The Technical Approach

A technical approach to trading is very different from the ‘academic’ approach outlined above. Fundamental analysis gives us the economic numbers which drive economies and shape economic policy set by the central banks. Technical analysis, then ‘frames’ all this opinion and sentiment on a simple

price chart for us, to which we then apply several analytical techniques to reveal where the market is likely to be heading in the future. Technical analysis, is therefore much more of an art than a science, and if you wanted to create a picture in your mind, the see-saw is a good analogy. The fundamentals sit at one end, the technicals sit at the other, and the relational is the central fulcrum around which the markets move.

As you may know, there are hundreds if not thousands of books which have been written on the various aspects and approaches to reading price charts. Indeed I have written my own. However, what I would like to do here is to explain some of the basic principles which I use every day, and this will then lead nicely into the next chapter on volume price analysis, which is the cornerstone of my own approach to trading forex, and every other market. Let me start with price action and how it is represented, and I’ll get straight to the point here - I only use Japanese candlesticks for all my trading, as I find them powerful, descriptive and clear, particularly when used in conjunction with volume. If you have never seen a price chart before, or indeed the term candlestick may be new to you, let me explain with a simple chart.

Fig 5.10 - Japanese candlestick chart

There are many ways to present the price action on a chart, but in my humble opinion this is the best, and the one I have used for over 16 years. It works, and is the one you will find in virtually every trading room around the world. The bars are referred to as candles or candlesticks, simply because they resemble a candle, and indeed we call the tails at the top and bottom, wicks. Therefore, for the remainder of this book I will refer to them as candles (except when I forget, and call them candlesticks!)

Each candle reports four prices during the session, whether this is a 1 minute chart or a 1 day chart. These are the Open, the High, the Low and the Close, and you can see these in the little diagram to the right of the chart, which I hope helps to explain. Now, of course price goes up and down during any trading period, and in the example here, I have used an ‘up’ candle, which is shown in blue, on the right. So how is the candle created?

Simply as follows: the price opened, and then at some point in the session, touched a low, before moving higher to touch a high, finally closing below the high of the session. In this case, the close is above the open, in other words the price action was higher in this session, and an ‘up’ candle was duly created. We also know that the low of the session was below the open, and the high of the session was above the close. It is this action which gives rise to the so called ‘wicks’, the thin narrow lines, which appear above and below the candle. I’ve shown several of these on the actual chart and as you can see, we have a n upper wick when it appears above the candle and a lower wick when it appears below. The solid centre of the candle, is referred to as the body.

The body of the candle is painted either blue or red (or whatever color you like - this is my preferred, but you can choose your own colors), which then denotes whether the candle closed higher or lower in the trading session, which is one of the many beauties of candles. You have an instant visual picture of the price action. Sometimes, the open and close are identical, in which case there is no body at all, but just a line. This is a particular type of candle which I will explain shortly, and is one with either no, or a very small body. We have one or two in this chart as you can see, where the body of the candle is very small.

There are many different types of candles, and candle patterns, that we see every day on our charts, but what I would like to do here is to introduce you to the most powerful candles that we look for all the time, and I’ll explain why as we go along. In simple terms, these are the candles, which when validated with volume, give us terrific signals of potential turning points and reversals in trend. In other words, they are an early warning signal that the market is about to turn, and we should pay attention!

To be honest, if you simply spent your trading career just studying these candles, and trading accordingly, you would be successful - that’s how powerful they are, based on price action alone. Imagine how much more powerful they become once we add volume into the equation. The candles that I am going to explain here for you are based on over 16 years experience.

They are not based on hypothesis, but are the candles which have netted me more money than all the others put together, so are deserving of close attention. And if you take nothing else away from this book, please study and understand these candles for yourself. They are so powerful and work in all timeframes.

Fig 5.11 - The hammer candle

The hammer really describes the price action for this candle perfectly. It is hammering out a bottom, which is why it is called the hammer. Let’s explore the price action here in a little more detail and examine why this candle, and the others are so powerful.

This is the GBP/USD on the M15 chart (15 minute) and, as we can see, the pair has been moving lower in a series of steps. Finally on our chart we see the hammer formed, and immediately this grabs our attention. There are no hard and fast rules when it comes to the precise formation, as this is an art not a science. But the body of the candle should be small, and the lower wick should be long, and as a rule of thumb at least three times the length of the body. The body of the candle can be either red or blue, either is fine, and of course, on occasion, there will be no body. A perfect hammer if you like, with an identical opening and closing price.

But what has actually happened over the 15 minutes here in terms of the price action, and why is this candle so powerful?

The market has been moving lower, so we know that in general the UK pound is being sold and the US dollar is being bought. The price on this candle then opens, with selling of the pound continuing. However, at some point during this period, buyers come into the market, buying the UK pound and selling the US dollar. Ultimately, the sellers of the british pound are overwhelmed by the buyers of the US dollar, who stop the price moving lower, and start to take the pair back higher, to close somewhere near the opening price. You can think of this as a tug of war with two teams, which is essentially all the market is - the buyers and the sellers, the bulls and the bears battling for supremacy in every candle.

In this case, imagine we have two teams and a tug of war rope, with a white flag attached at the centre of the rope. Both teams then take the strain as the candle opens, but the sellers are much stronger and pull the rope further and further to their side of the line. The buyers are losing the tug of war at this stage, but then urged on by encouragement from their coach, they find some reserves of energy. Slowly but surely they begin to drag the rope back, until finally the match ends with the white flag back in the centre, where it first started.

The significance of the hammer candle is this. It is sending a clear and unequivocal signal that the sellers have been overwhelmed and that buyers have started to take control. It is therefore the first signal of a potential reversal in the trend. However, please note the word potential. All we know at this stage is that we are paying attention, and now need to validate this price action which will then give us some clues as to how far any potential reversal is likely to travel. And to do that we use... volume of course! Which I introduce in the next chapter. But for now, just remember, the hammer is one of the most powerful candle signals. It is sending its own signal, purely based on the price action, that the selling has been absorbed and the buyers are moving in, possibly to take the market back higher, which is exactly what happened here.

Fig 5.12 - The shooting star candle

The shooting star in Fig 5.12, is the mirror image of the hammer candle, and occurs at the top of a trend higher. Once again we are on the 15 minute chart, this time for the EUR/JPY. The pair has been moving higher in this time frame, where the market has been buying euros and selling the Japanese yen. Then we see the shooting star candle form, giving us a loud and clear signal that the market may be tiring, only this time with the buyers being overwhelmed by the sellers. This is the reverse of what happened with the hammer candle.

It is the same price action as with the hammer candle, but in reverse as it is the sellers who are coming into the market, and forcing the price lower. This time in our tug of war, the buyers win the first half of the battle, but the sellers then drag the rope back to the mid point as the candle closes.

Once again the same ‘rules’ apply, and the example here is perfect. In this case we have a nice deep upper wick standing like a flag pole on the top of a

mountain, with a very narrow spread body below. The upper wick should be at least three times the depth of the body, and can be either red or blue. It makes no difference. I should have mentioned it earlier, (apologies) so will mention it here!

You can see that the shooting star has a small lower wick in this example. This is fine and nothing to worry about, and in the hammer candle, the reverse would also be true with a small upper wick, also being perfectly acceptable. I cannot give you hard and fast rules here, but the smaller the better, and certainly no more than shown in this example.

Once again, as with the hammer candle, we then validate the candle using volume, but this candle on its own is sending a clear signal of a potential reversal, this time from bullish to bearish (buying to selling). All we have to do is use volume price analysis to confirm the weakness and to asses the likely extent of the trend lower. As you can see in Fig 5.12, a nice position developed shortly after.

But now - a word of caution. Markets rarely turn on a dime. They take time to reverse, and in this example we had to wait for two more candles to form before the pair rolled over. This is a feature of market behavior that you have to understand. The market is like an oil tanker. When the captain stops the engines, the vessel will continue to move on for several miles. Therefore, don’t jump in too early. Wait and be patient. These are warning signals of a potential reversal which we then validate with volume, before taking any trading decision. The hammer and the shooting star are the two most powerful candles that you will see on your price charts. They are the first sign of a change, a reversal from bearish to bullish or from bullish to bearish. They stand alone as the most powerful and descriptive candles that you can use in your technical approach to trading. As I said earlier, these two candles have made me more money than any other, and they will do the same for you as well. I cannot stress this too strongly. Furthermore, if these were the only candles you waited for in all time frames, this alone would put you on the road to success.

Fig 5.13 - The long legged doji candle

The doji candle is a powerful signal of market indecision, and the simplest way to imagine the price action here, is to go back to our tug of war analogy.

First the buyers pull the rope well over the gain line, then the sellers pull it back again, then the buyers start winning again and pull the rope back, before the sellers find some renewed energy once more and haul the buyers back again. The tug of war ends with the rope firmly back in the middle ground with no clear winner.

This is exactly what is happening in this price candle. There is no clear winner and the buyers and sellers are canceling one another out. In other words, the market is lacking direction and this is classically seen following a news release, with an initial surge in one direction, followed by an equal surge in the opposite direction, before the market closes, close to the opening price.

always pausing, but the key one to watch for, which is far more powerful is the so called ‘long legged doji’ candle. As you can see from Fig 5.13, the upper and lower wick are extremely long in comparison to the body, which is very small. The candle resembles a flying insect called a daddy long legs, which is extremely delicate with a small body and very long thin legs. The power of the signal comes from the length of the upper and lower wicks, which are sending a clear signal that despite the price volatility, which is reflected in the length of the wicks, the market is lacking direction at this price point. The example is from a four hour chart for the USD/CAD.

There are several things to consider with the long legged doji candle.

First, unlike our previous candles which are specific to points in a trend, the long legged doji candle can appear at the bottom of a bearish trend, or the top of a bullish trend. The signal it is sending is one of indecision and potential weakness. After all, if the trend were strong, then this volatility would have helped the pair continue in the direction of the original trend. It’s therefore an early warning of a possible change, in other words a market that has become tired.

Next, on its own it is a powerful signal, but this power is increased when it validates either a hammer candle or a shooting star candle. If, for example we see a shooting star, followed by a long legged doji candle shortly after, then this is confirming the shooting star, and sending an even stronger signal that the market is indeed weak at this level. Equally, in a down trend, if we see a hammer candle, followed by a long legged doji candle, then this adds further validation to the hammer candle, and again is a strong signal of a potential reversal at this level.

Both of these candles would also be validated using volume price analysis, and several other techniques which I will explain later in the book.

The candle itself can have either a red body, or a blue body, it makes no difference, but the body itself must be very narrow, the legs should be four to five times as long as the body, and where possible the body should be at the mid point along the length of the legs. In other words as evenly balanced as possible, since this then reflects the fact that the battle between the sellers and the buyers has ended in a draw. The legs themselves should be as equal in length as possible, giving a nice symmetrical appearance to the candle.

soon after the hammer or the shooing star, that the long legged doji appears?’, and the answer is no. Sometimes this candle will appear immediately after, and at other times it may be several candles later. It does depend on the forces driving the market at that time. For example, a shooting star may appear, well ahead of a major piece of economic news, which then triggers the long legged doji. There are no hard and fast rules here. And indeed, no doji candle may appear at all. But when it does, look back to the previous candles to see if it is confirming an earlier signal. There is no guarantee that the market will reverse, it is simply sending a signal of indecision, nothing more nothing less. Volume will then validate the price action, along with our other techniques which come later.

The last two candles are in fact candle patterns. In other words two candles together, and these are called the tweezer top and the tweezer bottom candles, and let me start with the tweezer top.

The tweezer top candle pattern in Fig 5.14, is created when two candles close with deep upper wicks, and where the high of each pulls back from the same price point. In doing so, this then creates the ‘effect’ of a pair of tweezers. Hence the name.

However, first things first. Whilst the hammer, shooting star and doji candles are appropriate for all time frames, and indeed all markets (not just spot forex), the tweezer top and tweezer bottom are very different. They are scalping patterns only, and for the forex market only. In other words, they should only