Pitfalls of Candlesticks
3. Blending that may distort rather than enlighten. One technique in candlestick analysis is called blending
In this technique, candlesticks from two or more periods are blended and recalculated to present a diff erent view of the price trend. So a three-session change that provides no insight may be blended into a single candlestick that provides a strong indication.
International Business Machines (IBM) 40-point scaling
Properly applied, blending is nothing other than a change in the period analyzed. Just as traders may study charts on the basis of an hour or 20 minutes rather than a full day, the defi nition of a session can be expanded to cover several days.
Blending is an eff ective technique if used cautious-ly and oncautious-ly in circumstances justifying it. However, it is crucial to observe that a period-to-period compari-son is going to be distorted if the blended candlestick is compared to previous single sessions. When the sessions are dissimilar, the outcome has to be viewed with the distortion in mind.
It is also possible to blend any set of candlestick out-comes in a way that distorts the true meaning of the indi-cator, so that the insight expected is obscured. For exam-ple, one of the more interesting three-session indicators is called a squeeze alert. Th is involves a long candle ses-sion followed by two sesses-sions each smaller on both the opening and closing (they are squeezed within the range of the fi rst session). A bear squeeze alert starts out with a white session, but it predicts a coming price decline. If all three of these are blended, it looks like a long white candlestick, which is bullish. In this example, the blend-ing of a strong bearish signal creates a bullish signal.
4. Forcing indicators. Th e quest for “good” and “reli-able” information is a constant struggle for chartists.
Knowing how to interpret a signal is never easy, and one pitfall is to seek information where none exists.
During sideways price movement, for example, it is quite possible that no important information is going to develop. Traders have to wait out the indecision
between buyers and sellers before a new trend devel-ops. Any indicator must be confi rmed before acting on apparent signals.
For example, the chart for Apple (AAPL) displayed a long period of sideways movement and indecision.
At such times, any indicator must be confi rmed by other indicators before taking action. Th ree examples of this are shown in the next fi gure.
Th e fi rst looks like a strong uptrend. Four sessions move upward with price gaps and it would be easy to assume that the price direction is likely to continue.
As it turns out, this would have been a forced assump-tion. Without confi rmation, some signals—like this one—are false leads. Th e same is true for the second signal, an apparent start of a downtrend. After four black sessions, traders might easily assume that pric-es will continue moving south. Finally, the black spric-es- ses-sion might appear to provide a reversal and pending downtrend, but prices continues to drift sideways.
Th is example demonstrates how easily indicators can be forced. Traders in long positions may fi nd themselves seeking bullish signals because, if price does turn upward, they will make a profi t. However, in some cases a bullish signal will not be found be-cause price is going to move sideways or down. Th e pitfall is a form of wishful thinking, and as a matter of gaining experience traders will benefi t from know-ing about this danger and strivknow-ing for objectivity. In other words, it is more rational to study the signals to judge price movement, rather than seeking the type of price movement a trader desires.
Traders struggle will these pitfalls every time they look at a chart. Maintaining objectivity is diffi cult because everyone has specifi c biases toward bullish or bearish movement, as well as toward stocks they love or hate (of-ten not for rational reasons). Th e truth, however, is that a trader will maintain objectivity by ignoring the emotional tendency to like or dislike a particular company or trend, and to recognize the one universal truth about technical
analysis: It is possible to achieve profi ts in all types of markets, including bullish, bearish, and sideways trends.
However, in order to be able to position themselves to profi t, traders are going to have the best results when they remain analytical and avoid following the crowd or reacting the way most traders do, emotionally.
Th e overall pitfall to trading is to “gut react” to price changes. When prices rise strongly, the emotion of greed Apple (AAPL)
forcing indicators
beginning of a downtrend?
beginning of an uptrend?
reversal signal?
causes a majority of people to jump into long positions.
Th is often takes place right as prices peak. When prices fall, a majority tends to panic and sell to avoid further losses, and this is most likely to happen at the price bot-tom. So instead of applying the “buy low and sell high”
approach, the outcome of this broad pitfall is to “buy high and sell low.”
Th e contrarian approach to trading is the best way to avoid following the crowd and timing entry and exit poorly.
By recognizing that the emotions of greed and panic domi-nate short-term trading, traders can adopt a smart strate-gic approach and move opposite of the majority. A market adage summarizes this approach well: “Bulls and bears can make money, but pigs and chickens get slaughtered.”
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C
onfi rmation is an important aspect of technical analysis, notably when analyzing candlestick forma-tions. It is the observation of separate and independent signals that verify what the candlestick pattern predicts.For example, a candlestick reversal may be confi rmed by tests of resistance or support, momentum indicator changes, or moving average-based analysis. Two or more candlestick indicators may occur in proximity, providing very strong confi rmation.
Confi rmation is the core concept of technical analy-sis. Candlestick patterns and indicators are valuable additions to other technical signals, either as confi rm-ing indicators or as leadrm-ing indicators that may be confi rmed separately. A test of resistance or support, for example, may be fi rst made by a familiar technical signal (such as head and shoulders or double top or bottom) and then confi rmed by strong reversal candle-stick signals. Or a candlecandle-stick reversal may fi rst appear and then be confi rmed by failed tests of resistance or support. Th ere are many possible combinations
of cross-confi rmation between Western and Eastern (candlestick) signals.
Traders rely on confi rmation to improve their timing of entry and exit. Th e concept is necessary because no single indicator is always reliable. Even confi rmed signals may fail; however, with the use of confi rmation, the ratio of successful trade timing improves and failed signals are more easily spotted when secondary indicators contra-dict rather than confi rm what the initial signal indicates.
Confi rming indicators are those indicators occurring immediately after an initial indicator, or at the same time, when both point to the same price action expect-ed to follow. A confi rming indicator may be basexpect-ed on Western technical analysis or on Eastern (candlestick) signals or both.
A confi rming indicator may also consist of a second sign of the same type. For example, an initial candlestick rever-sal may be followed by an equally strong but diff erent can-dlestick revealing the same potential. When this occurs, the reliability of the dual signal is exceptionally strong.