Candlesticks with Support and Resistance

Using candlesticks in conjunction with support and resistance

Using candlestick charts for negative selection

We’ve touched upon this previously when we talked about the longer-term trader who’s looking to enter into a trade, but instead of jumping in with both feet waits to see whether the reversal patterns start to appear when the market gets down to an important support level.

Support and resistance levels are created because markets have a memory, and as a mass we remember where things have got down to previously. Where the buyers returned to the fray last time the market sold off. Where the market turned, and therefore where the buyers decided enough was enough. Or maybe they simply decided that things were just way too cheap!

But if a market gets down to a supposed support level and there’s not a sniff of a reversal from the candlesticks, maybe there isn’t going to be a reversal, and if we then leave well alone we can save ourselves from a bad trade. The candles have to come to the party as well, and if they don’t they can save us from bad trades.

This is what I mean by negative selection. Traditionally we look for candle charts to provide us with tradeable signals. What I’m suggesting here is that they can stop you from putting on bad trades.

 Support plays

Obviously views can change, but often you find markets bouncing from the same levels that they bounced from the previous hour, day, week, or sometimes even months and years.

You only have to look at the following chart to see a prime example of a market doing exactly that, and it’s no coincidence that the reversal patterns also appeared at this time. At the very least this should put you on alert that a change may be occurring.approach £20. Supply and demand tells us that this will result in lower prices as the market has to head lower to look for keen buyers. If there are more sellers than buyers the price has to go down...

If you get to a resistance level and reversal patterns start to appear you should be ready for a turnaround, as shown in the example of the Shooting Star in Figure 6-9.

Figure 6.10 shows gold failing at 875 on 21 January 1980, then topping out at 729 on a renewed move higher on 11 February 1980, and then again months later on 23 September 1980.

I think you’ll agree that 729 was a big level at this time.

          

Figure 6-10: COMEX Gold futures (unadjusted active continuation); weekly candlestick chart; November 1979 – February 1982

Then have a look at the following chart, Figure 6-11. Two Shooting Star candlesticks appeared in gold futures in May 2006, just when prices got back to the 26-year-old level of 729. Within days trading had changed tack and I was looking for a pullback, which duly came. 

          

Figure 6-9: CME Group Gold futures (unadjusted active continuation); daily candlestick chart; 11 January 2008 - 23 May 2008, showing 17 April 2008 Shooting Star, on former high from 28 March 2008. Then, on 2 May the price got down to the low from 22 January 2008 and a Hammer was posted, which ended that move.

Resistance plays

The same applies to upside levels, or resistance, as it’s commonly known. Markets quite often fall over at similar levels to previous failures. Think about the trader who was long last time the market went up to £20 but didn’t get out. He or she was still long when prices went back down to £15, and given a second chance - if prices get back to £20 again - the trader may well take his or her money and run. Think about the trader who wants to buy some but has seen that £20 has been a barrier previously. Maybe they’ll hold off until this hurdle is clear. The speculator trading via a spread bet or CFD has the opportunity to go short and may feel that this one’s ripe to fall over again on reaching the £20 mark. All of these factors would contribute to either a splurge of selling, or a dearth of buying, as prices

         

Figure 6-11: CME Group Gold futures (unadjusted active continuation); daily candlestick chart; 24 March 2006 – 16 June 2006

I’ve reproduced this chart many times; it’s one of my old favourites, and I’ve been challenged a few times that if you had adjusted for inflation then gold would need to get up to somewhere north of $2000 in 2006 to be anywhere near its 1981 levels in real terms. I don’t dispute this, but you also can’t ignore the fact that by drawing a horizontal line on the chart you would have been (and I was), at the very least aware of this level, and could have taken profit on longs somewhere near the high of the move.

A Shooting Star bang on a massive resistance level will surely carry more weight than a reversal signal that just appears out of the middle of nowhere?

At the time that these two Shooting Star candles appeared it was difficult to think about the idea of batting against such a solid trend, and looking back at my analysis at this time I didn’t change tack fully to the bear side until the market sold off through 650. At this time I targeted 550, a long-term Fibonacci retracement level that was reached a few weeks later. 

Waiting for confirmation - what to use

So this is how I do it: I’m always watching keenly for candlestick reversal patterns, and then when I see one I do absolutely nothing, preferring to wait for some confirmation before jumping on the reversal bandwagon. This is the result of years of experience - years of jumping too early!

This is where trend lines, moving averages, Fibonacci levels, gaps, Marabuzo lines and the like come into play. Upon seeing a reversal pattern in a rising market we immediately look for the first significant support level and we ask that it gets broken to confirm the reversal. Prior to this some lightening up of longs may be advisable, but an all out bear tack needs a bit more time to be decided upon.

Likewise, if the market is in a downtrend and a reversal pattern appears, we immediately look up and find the first strong resistance level. We want to see the market through here at the very least before we think about buying.

A few more practical examples of support and resistance combining well with candlesticks, over various time frames, can be seen in the following charts.

If you had taken this Shooting Star at resistance as a sell signal you would have traded to the short side from then on, until Point D was reached. The market got through the earlier lows, only to retake these levels very quickly, ending that 10-minute period with a Hammer, which would have flipped you back to the buy side. Again there would have been some instant gratification for longs after this pattern.

You didn’t need to be a bull or a bear to make money using these parameters. You didn’t need a directional view at all.

All you needed was a flexible approach to trading, tight stop criteria and discipline, and a keen eye for candlestick patterns coinciding with technical levels. This is a mistake I often make, as many traders do. I was bearish about the markets on this particular day, so would have favoured the sell trade after the Shooting Star, and would have missed the Hammer opportunities. My being “married to the bear tack” would have stopped me making money from the well flagged short-term up moves.

Some would argue this is no bad thing, though, since the market was in a pretty beaten up state around this time, and there was quite a bit of risk attached to trading on the long side. These are valid arguments, and decisions will depend on several factors, including time frames, expectations from trades, risk versus reward and running tight stops, all of which are beyond the scope of this introductory book.

Examples

The following chart illustrates how you can use candlesticks with support and resistance to place short-term trades that can make a quick profit and involve minimal risk.

 

Figure 6-12: LIFFE FTSE futures (March 2008); 10-minute candlestick chart; 4.00pm, 5 February 2008 - 3.10pm, 6 February 2008

Point A is the start of trade on 6 February. The first hour sees a range set of 5807.5 to 5862.5. It didn’t quite reach the first resistance from the previous day at 5878.5. Then the market sold off to point B, which saw the low from earlier in the day retested. Prices held this level, and a Hammer was posted to boot. In fact two were posted in a row. Combined with the hold of support this would have seen day traders buying. They would have made money trading on the bull side right up until the Shooting Star at point C was reached. This appeared when a high of 5875 was set, slightly above the 5862.5 high set in the first hour, but just below the 5878.5 high from late in the session on 5 February.