Technical analysis is the framework in which stock traders study price movement.
The theory is that a person can look at historical price movements and determine the current trading conditions and potential price movement.
The main evidence for using technical analysis is that, theoretically, all current market information is reflected in price. If price reflects all the information that is out there, then price action is all one would really need to make a trade.
Now, have you ever heard the old adage, “History tends to repeat itself“?
Well, that’s basically what technical analysis is all about! If a price level held as a key support or resistance in the past, traders will keep an eye out for it and base their trades around that historical price level.
Technical analysts look for similar patterns that have formed in the past, and will form trade ideas believing that price will act the same way that it did before.
In the world of stock trading, when someone says technical analysis, the first thing that comes to mind is a chart. Technical analysts use charts because they are the easiest way to visualize historical data!
You can look at past data to help you spot trends and patterns which could help you find some great trading opportunities.
What’s more is that with all the traders who rely on technical analysis out there, these price patterns and indicator signals tend to become self-fulfilling.
As more and more stock traders look for certain price levels and chart patterns, the more likely that these patterns will manifest themselves in the markets.
You should know though that technical analysis is VERY subjective.
Just because Raj and Rohan are looking at the exact same stock chart setup or indicators doesn’t mean that they will come up with the same idea of where price may be headed.
How to Trade Support and Resistance
Now that you know the basics, it’s time to apply these basic but extremely useful technical tools in your trading. Because here we want to make things easy to understand, we have divided how to trade support and resistance levels into two simple ideas: the Bounce and the Break.
As the name suggests, one method of trading support and resistance levels is right after the bounce.
Many retail stock traders make the error of setting their orders directly on support and resistance levels and then just waiting to for their trade to materialize. Sure, this may work at times but this kind of trading method assumes that a support or resistance level will hold without price actually getting there yet.
You might be thinking, “Why don’t I just set an entry order right on the line? That way, I am assured the best possible price.”
When playing the bounce, we want to tilt the odds in our favor and find some sort of confirmation that the support or resistance will hold.
Instead of simply buying or selling right off the bat, wait for it to bounce first before entering. By doing this, you avoid those moments where price moves fast and break through support and resistance levels. From experience, catching a falling knife when trading stock can get really bloody…
In a perfect stock trading world, we could just jump in and out whenever price hits those major support and resistance levels and earn loads of money. The fact of the matter is that these levels break… often.
So, it’s not enough to just play bounces. You should also know what to do whenever support and resistance levels give way!
There are two ways to play breaks in stock trading: the aggressive way or the conservative way.
The Aggressive Way
The simplest way to play breakouts is to buy or sell whenever price passes convincingly through a support or resistance zone. The key word here is convincingly because we only want to enter when price passes through a significant support or resistance level with ease.
We want the support or resistance area to act as if it just received a Chuck Norris karate chop: We want it to wilt over in pain as price breaks right through it.
The Conservative Way
Now, if enough selling and liquidation of losing positions happens at the broken support level, price will reverse and start falling again. This phenomenon is the main reason why broken support levels become resistance whenever they break.
As you would’ve guessed, taking advantage of this phenomenon is all about being patient. Instead of entering right on the break, you wait for price to make a “pullback” to the broken support or resistance level and enter after the price bounces.
A few words of caution… IN STOCK, THIS DOES NOT HAPPEN ALL THE TIME. “RETESTS” OF BROKEN SUPPORT AND RESISTANCE LEVELS DO NOT HAPPEN ALL THE TIME. THERE WILL BE TIMES THAT PRICE WILL JUST MOVE IN ONE DIRECTION AND LEAVE YOU BEHIND. BECAUSE OF THIS, ALWAYS USE STOP LOSS ORDERS AND NEVER EVER HOLD ON TO A TRADE JUST BECAUSE OF HOPE.
What is a Japanese Candlestick?
While we briefly covered Japanese candlestick charting analysis in the previous stock lesson, we’ll now dig in a little and discuss them more in detail. Let’s do a quick review first.
Japanese Candlestick Trading
Back in the day when Godzilla was still a cute little lizard, the Japanese created their own old school version of technical analysis to trade rice. That’s right, rice.
A Westerner by the name of Steve Nison “discovered” this secret technique called “Japanese candlesticks,” learning it from a fellow Japanese broker. Steve researched, studied, lived, breathed, ate candlesticks, and began to write about it. Slowly, this secret technique grew in popularity in the 90’s. To make a long story short, without Steve Nison, candlestick charts might have remained a buried secret. Steve Nison is Mr. Candlestick.
Okay, so what the heck are Japanese candlesticks?
The best way to explain is by using a picture:
Japanese candlesticks can be used for any stock time frame, whether it be one day, one hour, 30-minutes – whatever you want! They are used to describe the price action during the given time frame.
Japanese candlesticks are formed using the open, high, low, and close of the chosen time period.
Japanese candlesticks with a long upper shadow, long lower shadow and small real bodies are called spinning tops. The color of the real body is not very important.
The pattern indicates the indecision between the buyers and sellers.
The small real body (whether hollow or filled) shows little movement from open to close, and the shadows indicate that both buyers and sellers were fighting but nobody could gain the upper hand.
Even though the session opened and closed with little change, prices moved significantly higher and lower in the meantime. Neither buyers nor sellers could gain the upper hand, and the result was a standoff.
If a spinning top forms during an uptrend, this usually means there aren’t many buyers left and a possible reversal in direction could occur.
If a spinning top forms during a downtrend, this usually means there aren’t many sellers left and a possible reversal in direction could occur.
Sounds like some kind of voodoo magic, huh? “I will cast the evil spell of the Marubozu on you!” Fortunately, that’s not what it means. Marubozu means there are no shadows from the bodies. Depending on whether the candlestick’s body is filled or hollow, the high and low are the same as its open or close. Check out the two types of Marubozus in the picture below.
A White Marubozu contains a long white body with no shadows. The open price equals the low price and the close price equals the high price. This is a very bullish candle as it shows that buyers were in control the entire session. It usually becomes the first part of a bullish continuation or a bullish reversal pattern.
A Black Marubozu contains a long black body with no shadows. The open equals the high and the close equals the low. This is a very bearish candle as it shows that sellers controlled the price action the entire session. It usually implies bearish continuation or bearish reversal.
Doji candlesticks have the same open and close price or at least their bodies are extremely short. A doji should have a very small body that appears as a thin line.
Doji candles suggest indecision or a struggle for turf positioning between buyers and sellers. Prices move above and below the open price during the session, but close at or very near the open price.
Neither buyers nor sellers were able to gain control and the result was essentially a draw.
There are four special types of Doji candlesticks. The length of the upper and lower shadows can vary and the resulting stock candlestick looks like a cross, inverted cross or plus sign. The word “Doji” refers to both the singular and plural form.
When a Doji forms on your chart, pay special attention to the preceding candlesticks.
If a Doji forms after a series of candlesticks with long hollow bodies (like White Marubozus), the Doji signals that the buyers are becoming exhausted and weakening. In order for price to continue rising, more buyers are needed but there aren’t anymore! Sellers are licking their chops and are looking to come in and drive the price back down.
If a Doji forms after a series of candlesticks with long filled bodies (like Black Marubozus), the Doji signals that sellers are becoming exhausted and weak. In order for price to continue falling, more sellers are needed but sellers are all tapped out! Buyers are foaming in the mouth for a chance to get in cheap.
While the decline is sputtering due to lack of new sellers, further buying strength is required to confirm any reversal. Look for a white candlestick to close above the long black candlestick’s open.
In the next following sections, we will take a look at specific Japanese candlestick pattern and what they are telling us. Hopefully, by the end of this lesson on candlesticks, you will know how to recognize different types of stock candlestick patterns and make sound trading decisions based on them.
Learn how to use single candlestick patterns to identify potential market reversals.
Here are the four basic single Japanese candlestick patterns:
The hammer and hanging man look exactly alike but have totally different meanings depending on past price action. Both have cute little bodies (black or white), long lower shadows, and short or absent upper shadows.
The hammer is a bullish reversal pattern that forms during a downtrend. It is named because the market is hammering out a bottom.
When price is falling, hammers signal that the bottom is near and price will start rising again. The long lower shadow indicates that sellers pushed prices lower, but buyers were able to overcome this selling pressure and closed near the open.
Just because you see a hammer form in a downtrend doesn’t mean you automatically place a buy order! More bullish confirmation is needed before it’s safe to pull the trigger.
A typical example of confirmation would be to wait for a white candlestick to close above the open to the right side of the hammer.
The hanging man is a bearish reversal pattern that can also mark a top or strong resistance level. When price is rising, the formation of a hanging man indicates that sellers are beginning to outnumber buyers.
The long lower shadow shows that sellers pushed prices lower during the session. Buyers were able to push the price back up some but only near the open.
This should set off alarms since this tells us that there are no buyers left to provide the necessary momentum to keep raising the price.
The inverted hammer and shooting star also look identical. The only difference between them is whether you’re in a downtrend or uptrend. Both candlesticks have petite little bodies (filled or hollow), long upper shadows, and small or absent lower shadows.
The bullish engulfing pattern is a two candlestick pattern that signals a strong up move may be coming. It happens when a bearish candle is immediately followed by a larger bullish candle.
This second candle “engulfs” the bearish candle. This means buyers are flexing their muscles and that there could be a strong up move after a recent downtrend or a period of consolidation.
On the other hand, the bearish engulfing pattern is the opposite of the bullish pattern. This type of candlestick pattern occurs when the bullish candle is immediately followed by a bearish candle that completely “engulfs” it. This means that sellers overpowered the buyers and that a strong move down could happen.
The tweezers are dual candlestick reversal patterns. This type of candlestick pattern are usually be spotted after an extended uptrend or downtrend, indicating that a reversal will soon occur.
Notice how the candlestick formation looks just like a pair of tweezers!
The most effective Tweezers have the following characteristics:
The inverted hammer occurs when price has been falling suggests the possibility of a reversal. Its long upper shadow shows that buyers tried to bid the price higher.
However, sellers saw what the buyers were doing, said “Oh heck no!” and attempted to push the price back down.
Fortunately, the buyers had eaten enough of their Wheaties for breakfast and still managed to close the session near the open.
Since the sellers weren’t able to close the price any lower, this is a good indication that everybody who wants to sell has already sold. And if there are no more sellers, who is left? Buyers.
The shooting star is a bearish reversal pattern that looks identical to the inverted hammer but occurs when price has been rising. Its shape indicates that the price opened at its low, rallied, but pulled back to the bottom.
This means that buyers attempted to push the price up, but sellers came in and overpowered them. This is a definite bearish sign since there are no more buyers left because they’ve all been murdered.
Evening and Morning Stars
The morning star and the evening star are triple candlestick patterns that you can usually find at the end of a trend. They are reversal patterns that can be recognized through three characteristics. We’ll use the Evening Star Pattern on the right as an example of what you may see:
Three White Soldiers and Black Crows
The three white soldier’s pattern is formed when three long bullish candles follow a downtrend, signaling a reversal has occurred. This type of triple candlestick pattern is considered as one of the most potent in-yo-face bullish signals, especially when it occurs after an extended downtrend and a short period of consolidation.
The first of the three soldiers is called the reversal candle. It either ends the downtrend or implies that the period of consolidation that followed the downtrend is over.
For the pattern to be considered valid, the second candlestick should be bigger than the previous candle’s body. Also, the second candlestick should close near its high, leaving a small or non-existent upper wick.
For the three white soldier’s pattern to be completed, the last candlestick should be at least the same size as the second candle and have a small or no shadow.
The three black crow’s candlestick pattern is just the opposite of the three white soldiers. It is formed when three bearish candles follow a strong uptrend, indicating that a reversal is in the works.
The second candle’s body should be bigger than the first candle and should close at or very near its low. Finally, the third candle should be the same size or larger than the second candle’s body with a very short or no lower shadow.
Three Inside Up and Down
The three inside up candlestick formation is a trend-reversal pattern that is found at the bottom of a downtrend. This triple candlestick pattern indicates that the downtrend is possibly over and that a new uptrend has started. For a valid three inside up candlestick formation, look for these properties:
Conversely, the three inside down candlestick formation is found at the top of an uptrend. It means that the uptrend is possibly over and that a new downtrend has started. A three inside down candlestick formation needs to have the following characteristics: