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CANDLESTICK CORNER


Stop-Losses Using Candlestick Signals

03/01/12 11:23:50 AM PST
by Stephen W. Bigalow

Most investment professionals advise you to cut your losses short and let your profits run. But how do you do it?

Cutting losses is difficult because your ego gets in the way. Why? When you make a decision to buy or sell or hold, it is the result of your evaluation. If you establish a position after your analysis and the market moves in the opposite direction of what you thought it would, however, you will be reluctant to close the position at the appropriate time. It is a blow to your ego. But candlestick signals make the process more mechanical, which can eliminate a lot of the emotion involved.

CANDLESTICK CHARTS
Logic dictates that if you see a candlestick buy signal, you can expect certain results. If those results don't occur, the trade is not working; the trade should be closed out immediately. Once investors have learned the attributes of the 12 major candlestick signals, learning where to place stop-losses becomes a matter of mechanics, not an emotional decision.

The Japanese rice traders who first developed the candlestick charting technique came up with a simple strategy for placing effective stop-loss orders. If a candlestick buy signal reveals the bulls are taking control, then the bears should not be able to close the price back down through the halfway point of the bullish signal. If the bears were capable of closing more than halfway down the bullish signal, that would indicate the bears are still in control of the trend. As can be seen in the US dollar chart in Figure 1, a bullish harami is a signal that indicates the selling had stopped. Bullish confirmation of a trend reversal requires positive trading the next day. Note that the day after the positive trading day, the close was below the halfway point of the confirmation candle, revealing the bulls were not in control.



FIGURE 1: SIGNS INDICATING SELLING HAS STOPPED. In this chart of the US dollar, the appearance of a bullish harami suggests that selling has stopped. Bullish confirmation of a trend reversal requires positive trading the following day. The day after the positive trading saw a close below the halfway point of the confirmation candle. This indicates that the bulls were not in control.

Having the ability to identify reversal signals creates a beneficial dynamic for investors. Once you become comfortable with the fact that the signals represent a high-probability situation, you can better implement trading rules. The elimination of emotions, especially fear and greed, should be your prime goal.

Emotions are the most difficult hurdle to overcome. When our own money is on the line, rational thought processes are overwhelmed. It becomes important to create guidelines and rules that keep emotional decision making to a minimum. Trades are skewed with investors' hopes versus what indicators are showing.

Every time an investor puts on a position or takes one off, he or she makes a decision. Our egos come into play. Of course, we like to believe that we are smarter than everyone else. Confirmation of what we believe about ourselves is quantified every time we make an investment decision.

PRESERVING CAPITAL
Most investment professionals advise investors to preserve capital. This is good advice. If you assume that candlestick signals produce a good possibility of being in a trade at the right time, preserving capital becomes more important, not so much for merely preserving capital, but for maintaining the capital base so it can be applied to future trade situations.

Investment advisors tell you to close out a position after you had a loss of 3%, 5%, 6%, or some arbitrary percentage that they have deemed to be the proper loss amount. There is a problem with this approach. The market does not give a hoot where you have established a position. Do you buy at the very bottom? Or did you wait for a candlestick signal confirmation?

Where you bought a position should have been based on the identification of a bullish reversal signal. An aggressive investor may have bought while a signal was forming in the oversold condition, while a more conservative one may have bought during the next time frame as the signal was being confirmed. Where you should put a stop-loss has nothing to do with the percentage price move going against you.

The proper stop-loss technique identifies the price level that negates the signals. The signals are created by a change in investor sentiment. A bullish candlestick signal has facets that we can identify. A buy signal involves a graphic depiction of when and where bullish sentiment is taking control of a trend. A critical factor for successful stop-losses is identifying a level that would negate the bullish signal. This has nothing to do with a preestablished percentage loss; a proper stop-loss level for one trade may be a 1% loss, whereas for another trade it could be a 12% loss. The variation in the percent losses has to do with the magnitude of the bullish signal. Candlestick analysis makes it easy to identify the price level that would make a good potential trade.

The first question an investor should ask after they've analyzed a strong bullish signal is, "What level would prices have to move back down from to negate what the bullish signal was revealing?" This can be done quicker and easier than when calculating where a 6% loss would be after you open a position.

A predetermined percentage loss may have nothing to do with the volatility of price. For example, if trading the eminis or soybeans on a one-minute chart, a 6% loss or even a 1% loss may have devastating ramifications for the trade and your account. Candlestick analysis has the benefit of telling us when to be in a trade and the level where to exit.

Successful stop-loss processes are important in commodity trading or any fast-moving trading entities; this refers back to volatility. Candlestick signals produce an excellent possibility of being correct. The adage is that if you can be correct 55% of the time in your commodity trades, you can make a fortune. Assuming that candlestick analysis produces results above the 50% accuracy trade ratio level, stop-losses have an important function.

The preservation of capital should be your first criterion. Even if the correct trade ratio were 90%, that would mean that 10% of the trades were unsuccessful. If an unsuccessful trade were not controlled, profit production would become an uphill battle. It becomes even more difficult to produce profits if the correct trade ratio is 55%, 60%, or even as high as 70%. If losing trades occur 30%, 40%, or even 45% of the time, stop-losses become an integral part of any trading program.

When you trade using candlestick analysis, you are in a favorable situation. The purpose of the stop-loss is to minimize the possibility of losing too much if prices move too far in the direction you didn't anticipate.

Taking small losses is like taking bad-tasting medicine. You may not be happy right now, but you will be when the results are tallied. Taking a $300 loss two minutes after you establish a trade is much better than trying to figure out what to do if your position is down $2,000.

Many investors are devastated when they are faced with a big loss. Their thought process becomes completely skewed. If they decide to take a small loss instead of holding on hoping for a market turnaround, that leaves their minds clear for their next trade. Their money is ready to be placed someplace else. They can look for chart patterns and signals more likely to produce a profit.

If they are sitting in a $2,000 losing position, they lose the opportunity to place their next trade since their capital is tied up. They have just lost money in their soybean/gold/dollar/cattle trade and they want it back.

ALL ABOUT DISCIPLINE
The common sense attributes of candlestick analysis allow for cutting losses short and letting profits run. Simple candlestick rules allow an investor to maintain an investment discipline. The probabilities built into candlestick signals create stop-loss procedures. Cutting losses is not merely for preserving capital but also for maintaining clear thinking for the next profitable trade.

RELATED READING

  • Bigalow, Stephen W. [2011]. Profitable Candlestick Trading, John Wiley & Sons.
  • ____ [2011]. Candlestick Profits: Eliminating Emotions With Candlestick Analysis, Profit Publishing.
  • ____ [2005]. High Profit Candlestick Patterns, Profit Publishing.





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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