Combining Candles with Momentum

Combining candles with momentum studies

When I spend a good amount of time with a group of trainees the thing I try to impress upon them is that they are all individuals and that they’re all going to find different things that work well for them as individuals from the huge array of technical tools available. I’m even happy to concede that they might choose not to use technicals at all, although I say this through gritted teeth!

Work out your favoured canvas

My best suggestion is to work out what your favourite canvas is. Some swear by Market Profile charts, some see Point & Figure as the cleanest and clearest way of viewing the markets and gleaning signals. Some will firmly stick to bar charts even after reading this book, I guess (astonishing!)

Whatever you decide, there’s more to do once this decision has been reached. We’ve talked about waiting for confirmation before taking a reversal signal in the previous chapter, but there are other methods that can be employed for confirmation purposes. A reliable moving average, a trend line, or a signal from an indicator like Stochastics or RSI are the sort of thing that you can incorporate into your decision making process.

It comes back to the analogy I used earlier: if you wake up one morning and decide to buy a red jumper do you go to the high street and buy the very first red jumper you clap your eyes on, or do you have a few more criteria you want to satisfy? On something as simple as buying a pullover you’ve got more than one condition, and you need to have layers of conditions that need satisfying before jumping into a trade.

Over the following pages you will see the same chart reproduced several times, each time with a different method of confirmation used. I have accompanied each chart with a brief explanation of the method. This is by no means a definitive discussion, more a precis of each method, with enough to help you decide whether it’s something you might attempt to incorporate into your strategy.

 

Figure 6-13: Eurex Bobl futures (adjusted active continuation); daily candlestick chart; 11 February 2008 - 23 April 2008

We have shown this chart before. We talked about it in Chapter 3 (Figure 3-22). The candle at the very top of this chart is a Rickshaw Man. As you can see this pattern appeared on the day the market retested the high from a few days earlier. At the time that the market got above that previous high, the bulls were in charge and looking good for it. But they dropped the ball, and prices ended up back where they started. The market started selling off from the very next day as the bears picked up the ball and started running back up the other end with it!

Support and resistance

This is a recap of the previous section but it fits in nicely with what I’m trying to do in this section, so here goes!

Support occurs when a market that is selling off reaches a level where the buyers return to the fray sufficiently to turn things around. Using the basic laws of supply and demand we know that a market that is selling off is the result of more sellers than buyers. Supply is outstripping demand. But the moment when price reverses and the market starts to go up is where the balance between buyers and sellers changes.

It is often noted that markets change from downwards to upwards at similar levels to previously, so chartists look back at the historic prices to see where previous turning points occurred.

Resistance is the opposite to support: a high price where the balance between buyers and sellers shifts back in favour of the sellers. In an uptrending market the bulls, or buyers, are dominating. The top of a move is when the sellers take over, where demand no longer outstrips supply, causing a top in price. Previous highs are well watched levels when a market is rising. These levels are the moments at which market conditions changed previously, where the balance of power changed from bulls to bears. It’s obvious why they are classed as so important.

To take support and resistance one very simple step further, many chartists and traders look for a clearly defined trend whenever they fire up a chart. Charles Dow first mooted the simple idea that an uptrend is a series of higher highs and higher lows, whereas a downtrend is comprised of lower highs and lower lows.

 

Figure 6-14: CME Group mini-Dow futures (unadjusted active continuation); daily candlestick chart with support and resistance lines; 7 March 2007 - 8 June 2007

Using this basic assumption on the preceding chart, you can see where the uptrend started (hence giving us a buy signal), and where the market broke a previous higher low to stop the long trade out. On this occasion the lower lows and lower highs were not really clearly defined when we got out of the trade, but things had started to look messy and the price had broken an important support, thus triggering liquidation of the long position.

Moving averages

Figure 6-15: CME Group mini-Dow futures (unadjusted active continuation); daily candlestick chart with 20 and 50-day simple moving averages; 7 March 2007 - 7 June 2007

Many traders and analysts use a moving average line as a reference for market direction, as it smoothes the data set. Sometimes candlesticks can be a tad confusing and trends can be difficult to define. A moving average takes the average value of a set amount of data (usually closes) and plots them as a line. They are called moving averages because the lines move with the market. A 10-day moving average adds up the last ten days of data and divides the total by ten. Obviously as a new candlestick is added to the right hand side of the chart we lose one from 11 days before from our calculation. Hence the line moves with the movement of the candlesticks.

The preceding chart - Figure 6-15 - is a daily candle chart with 20-day and 50-day simple moving averages applied. Note particularly how the 20-day line reacts more quickly to the price trend changing than the 50-day average.

Also see how on several occasions we saw a pullback in the uptrend that got prices down to the 20-day average line.

So if after the Evening Star in early March and the Hammer in mid-March (the bottom left hand side of the chart - there should be no need to highlight them by now), you ask for a break of the 20-day moving average to confirm, you got your confirmation on 20 March and bought at 12,381. If you subsequently used the same 20-day moving average line as a trailing stop you would have been at most 66 ticks offside on 30 March, and you would have sold out for a profit of 1080 points on the close on the 6 June.

A simple rule of thumb if you want to apply moving averages to candlesticks is to use your eyes, and find the average line (by playing around with different period settings) that acts as good support in a rising market (i.e, any pullbacks in the uptrend find a bottom at or around the moving average line), and good resistance (i.e, it caps upside advances) in a falling market. Then you want to see that it gives clear signals when the market crosses the line.

This all sounds easy but it isn’t, and a lot of patience and time is required to find the line that does the best job for you. One of the biggest problems with moving averages is that they become rather unreliable during trendless or sideways markets, so this is something to watch out for and guard against when you’re backtesting.

Trend lines

 Figure 6-16: CME Group mini-Dow futures (unadjusted active continuation); daily candlestick chart with trend lines; 7 March 2007 - 8 June 2007

Trend lines are straight lines that define trends. It is amazing how many times the market moves higher or lower with a consistently steady velocity that can be tracked by a straight line.

An uptrend line is a straight line that joins a series of higher lows in a market that is travelling higher. You draw them below the price action, sloping higher from left to right. You can use them to define the move and keep you in a long trade. You can put a trailing stop below a trend line, and your stop order will move higher as the market moves higher.

A downtrend line is a straight line that sits above a downtrending market, joining successive lower highs.

I always apply a “rule of three” to the drawing of trend lines. I want to see three lower highs joined together before classing a line as a hard and fast downtrend line.

A move up to a downtrend line where a bearish reversal pattern is posted is a good start for a short trade set up. Once in the trade, as long as the market moves back down, away from the line, you can use the line as a reference for a trailing stop.

If you have three higher lows that can be joined with a straight line you have a valid uptrend support line and you should be looking to buy dips to this line, especially if the market displays bullish candlesticks when hitting the line.

Using the same chart as before we can see that in this case the short-term downtrend line was broken after the candlestick reversal patterns, but just prior to our moving average buy signal. The exit was a few days later than the moving average sell signal, but at similar levels. The main message was that the trailing stop using the trend line kept you in the trade for a good while.

Parabolic SAR

 

Figure 6-17: CME Group mini-Dow futures (unadjusted active continuation); daily candlestick chart with Parabolic SAR; 7 March 2007 - 8 June 2007

This is a study devised by Welles Wilder and introduced in his 1978 book New Concepts in Technical Trading Systems. It relies on a trailing stop that gets closer to the action as the trend progresses. As you can see, trades are triggered when prices move through the dashes in one direction or the other.

It is an “always in” trading tool, which means you are either short or long at all times. SAR stands for Stop and Reverse, i.e, you stop out the previous position, and simultaneously move to the opposite tack. I don’t tend to use it quite so literally. I find it can be good to keep you in a strong trend for as long as possible. It is another effective tool for stop placement, and for giving trend beginning and trend ending signals, but as with a moving average it can be a rather unreliable tool during sideways markets.

Once again we’ve kept the same chart for this as the previous examples of moving averages and trend lines. We got an earlier signal, and this would have actually seen you quite a bit offside before things came good. In this instance the SAR dashes didn’t do the best job for us, although you can see how they can have value in strongly trending conditions.

MACD

Figure 6-18: CME Group mini-Dow futures (unadjusted active continuation); daily candlestick chart with MACD (12,26,9); 7 March 2007 - 8 June 2007

MACD stands for moving average convergence/divergence and is a momentum study that gives clear-cut buy and sell signals with the crossing of two lines, one of which is a moving average of the other. The faster base line (the blue line in this example) tracks the difference between two moving averages (the default being the 12 and 26 day exponential moving averages). Longer-term traders find this a robust, reliable momentum study. Once you’ve seen a candlestick reversal pattern you want to add weight to the argument for a reversal, and a corresponding signal from something like MACD is a good example of the sort of thing you may want to add into your check box system.

You can see once more that after our reversal patterns we get a buy signal from the crossing of the MACD lines, and once the market starts to fall over so do the lines, leading to a sell signal which came slightly earlier than those seen so far from trend lines, moving averages and the like.

RSI

Figure 6-19: CME Group mini-Dow futures (unadjusted active continuation); daily candlestick chart with RSI (14 day); 7 March 2007 - 8 June 2007

This is a momentum study dealing with the ratio of up days to down days over a set time period. It is constructed only using one line, which generally moves in the same direction as the market. Many traders look for Divergence set ups, where the indicator goes in one direction and the market in another; these can work extremely well combined with candlestick analysis, with one signal confirming the other. One of my favourite momentum studies, and well worth reading up on (once again this was introduced by J Welles Wilder in New Concepts in Technical Trading Systems)!

As you can see, throughout most of May the market kept heading higher but the RSI had topped out a lot earlier, and didn’t subsequently emulate this high. Even a month later in July, the indicator failed to follow when the Dow rallied to new highs before finally topping out and cracking nastily lower as the 2007 sub-prime crisis bit hard.

Stochastics

Figure 6-20: CME Group mini-Dow futures (unadjusted active continuation); daily candlestick chart with Slow Stochastics (10,3,3); 7 March 2007 - 8 June 2007

The Stochastic Oscillator has a similar interpretation to MACD and RSI. This short-term momentum study employs two lines, with the crossing of the lines giving definitive buy and sell signals. Once again you can use something like a Stochastics signal as confirmation for any candlestick reversal pattern.

A classic buy signal is the lines coming out of oversold (ie, from below a reading of 20) then crossing, with the blue line piercing through the red line. As you can see this gave a pretty early signal in this instance, hard on the heels of the Morning Star formation, but as with the Parabolic SAR discussed earlier there was a fair bit of draw down after the signal was given before the Hammer was posted and the market got going to the upside once more.

The other thing this chart shows well is how unreliable signals can be from a short-term momentum study when a market is in a solid trend, but as with the RSI a divergence setup came to the rescue to try and make sense of things. If this had caused you to liquidate longs you would have missed the last month of the bull move, but you would not have been long when things started selling off hard soon after that.

So what to use?

One thing that the past few pages may have had you thinking is that across all the different methods discussed we ended up with pretty similar confirmation signals, and pretty similar exits. I did this deliberately, with a familiar and constant chart; to try and get you thinking. This won’t always be the case, and there will be certain indicators or methods that work better for you than others. Your job is to discover what works best for you on your charts, taking into account your time frame and your style of trading.

In other words, you need to work it out and decide!

Tick the boxes

I encourage the idea of producing, at least in the early days, a grid where you need to tick say four boxes before pulling the trigger. Below is an example:

Conditions for a buy signal

Established long/medium term uptrend                      Y/N

Retracement sell off seen on light volume                    Y/N

Bullish candlestick reversal pattern after pullback      Y/N

Now rallying, and breaks first strong resistance          Y/N

Buy signal from Slow Stochastics                                    Y/N

Pick up in volume as buyers return                                 Y/N

If most of the answers are “Yes,” then you have a compelling argument that the selling is done and you should be getting long...

After a while this way of systemizing your trading decisions will become second nature, but even then if you find yourself starting to make undisciplined “hope” trades, you can go back to using this sort of grid in order to force yourself to justify your decisions.

Once you're in, stay in!

One other idea I would also like to try and encourage you to think about is that you will probably need something else to keep you in a winning trade for as long as possible, but which will get you out in a timely fashion. It’s an easy trap to fall into to use the same thing for entry and exit, but I don’t think that’s necessarily the way forward.

Obviously using the example grid on the previous page, you could argue that you get out of a long position once you tick all the boxes that are saying you should sell, but I’m not sure it’s as simple as that. I like to find a way to use a trailing stop once you’re in a trade, and obvious candidates to achieve this result are moving averages, trend lines, or one of my favourites: Welles Wilder’s Parabolic SAR.

I also like using Marabuzo lines for this, as you can see from Figure 6-21. At the bottom is a Hammer on a strong support. The market then starts to move higher in an obvious uptrend, and we were able to stay bullish all the way up in this one, and use Marabuzo lines as a reference to stay with the bulls every time they appeared. The trend was extremely strong during this period, and the lines all pretty much held like a dream. Sweet!

Figure 6-21: ICE Gas Oil futures (unadjusted active continuation); daily candlestick chart; 14 November 2007 - 27 March 2008

There’s a load more on this chart as well, though. Have you spotted the variation on an Evening Star at key resistance at the start of January? Or the Hammer on support towards the end of January? How about the Inverted Hammer that was confirmed the following day just a few weeks later? Not the strongest of patterns, until the market gapped higher the next day. Then the market got through the previous resistance and posted a nice big reaction day in mid-February. There was no stopping the market then, not until prices got up to the psychologically important $1000 mark. The day this level was hit a Shooting Star was posted. Then traders sold off, but only to a Marabuzo line, where a small bodied candlestick was posted upon hitting this key support.

I could point all of these out to you, but we’re at the end of the book, and I’m rather hoping you’re finding them yourself now!

Chapter summary

A lot of time and energy is spent on momentum indicators these days, among both professional and beginner traders. I always beg newcomers not to get too bogged down with these, and to make sure they don’t have too many indicators all running alongside each other, as they will often be telling you the same thing.

“Paralysis by analysis” is a phrase that springs to mind.

But even saying that, an indicator can be an integral element of a trading system, and there’s nothing more important than having a system.

I’m a big believer that candlesticks can be incorporated into any trading system, and can enhance your system, for example by providing an earlier “heads up” indication of trend change.