Better than Candlestick Patterns
– Part Three
ByLance Beggs August 6, 2010
In parts 1 and 2 of this short article series we discovered a technique
for determining the short-term sentiment displayed by any sequence
of candles.
(Go here first if you missed part 1 or part 2)
It’s time now to consider the context.
‘Consider the context’ means we consider where the current price
pattern appears with respect to the background market environment
and price action, and what that means.
The same pattern can have numerous meanings, depending on
where it occurs in the market.
Referring to the diagram below, we can see that the Low Close
Range Candle on the left hand side is occurring after a weakening of
an uptrend right into an area of resistance. The first bullish candle
broke above recent price action and penetrated the resistance area
by a couple of pips before being rejected. Trapped longs will be
exiting on any break below this candle. Although a low close range
candle is generally considered to display neutral sentiment, when we
consider the location of the pattern it has reasonably bearish
connotations.
Compare that to the low close range candle on the right hand side,
which is occurring within the middle of a period of narrow range
sideways congestion. The occurrence of this pattern in this location
:
shows absolutely no sign of any potential change to market bias.
This is clearly neutral.
In determining the impact of a candle pattern, you MUST consider
where it is occurring on the chart.
While I monitor all candles as they develop, and the ebook will go
into more detail on this process, what we’ll consider here in this
article is the most important locations, at which you MUST observe
price action.
Changes of sentiment at these location can have very significant
meaning for future market bias.
These ‘important locations’ will typically be any location which plays
a part in defining your market structure or your trend. I trade based
upon support and resistance levels, so in considering the context of
background market structure and price action, I primarily look at
three main areas…
Where is price in relation to the higher timeframe S/R? Where is it in
:
the trend? Where is it in relation to key swing highs and lows? And
what does this mean?
Support and Resistance
Where is the pattern occurring with respect to higher
timeframe support and resistance?
Has the market shown strength or weakness on approach to the
S/R area? Is the current candle pattern sentiment continuing this
strength or weakness, or has something changed?
Is the pattern showing signs of orderflow opposing the move
into S/R, such as tails rejecting price at or near the S/R level?
Has the pattern breached the area of S/R? If so, is it now
showing signs of acceptance or rejection of this new area?
Trend
Where is the pattern occurring within the current trend?
Is it on an extension? Is it early in the move, or late and
overextended? Has it managed to pass the previous swing
high/low?
Is it on a pullback? Is it early in the move, or has it continued
deeper than anticipated? Is it a single swing pullback, or is this
pattern a part of a multiple swing retracement.
Or is the pattern within a sideways trading range or other form
of consolidation pattern?
Swing Highs and Lows
Is price testing any areas of swing highs or lows?
:
For an uptrend:
Pullbacks to previous areas of swing low support should be
watched closely. We expect them to hold. Is the price action
showing signs of the level holding, or is it threatening to break?
If it breaks, is price showing signs of rejection (opposing
orderflow / difficulty continuing) or is price accepting this new
area?
Pullbacks to previous swing highs (within an uptrend) are not as
critical, but should still be watched for their reaction.
Extensions are expected to break the previous swing high. Is
price action supporting that premise, or is the candle pattern
showing weakness. If it can’t exceed the previous swing high,
we need to be alert for further signs of weakness which may
forecast a complex correction or reversal.
For a downtrend:
Pullbacks to previous areas of swing high resistance should be
watched closely. We expect them to hold. Is the price action
showing signs of the level holding, or is it threatening to break?
If it breaks, is price showing signs of rejection (opposing
orderflow / difficulty continuing) or is price accepting this new
area?
Pullbacks to previous swing lows (within a downtrend) are not
as critical, but should still be watched for their reaction.
Extensions are expected to break the previous swing low. Is
price action supporting that premise, or is the candle pattern
showing weakness. If it can’t break the previous swing low, we
need to be alert for further signs of weakness which may
:
forecast a complex correction or reversal.
For a sideways trend:
Is price testing a range boundary?
Has the market shown strength or weakness on approach to the
boundary? Is the current candle pattern sentiment continuing
this strength or weakness, or has something changed?
Is the pattern showing signs of orderflow opposing the move
into the range boundary, such as tails rejecting price at or near
the level?
Has the pattern breached the area of range S/R? If so, is it now
showing signs of acceptance or rejection of this new area?
You’ll note as we discussed these areas of influence that they simply
raise a lot of questions rather than provide you with answers. Fixed
rules don’t apply here. There is no rule that states if a bullish
sentiment pattern occurs at position xyz on a chart, then it means …
:
Every occurrence of every pattern is unique.
By considering the pattern in the context of background structure
and price action, we are ultimately attempting to gain a feel for how
that pattern will impact upon the strength and weakness of the
underlying trend, and how that might influence future orderflow.
While many elements of a price pattern can be objectively seen on a
chart, determining the influence that pattern will have on future price
action is a purely subjective process.
You gain that subjective feel through questioning what you see on
the charts.
The next step…
So, having defined the sentiment of the current pattern, and
considered the behaviour of price at key context areas, what’s the
next step? We’ll talk about that in the next article, part 4, where we
wrap up this series and discuss how we use this information…
More to follow in Part 4…
Lance Beggs
Followup Articles:
Part 4 – https://yourtradingcoach.com/trading-process-and-
strategy/better-than-candlestick-patterns-part-four/
Part 5 – https://yourtradingcoach.com/trading-process-and-
strategy/better-than-candlestick-patterns-part-five/
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