a lid that does not fit, there is a lid that does"

Options, at times, confer advantages over underlying positions. Specifically, options offer:
1. Staying powerbuying an option limits risk to the premium paid.

Options are thus useful when trying to pick tops and bottoms. These are risky propositions, but judicious use of options can help mitigate some of the inherent risks in such endeavors. 2. The ability to benefit in sideways markets- using options, one can by profit if the underlying contract trades in a lateral range (by selling straddles or combinations). 3. Strategy flexibility-one can tailor risklreward parameters to one's price, volatility, and timing projections. 4. Occasionally superior leverage- instance, if the market swiftly rallies, for under certain circumstances, an out-of-the money call may provide a greater percentage return than would an outright position.

268

The Rule of Multiple Technical Techniques

OPTIONS BASICS
Before discussing how candlesticks can be used with options, we'll want to spend some time on option basics. The five factors needed to figure the theoretical value of a futures options price are the exercise price, the time to expiration, the price of the underlying instrument, volatility, and, to a minor extent, short-term interest rates. Three of these variables are known (time until expiration, exercise price, and short-term interest rates). The two components that are not known (the forecasted price of the underlying instrument and its volatility) have to be estimated in order to forecast an option price. One should not underrate the importance that volatility plays in option pricing. In fact, at times, a change in volatility can have a stronger impact on option premiums than a change in price of the underlying contract. Consider as an illustration an at-the-money $390 gold call with 60 days until expiration. If this option has a volatility level of 20%, its theoretical price would be $1,300. At a 15% volatility, this same option would be theoretically priced at $1,000. Thus, volatility must always be considered since it can so forcefully affect the option premium. Volatility levels provide the expected range of prices over the next year (volatilities are on an annual basis). Without getting into the mathematics, a volatility of 20% on, say, gold suggests that there is a 68% probability that a year from now gold's price will remain within plus or minus 20% of its current price. And there would be a 95% chance that a year hence golds's price will remain within plus or minus two times the volatility (that is, two times 20% or 40%) of its price now. For example, if gold is at $400 and volatility is at 20%, there is a 68% chance that its price after one year will be between $320 and $480 (plus or minus 20% of $400) and a 95% probability that it will be between $240 and $560 (plus or minus 40% of $400). Keep in mind that these levels are based on probabilities and that at times these levels are exceeded. The greater the volatility the more expensive the option. This is due to at least three factors. First, from the speculators' point of view, the greater the volatility, the greater the chance for prices to move into the money (or further into the money). Second, from a hedger's perspective, higher price volatility equals more price risk. Thus, there is more reason to buy options as a hedging vehicle. And, third, option sellers also require more compensation for higher perceived risk. All these factors will buoy option premiums. There are two kinds of volatility: historic and implied. Historic volatility is based on past volatility levels of the underlying contract. It is usually calculated by using daily price changes over a specified number of business days on an annualized basis. In the futures markets, 20'or 30

Candlesticks with Options

269

days are the most commonly used calculations. Just because a futures contract has a 20-day historic volatility of 15% does not mean it will remain at that level during the life of the option. Thus, to trade options it is necessary to forecast volatility. One way to do this is by having the market do it for you. And that is what implied volatility does. It is the market's estimate of what volatility of the underlying futures contract will be over the options's life. This differs from historic volatility in that historic volatility is derived from prior price changes of the underlying contract. Implied volatility is the volatility level that the market is implying (hence its name). Deriving this number involves the use of a computer but the theory behind it is straightforward. To obtain the option's implied volatility, the five inputs needed are the current price of the futures contract, the option's strike price, the short-term interest rate, the option expiration date, and the current option price. If we put these variables into the computer, using an options pricing formula, the computer will spit back the implied volatility. Thus, we have two volatilities-historic, which is based on actual price changes in the futures, and implied, which is the market's best guess of what volatility will be from now until the option expires. Some option traders focus on historic volatility, others on implied volatility, and still others compare historic to implied.

OPTIONS WITH CANDLESTICKS
If a strong trending market has pushed volatility levels to unusually high levels, the emergence of a candlestick reversal indicator may provide an attractive time to sell volatility or to offset a long volatility trade. In this regard, the most effective candlestick formations may be those which imply that the market will move into a state of truce between the bulls and bears. These include the harami, counterattack lines, and other patterns discussed in Chapter 6. Selling volatili