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CANDLESTICK CORNER


Candlesticks And Trendlines

05/12/04 04:01:55 PM PST
by Ashwani Gujral

You can use them together. Here's how.

On any time frame, traders face a number of possibilities when a price approaches a trendline. The price could be trending up or down or be in a trading range. Traders often attach a lot of importance to breakout and breakdowns and prices testing a trendline. The questions that the trader faces when the price nears a trendline are:

  • Will price break out or break down at the trendline?
  • Will there be a false breakout?
  • Will the trendline prove to be formidable resistance to overcome, or will it provide support?
  • Will the behavior of the trendline change from resistance to support once the trendline is broken?

Trendlines may be rising, falling, or moving horizontally, in which case they are support and resistance lines. They can be make- or breakpoints on the chart and are areas where the bulls and bears are matched evenly. Finally, bulls or bears break down or break out ̶ but how do you know which one? Candlesticks could give you the answer.

Candlesticks often provide clear indications on whether a reversal or a continuation of the trend may be expected. Candlesticks, however, are unable to provide price objectives or targets, but western technical indicators can.

By using a convergence of candlesticks and trendlines, you get a better picture of price behavior near important trendlines and an idea of price objectives of any given move. In this article, I first discuss the benefits and rules regarding the trendlines, followed by a study of candlestick reversal patterns.

Using trendlines

As the name suggests, trendlines are used to identify the presence of a trend, the breakdown or breakout of which suggests reversal of an existing trend. There aren't too many traders who don't use some form of trendlines. This makes them an important tool to understand so they can be used in more innovative ways. Trendlines are very simple and very handy, and if they are applied correctly, they can greatly ease the burdens of your trading life. The trendline can be used on any chart: yearly, quarterly, monthly, weekly, daily, 60 minutes, or five minutes, and on any chartable price/data series (see Figures 1 and 2).

Figure 1: Trendlines in Cisco Systems (CSCO). Here you see how trendlines can be used to show the beginning and end of trends.

Figure 2: S&P 500. Trendlines are useful in drawing a roadmap on any time frame.

Certain rules must be followed while drawing trendlines, which are as follows:

  1. There should be at least two nonconsecutive points joined by the trendline: It should be a line that shows a trend, the breakdown/breakout of which should show some kind of reversal. In my experience, at least three nonconsecutive points should be joined to form a valid trendline.
  2. The longer the trendline, the more significant is any breakdown through it: The length of a trendline is critical to determining its significance. The longer the trendline, the more lethal will be the consequences if prices break down beneath it. For example, a two-year trendline is more significant than a two-month trendline, and a two-month trendline is more significant than a two-day trendline.
  3. The flatter the trendline, the more significant any breakdown through it: Trendlines with steeper slopes are known to be broken easily, so a breakdown/breakout of a flatter trendline will be much more significant, as it would show huge selling/buying having taken place at that level.
  4. The more a trendline is tested, the greater its significance: A trendline that has provided support or resistance in the past needs to be respected. Not only is it likely to provide support at a later time, any breakout through it can be a tradable move in that direction.
  5. Use trendlines to define stops: Another important application of the trendline is that it provides a reference for placing stops. For example, a stop can be placed at least 3% above or below where a breakdown/breakout occurs.
  6. Use only closing prices to assess if a trendline has been broken: Often, the breakout/breakdown through trendlines are at well-advertised levels. Sometimes, the large traders and institutions create the particular breakout or breakdown intraday, leading casual investors and traders to believe that a significant change has occurred. When these individual traders take positions, the market is conveniently reversed, and such a breakdown or breakout is referred to as a false breakdown or false breakout. This leads the market to close at a level higher than the trendline, validating the trendline. This can happen in any time frame, and it is likely to happen in illiquid and small stocks. Traders should not anticipate a breakdown or breakout till it actually occurs and the closing prices confirm the particular breakout or breakdown.
  7. Trendline breakdowns should occur on higher than average volume. I would be cautious on a breakout or breakdown that has occurred on low volume.
  8. Trendlines should be extended into the future: They often continue to provide support and resistance at those levels, even at a future date.

Even though trendlines may appear to meet all the criteria, it is important to look for other information that substantiates a new trend. This could be any number of factors such as classical chart patterns on the current time frame, or market action on a longer time frame.

One of the key tools that provide forewarning of the behavior of the trendline in the same time frame are candlesticks.

About reversals

A reversal in market psychology precedes a trend reversal. A reversal in trend is not necessarily a change from downtrend to uptrend or uptrend to downtrend; it could be a move to a sideways market that precedes a reversal in direction. A stall in an ongoing trend often produces sharp whipsaws, which can end up eating part of the profits earned in the previous trend.

So it is important to be aware of the possibility of a stall, and candlestick reversal patterns can indicate a change in market psychology or stalls in trends. As in the case of other technical indicators, you cannot often conclude much from only a candlestick reversal pattern on a chart. It is important to look for either a convergence with western indicators like overbought and oversold oscillators or with basic trader tools like the trendline to filter the candle signals.

One very important candlestick is the doji, a candlestick formation where the open and close are approximately the same. A doji invariably occurs whenever a trend stalls or a reversal is imminent. The doji represents the concept that the bulls and bears are evenly matched and there is indecision with regard to the trend. It is important to remember that a doji is not a trading signal, but a warning that the technical position of the market or stock may be changing (Figure 3).

Figure 3: Here is the appearance of doji at turning points.

All dojis need confirmatory candles to act as a trading signal for a fresh move. Traders would do well to look for a doji at extreme zones of western indicators or at significant trendlines and use them for expecting a reversal in market psychology and taking profits.

In my trading experience, while exiting on a doji formation might not protect your entire move, it makes it worthwhile to book profits over the long run whenever a doji occurs after a substantial move, either up and down. This is because in a majority of cases, the doji leads to trends stalling and reversals, both minor and major.

In my next article, I will provide examples of how candlestick patterns can be used in conjunction with trendlines.

Figure 4: Here are some important candlestick reversal patterns.

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

Related reading

Nison, Steve [1991]. Japanese Candlestick Charting Techniques, New York Institute of Finance/Simon & Schuster.

_____ [1994]. Beyond Candlesticks, John Wiley & Sons.

Charts courtesy eSignal

Current and past articles from Working Money, The Investors' Magazine, can be found at Working-Money.com.





Ashwani Gujral




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