Like playing with fire, those who trade stocks and options without respecting certain key facts can suffer significant pain.
Heck, ask enough traders and you’ll likely find a few with physical wounds left from lashing out at a nearby telephone or computer monitor during those inevitable times the market just didn’t act as they expected.
How do you get to Carnegie Hall? Practice, Practice, Practice
Through the “school of hard knocks,” successful traders learn to respect certain key facts about the market.
Facts such as the market doesn’t owe you anything, stocks always mean revert after an extreme move ends, and price patterns don’t always work are just a few items that can only be learned by practicing.
That’s why it is always a good idea for new traders to take advantage of the free demo accounts offered by many discount brokers these days.
Another key fact, which we will focus on in this article, is that price is the ultimate arbiter.
What does this mean?
It means that no matter what your sophisticated trading model or fancy technical indicators might be suggesting, these signals are secondary to price.
Indicators that measure things such as momentum and sentiment are incredibly helpful in telling a trader when price may have become stretched too far, but it is ultimately price that is telling you what the market’s view of the stock is at any given moment.
Armed with this knowledge, a trader can then look at price itself to confirm what your secondary indicators are showing.
That’s one of the advantages of candlestick charts.
Candlesticks are helpful market timing tools.
More than just a collection of thick price bars (“real body”) with long upper and lower lines (“shadows”), candlestick reversal patterns help traders identify when there has been a meaningful change in market sentiment with better precision.
Members of my trading services are given a candlestick cheat sheet to help guide them in their trading.
Just like so many things in trading, one signal on its own is not as strong as a signal that is being confirmed by other important indicators.
For example, if a “bullish engulfing candle” forms it is an indication that buying pressure has begun to overpower selling pressure after a prolonged downtrend, but that alone does not tell a trader how significant the turning point might be.
This is where other indicators such as momentum, support, and mean dispersion can be layered into the decision-making process.
Let’s look at a couple of examples.
On this first chart, you’ll notice that the “bullish engulfing” pattern at the point labeled X did not generate any upside follow-through.
Technically, there are several reasons for this.
First of all, momentum (measured here by 10-day RSI) at the time of the pattern’s development was not extended.
In fact, momentum was still showing a bearish configuration after price transitioned into a new downtrend on March 3rd (see red arrow).
Next, price was essentially range-bound, showing no signs of being displaced at an extreme distance from either the 20- or 50-day moving averages (see black box on chart).
Lastly, at the most recent low on March 5th, the stock still had not satisfied the downside potential left by the March 3rd break below a “head-&-shoulders” price top, which occurred the following week (see blue arrows).
This leads us to the next example, where a confluence of supportive indicators helped create a more reliable “bullish engulfing” signal.
On this next chart, the most important observation to be made is that the prevailing trend is to the upside. While oversold conditions within a downtrend often provide excellent trading setups when “bullish engulfing” patterns develop, trading with the trend, as this next chart shows, often provides the best odds of success.
Within this uptrend, the “bullish engulfing” candlestick reversal at labeled X occurred one day after price tested support at both the rising 50-day moving average and the late-March pivot low.
In addition, the “bullish engulfing” developed one day after price dispersed 2 standard deviations below the 20-day moving average (i.e., price fell to the bottom Bollinger Band).
Lastly, the bullish reversal happened one day after RSI tested and held the level (40) that represents the bottom of this indicator’s bullish range.
While hindsight is always 20/20, these historical examples are meant to teach you how to identify higher probability bullish candlestick reversal patterns.
Is it possible that a less than desirable setup such as that shown in the first example above might one day produce immediate upside follow-through after a bullish candlestick reversal pattern develops?
Sure…anything’s possible in trading.
In the end, though, it all comes down to probability.
So, train yourself to be patient and wait for the higher probability setups such as that shown in the second example.