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CANDLESTICK CORNER


Don't Fight The Candlesticks

09/29/05 11:28:11 AM PST
by Stephen W. Bigalow

Here's a simple process using candlestick signals.

When is it time to buy? Usually when there is panic in the streets! However, most investors cannot get past the emotional hurdles of buying at the bottom or selling at the top. Japanese traders have a saying: "Let the market tell you what the market is going to do." In that tradition, candlestick signals hold an immense amount of information in their formations, and can help traders hear what the markets are saying.

Centuries ago, Japanese rice traders made their fortunes by recognizing recurring patterns in investor sentiment. Found in the formations of candlestick signals, these same signals continue to produce profits, and — after hundreds of years of refinement — have proved to be as accurate for defining the time to buy as they are for showing the time to sell.

BUY LOW, SELL HIGH
It is often difficult to sort out price direction when listening to the many scenarios from the market "experts." The financial news stations are no better, as they will always provide a multitude of opinions of where the market or a stock price is going. The one basic factor built into candlestick signals is that they are formed by the cumulative knowledge of all the investor input — the buying and selling of trading entities during a certain time period.

No matter what you hear about potential price moves, candlestick signals circumvent all that noise. They will tell you exactly what investor sentiment is doing now, making it relatively easy to analyze the direction of the markets and stock price trends. Consequently, using major candlestick signals can immensely increase your profits.

INVESTOR SENTIMENT/FEAR FACTOR
When an investor is fortunate enough to be sitting on a stock that has made a strong upmove, two specific and difficult emotional factors enter the selling decision: greed and fear. As you might expect, greed is first. The average investor wants to hold onto a profitable stock position because "this could be the one" that shoots up to the moon. We imagine how much money we could make if the trend continued for another profitable 20 points. This emotional thinking usually deters the rational decision for selling when it is time to sell. Instead of analyzing where the trend could end, anticipating what the stock price could do becomes the overriding factor. Unfortunately, prices don't give a hoot what an investor is hoping for.

After the onset of greed, fear is the next factor to influence an investor's decision about when to buy or sell. Of course, the biggest fear is selling out too early. Investors usually have a hard enough time identifying profitable trades, and they never want to sell out too early. Who wouldn't be upset to sell a stock at $20 and then watch it hit $30? That fear causes investors to hold onto a position well past the time it should have been sold, sacrificing a good portion of the profits.

PROFIT PROBABILITY
Most investors do not have a game plan when it comes to their investment dollars. They buy when somebody tells them about a good stock to buy. The next purchase might be something they read about in the newspaper or a magazine article. After a while, they look to their portfolio and don't remember why they bought the position they bought which almost certainly means they do not have a program for selling.

Candlestick analysis eliminates that dilemma. Hundreds of years of refinement defines "high-probability" sell signals and provides a format for establishing buys and sells. The critical word here is "probability"; buying a position using a candlestick buy signal gives the investor a high probability of executing a profitable trade. Likewise, by selling a position using candlestick sell signals, an investor creates a high probability of trading near the optimal sell areas.

Does that mean every buy or sell signal is going to work the way you want it to? Definitely not! But buy signals do get the candlestick investor into positions with great probability of profit. They also allow the investor to close out trades that aren't working immediately, cutting their losses short. As for the candlestick sell signals, every one may not indicate the absolute top of a trend, but each one does provide a format indicating the very high probability that a top is near.

Remember: The point of investing is not to maximize your profits on each trade. The point of investing is to maximize your profits in your account. That said, there is nothing wrong with buying or selling a position when the probabilities say it's time to buy or sell and then reopening or reclosing your position later — even at a higher price — when the signals indicate that buyers or sellers are getting back in. When the candlestick signals indicate that the probabilities are not in your favor, why fight it?

The Dow Jones Industrial Average (DJIA) chart in Figure 1 is a good example of reading the signals to buy back a position. As you can see, the bullish trend from late October into mid-November started to reveal candlestick sell signals: an evening star signal, a bearish engulfing signal, and a few dojis. This congestion area became an opportune time to take profits in some of the stock charts that had moved up and were getting toppy.

FIGURE 1: TAKING PROFITS. Several candlestick signals suggest the market is getting toppy. Here you see a shooting star, a bearish engulfing pattern, and a hanging man.

Now look at the trend exhibiting bullish candlestick formations, coming out of the congestion area. With simple candlestick analysis, we see that this would have been a signal to buy back into the positions that had previously pulled back, or to buy new positions that were showing good, strong buy signals when the DJIA moved up again.

This is not rocket science. This is being able to visually analyze what the candlestick signals are telling us. The final trend has come to an end when stochastics show an overbought condition and candlestick sell signals appear. Once again, the probabilities tell us it is time to take profits.

When the market in general starts to get toppy, the evaluation of individual stock charts becomes easier to analyze. If the markets are getting toppy and a stock position is following suit, why go against the probabilities? Take profits! If the market turns back up or the stock starts showing buy signals again, it can always be bought back. There is no reason to sacrifice profits when signals that have worked effectively for centuries indicate other investors are getting out.

As can be seen in the Broadway Corp. (BWNG) chart in Figure 2, the stochastics were in the overbought area for a few weeks. As the markets started to show some weakness at the end of 2004, BWNG formed a doji/harami, followed by selling confirmation the next day, causing the stochastics to start to curl down.

FIGURE 2: CONFIRMING INDICATORS. In this chart of Broadwing Corp. (BWNG), the stochastics were in overbought territory for most of December. The doji/harami that formed after the large bullish candle indicated that a top had been reached.

All these conditions — a bearish harami confirmed and the markets starting to sell off — create a high-probability situation indicating that it is time to close out BWNG and take profits.

COULD THE PRICE GO HIGHER?
Despite what the charts may indicate, once an investor begins to hope that a trade will work, that investor will start hoping for a low-probability situation. That is not how to invest. Rather than hope for a successful trade, depend on a trading program like candlestick analysis. Interpreting the signals is an easy process to learn, and can provide high-profit situations.

Naturally, emotional obstacles like greed and fear can make it difficult for any investor to consistently follow any system and produce profitable trades. It's especially difficult to find a system that designates sell signals that an investor is willing to listen to. Yes, the price could always go higher. But whether you are a fundamental investor or a technical trader, the signals provide an excellent format for establishing when to buy and when to take profits. When the candlestick signals tell you it's time to sell, don't fight a system with centuries of evident success.

Stephen W. Bigalow is author of Profitable Candlestick Investing, Pinpointing Market Turns to Maximize Profits and High Profit Candlestick Patterns. He is also the principal of www.candlestickforum.com. He may be reached at steve@candlestickforum.com

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



Stephen W. Bigalow

Stephen W. Bigalow is an author and the principal of the www.candlestickforum.com, a website for providing information and educational material about candlestick investing.

Website: www.candlestickforum.com
E-mail address: sbigalow@msn.com


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