In our last post we concluded our basic overview of Japanese Candlestick Charting with an explanation of the doji. Now let`s try to combine the Japanese approach with Western Technical Analysis methods.
Support and Resistance Lines with Candlesticks
One method of determining a trend is by using the most basic tool, the trendline.
The first example below shows an upward sloping support line. It is formed by connecting at least 2 reaction lows. This line shows that buyers are more aggressive than sellers since demand is stepping in at higher lows. Such a line indicates a market that is trending higher.
Upward Sloping Support Line
The next example displays a downward sloping resistance line. It is made by joining at least 2 reaction highs. This line shows that sellers are more aggressive than buyers; the sellers are willing to sell at lower highs. This reflects a lower trending market.
Downward Sloping Resistance Line
The next chart demonstrates that the lows in late March (near $173) formed a support area which was tested successfully in late April. This successful support test in April had an extra bullish confirmation when we look at the candlesticks. More specific, the 3 sessions on April 20 to 22 formed a bullish morning star pattern.
Example of a Support Line with Japanese Candlesticks
How to Use Trendlines with Candlestick Indicators
The following chart shows a wealth of information about using trendlines with candlestick indicators. This includes:
- The appearance of support line 1 (late January – early February) indicates that the 2 lows on January 29 and 31 were the initial 2 points of this line. The 3rd test of this line on February 7 was also a bullish hammer. The combination of these 2 factors represents a bottom reversal signal.
- The emergence of support line 2 (mid-January – early March) has a higher importance than support line 1 since it was in effect longer. On March 2, the 3rd test of this line came by a bullish hammer. Since the major trend was up, (displayed by the upward sloping support line 2), the bullish hammer and the successful test of support, presented a buy signal for March 2. Protective sell stops could have been placed 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 halted. The harami gave the first indication of trouble.
Risk control by using stops
This example illustrates the importance of stops. As explained above, there were numerous reasons to suppose that the market was going higher when it tested support line 2 via a hammer. But the market pulled back. You should be confident to place the trade but always take into account doubt and uncertainty. One of the most important concepts in trading is risk control. The use of stops is synonymous with risk control.
Example of Support Lines with Japanese Candlesticks
In the next example, dark-cloud covers 1 and 2 formed a resistance line. Dark-cloud cover 3 intersected at this resistance line and as such confirmed this line’s importance as a supply area.
Example of Resistance Line with Japanese Candlesticks
Protective Stops are Important
Risk control means using protective stops to help protect against unanticipated adverse price movements.
It is best to place a stop at the time of the original trade; at this point in time, a trader one is the most objective. Stay in the position only if the market performs according to expectations. Whenever subsequent price action either contradicts or fails to confirm the expectations, it is time to exit.
Keep these 2 facts in mind:
- all long-term trends begin as short-term moves, and
- there is no room for hope in the market. The market goes its own way without regard to your position.
Always take protective measures
There is one thing worse than being wrong and that is staying wrong. Better lose your opinion, than losing your money. If you are trading on HitBTC and the market has moved against your position, it is time to exit and start searching for a better opportunity.
The example of an upward sloping resistance line below is a trendline that connects a series of higher highs. While not as popular as the downward sloping resistance line (see the beginning of this post), this can be a useful signal for longs. When the market comes near this kind of line, longs should take defensive measures in anticipation of a pullback.
Upward Sloping Resistance Line
Such protective measures could include taking profits on long positions, moving up a protective stop, or selling calls. Although pullbacks should be temporary in this scenario (since the major trend is up), the failure from this line could be an early indication of the beginning of a new downtrend.
The example of a downward sloping support line is another type of line not used very often, but it can occasionally be valuable for those who are short. More specific, the downward sloping support line is indicative of a downtrend (as measured by the negative slope). But, when the market successfully holds this type of support line, shorts should take defensive measures in preparation of a price bounce.
Downward Sloping Support Line
In our next post we will pick up further on the combination of trendlines and Japanese Candlesticks in a non-trending market. We will also explain the change of polarity principle.
Source: Japanese Candlestick Charting Techniques (by Steve Nison)