Candlestick Filtering

This article is written from a trader's point of view and depicts how I use candlestick charting in my daily trading. I will avoid using statistics here because that can be read elsewhere from some of the literature available on candlesticks. I will also avoid the repetition of a description of all the reversal and continuation patterns available in candlestick charting.

ORIGINS

First developed in 17th-century Japan for rice trading, candlestick charting consists of depicting price information in terms of hollow or white bodies or filled or black bodies with wicks at both ends. The white body is interpreted as the opening price of the session being below the closing price and the black body is interpreted as the opening price of the session being above the closing price of the session. The wicks at the top and bottom of the real bodies depict the high and low of the day.

The major difference between the Western charts and the candlestick method is that the candlesticks give a clear view of market behavior both in terms of buying and selling activity in the market and in terms of indecisiveness or clear trend. Candlestick patterns often provide the trigger for the buying or selling decision once the Western indicators move to extreme overbought and oversold conditions.

The indicators that the candle charts will be tested against are:

• Relative strength index (RSI): 7
• Slow stochastic: 7,10
• Average directional moving index (ADX): 14
• Moving average convergence/divergence (MACD): 26,12,9

We will first go through the shapes and interpretations of the candle patterns that must be tested. This will allow us to determine whether a particular candle formation should be accepted or rejected. We will study both entries and exits into trends. All signals will be taken only when the indicators are in the extreme overbought or oversold territory. Ignore signals occurring in other conditions. We will avoid countertrend trades for this analysis. The main trend in all cases being considered is up.

The various candle patterns with their shapes and interpretations can be seen in Figure 1.

	The doji occurs when the open and the close for the day are the same. It depicts indecision and can often mean impending weakness in an uptrend.
	The real body is small and at the upper end of the range; the color is not important. The lower wick should be longer than the upper body; generally bullish.
The hanging man is considered bullish because of the uptrend. The color is not important; could be bearish if the body is black and the next day opens lower.
	The shooting star indicates an end to the upmove. The body of the shooting star does gap up over the previous day.
	In an uptrend, on one day a small white body occurs. The next day prices open at new highs and quickly sell off, closing below the open of the previous day.
	In a downtrend, a small black body occurs. The next day prices open at new lows and then quickly rally to close above the close of the previous day.
	The dark cloud is a bearish reversal pattern. This pattern occurs only in an uptrend. The first day is a long white body; the second day is a bearish black body.
	The morning star is a bullish reversal pattern. Ideal morning stars have gaps before and after the middle day's body.
	Evening star is a bearish reversal pattern. It occurs after an uptrend and should have gaps before and after the middle day's body.

FIGURE 1: Here are various candlestick pattern shapes and interpretations.

USING RSI WITH CANDLESTICKS

Figure 2 is of the Nasdaq 100 daily scanned for the eight candlestick patterns along with the seven-period RSI. The oversold RSI in an uptrend provides low-risk entries into a trend. Candlestick patterns can be used to determine when the correction is over. By filtering the candle signals with the RSI, taking the signals appropriate with the market signals, we can avoid false signals. Readers should also remember that the RSI can be used as an oscillator, to trade overbought and oversold levels in a range-bound situation. Again, in this case the candle entry signals can be filtered by using the RSI. The circled numbers in the figure list the response for each candle signal received after filtering with the RSI.

FIGURE 2: Candlesticks and RSI. Here you see how using an indicator such as the relative strength index together with candlestick patterns helps avoid false signals.

The RSI 30 and 70 levels are considered overbought and oversold:

1. Doji:RSI overbought, become cautious, move stops closer; the uptrend may weaken
2. Dark cloud: RSI shows divergence with price; get out of long positions
3. Morning star: RSI hits oversold levels, bullish candle formation; enter long
4. Doji: RSI overbought, become cautious, move stops closer; the up trend may weaken
5. Hammer: RSI oversold in an uptrend, bullish candle; go long
6. Bearish engulfing: RSI overbought; get out of longs
7. Morning star: RSI still overbought; ignore this bullish signal
8. Doji: RSI overbought, become cautious, move stops closer; the uptrend may weaken
9. Bullish engulfing: RSI oversold; enter the trend on this bullish signal
10. Evening star: RSI still oversold; ignore the bearish signal
11. No signal: RSI oversold, but no candle signal; move missed.

As is evident from this analysis, by using a combination of Western indicators and Japanese candlesticks, a number of false signals can be avoided. It is clear that returns can be bettered by a combination of both techniques.

Further, all entries gained were true. Readers can use computers to do a similar analysis across a large number of stocks and compare the results with only the candlesticks and the RSI.

STOCHASTICS WITH CANDLESTICKS

Figure 3 shows the daily chart of technology bellwether Cisco Systems (CSCO) with a slow stochastic with 7, 10 settings. The overbought and oversold levels in this case are 80, 20. The stochastic gives clear, sharp signals and is acknowledged by many as the indicator that works best with candlesticks. In this case, the stochastics are again used to take low-risk entries into the uptrend. Again, the signals here are taken when the stochastic is in extreme zones. Given here is each encircled candlestick pattern generated:

FIGURE 3: Candlesticks and stochastics. In this chart you see how using stochastics on candlestick charts catches all the major swings.

1. Doji: Overbought stochastic, tighten stops; trend may be weakening
2. Morning star: Stochastic not in extreme zones; ignore.
3. Shooting star: Overbought stochastic; get out of longs
4. Bullish engulfing: Oversold stochastic; go long
5. Shooting star, evening star: Overbought stochastic; get out of longs
6. Hanging man: Oversold stochastic; go long
7. Evening star, doji: Overbought stochastic; get out of longs
8. Hanging man: Oversold stochastic; go long
9. Shooting star, doji: Overbought stochastic, get out of longs
10. Bearish engulfing, dark cloud, morning star: Overbought stochastic, get out of longs; ignore morn ing star.

As we have now seen that the stochastic gives much cleaner signals than the RSI, it is my indicator of choice to use with candlesticks. All the major swings were caught using this technique. Numerical values of actual gain can be found by running a computer simulation.

USING ADX WITH CANDLESTICKS

The daily chart of General Electric (GE) in Figure 4 shows the price chart with the ADX. Since the main trend of the GE stock is up, we take the ADX moving higher than the moving average (14-period) as a buy signal and moving lower as a consolidation signal.

FIGURE 4: Candlesticks and ADX. Using the average directional moving index (ADX) helps stay with the trend.

As we all know, the ADX indicates the strength of the trend. An ADX above 30 and one rising above 20 indicate a strong trend. An ADX below 30 and one declining below 20 is, at best, consolidation. Given below are the filtered signals:

1. Hanging man: ADX rises momentarily over the moving average; go long
2. Doji, hanging man: ADX declines; cut long positions
3. Evening star, doji, hammer: As the ADX is rising over the MA, ignore bearish signals; go long
4. Dark cloud: ADX still rising, so the signal is ignored
5. Shooting star: ADX declines again; cut longs
6. Hammer, hanging man: ADX rises above MA, go long
7. Shooting star, bearish engulfing: ADX declines, cut longs
8. Morning star: ADX rises above MA, go long
9. Evening star: ADX rising, ignore
10. Doji, bullish engulfing: ADX rising, ignore doji; stay long
11. Shooting star: ADX still rising, ignore.

As we have seen, ADXR has also performed well with the candlesticks, particularly once it started trending. It did not let us get out of the trade. In addition, during the consolidation phase, it got most of the signals. ADX is one of the most useful indicators, and one whose importance is sometimes understated. ADX can be used in a variety of ways and is a true gauge of the trend strength. Once the market starts trending, putting it as a filter on the candlestick chart can ensure the trader just goes with the trend.

MACD WITH CANDLESTICKS

The daily chart of Oracle Corp. (ORCL) displayed in Figure 5 shows how to apply the MACD with candlesticks. The MACD is a great indicator in both trending and sideways markets. The MACD histogram is a good lead indicator to cycles of any size. The MACD can be used in conjunction with the candlesticks. The MACD signals a buy when the fast moving average (MA) crosses over the slow MA and signals a sell when the slow MA moves above the fast MA, but I like to use the histogram more than the moving averages because it leads price action.

FIGURE 5: Candlesticks and MACD. Although the results weren't too overwhelming, you still managed to stay out of bad trades using moving average convergence/divergence (MACD).

Generally, whenever there is divergence between the price and histogram action, it's time for a reversal or a correction. The bigger the amplitude of the histogram cycles, the larger the price cycles.

Now looking at the chart of Oracle, we see that there are a lot of swings in the price action. Let's see how many we can catch by filtering the candlestick signals with the MACD:

1. Hanging man: The histogram is moving up followed by a MA upward crossover; go long
2. Bearing engulfing: The histogram leads the decline followed by the MA downward crossover; cut longs
3. Bearish engulfing: There was no buy signal for this upswing, so we remain out of the market
4. Hanging man, shooting star doji: Histogram rising, ignore doji and shooting star; go long
5. Shooting star, evening star, bearish engulfing: MACD flat, prices go sideways, book profits; divergence in the histogram
6. Dark cloud, bearish engulfing: MACD still flat, stay out.

The MACD did not outperform, in terms of absolute returns, but it did manage to keep us out of trouble by keeping us out of false trades.

IN SUMMARY

With all four indicators, the numbers of trades were drastically reduced compared to results for candlestick patterns alone. Further, there was some improvement in the returns, as false trades were avoided.

The methodology I have explained in this article can be programmed into a computer and it can be run across a number of stocks, but I doubt that the results would differ a great deal. The filtering of the candle signals gives great leading signals in extreme market conditions. They should always be used in conjunction with the Western indicators as filters, so that false signals can be eliminated.

Ashwani Gujral is a technical analyst, commentator, author, and trainer based in India. He follows both Indian and US markets. He is also an active short-term trader and money manager.

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SuperCharts (TradeStation Group)

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