How to Use Candlestick Patterns for Swing Trading

Using Candlestick Patterns for Swing Trades

I was a mess.  I thought I had my sh*t together when entering swing trades, but really, it was a pretty sad picture.  Let me paint that picture for you…

I would swing trade based on support and resistance  lines, trendlines and trend pattern formations.  I also added indicators to help reaffirm that what I was seeing with the lines I was drawing on the chart were “confirmed” by the indicators.

I’d take click the mouse, enter my buy order and then hold my breath, for hours, days, weeks…watching to see if my trade would work out.  Sometimes it did and I thought I was a genius.  However, many times it didn’t and I’d watch my trade go in the wrong direction from the minute I bought it.

When I analyzed my win/loss percentage, as well as how much I gained on my winners and lost on my losers, I was treading water.  Hey, at least I wasn’t losing money and staying about level, but the mental anguish sucked.  I didn’t understand why sometimes my trades seemed to work out perfectly sometimes and others go horribly wrong.

When I analyzed the charts and looked at my analysis, sometimes it seemed liked the exact same scenario produced two different results!

You probably know what I’m talking about right?

I couldn’t figure out why.

In the effort to turn myself around to profitability, I started grabbing at straws, becoming more desperate, trying drastically different trades methods and ideas, following a few hot hands on Stocktwits…it sucked.  My account went into the red.

Finally I just stopped and didn’t want to even think about trading anymore.  Stepping back from the brink was helpful.  I was on the path to blowing up my account…again (Yes, I’ve done that before).

Over the years, I had developed quite a library of books on trading and investing.  I went back to those books.  I realized that it wasn’t the worst thing to have been staying even, not losing money and not making money.  Most traders can’t even do that.

The line and trend analysis had at least been doing that.

The addition of a few indicators I liked had at least been doing that.

I needed something more.  A tweak.  Something extra combine with my western style line, pattern and indicator analysis.  Finally, while re-reading a book on candlesticks, it came to me.  What about candlesticks?

Well, what about candlesticks?  I started trading again.  I started using them to help me decide if I should take a trade I was looking at or pass.  It took some time to get the feel for things, but I can tell you today that candlesticks helped turn my trading around.

Are candlestick patterns the end all and be all?  No.

Do candlestick patterns hold some secret trading holy grail, hidden behind mysterious names like Three River Bottom Pattern, Homing Pigeon and Inverted Hammer?  No.

Are some candlestick patterns better than other candlestick patterns?  No.

Candlestick patterns simply display the psychology behind pricing action.  After all, behind every trade in every market, there are humans.  Even  automated programs, the bots, moving millions and billions of dollars, are programmed by humans.

Fear and greed.  Candlestick patterns shine the light on the underlying emotions built into the market.

Getting an understanding of what is driving recent price action and where it might be headed is the key to trading and candlestick patterns are amazing at doing that.

To me, candlestick patterns have been a critical piece of the puzzle that I was looking for to help me understand whether to take a swing trade or not.  In this article, I wanted to provide an in-depth summary of candlesticks, and how I use them for my trading today.

Candlestick Patterns: Where the heck do they come from and what are they?

Candlestick patterns came from Japan, dating back to the 1600’s.  It’s an old form of technical analysis.  Candlestick charts are maybe the oldest form of technical analysis.  They were used by traders to trade contracts in rice.  Yep…futures contracts!  Started in Japan around the beginning of the 1700’S.

As trading in rice contracts developed someone named Homma Munehisa, a rice trader from Sakata Japan, became extremely wealthy trading using candlestick patterns.  He understood that by analyzing the emotions of the market, it would help him predict prices.  He wrote a book in 1755 about his methods of using candlestick patterns to predict prices.  In Japan, candlesticks became the standard method to chart and predict future prices.  And there they remained until the 1980’s.

Enter Steve Nison.  He is widely recognized as the person to bring Eastern candlestick charting to the west.  He wrote a landmark book, Japanese Candlestick Charting Techniques, that opened the door to the world of candlestick charts to everyone outside of Japan.
A single candlestick had 4 data points:

  • Open
  • Close
  • High
  • Low

 

 

 

 

 

With the candlesticks above, you can see that the entire bar representing all trading is neatly summarized within 1 candle.  A candle can represent 1 day, 1 week, 1 month, 1 minute, 5 minutes, 15 minutes…you get the idea.  It is a defined period of time, where the pricing is summarized by the very first trade (the open), the trading throughout the period (the candlestick “wicks” in the case above, and then the close.  If the close is higher than the open, it is typically filled in with green or white.  If the close is lower than the open, typical filled in red or black.

There are tons of variations that of individual candlesticks, but can be boiled down to various combinations of the following 2 candlesticks, the Doji and Marubozu.

Doji

Marubozu

   

 

You can see the doji has an open and close that are at exactly at the same price, with movement (high and low) up and down during the period, with the rare exception where the price never changed.  Then the Marubozu, where the open and close occur at either the high and low for the period.

The doji is typically meant to show indecisiveness, where the trading occurred up and down (back and forth all day), and then closed back at the same price as the open.  The wider the tails, the more wild manic the trading must have been!  The trend can go up or down here, nobody knows since there was an even battle between bulls and bears.

The Marubozu shows a decisive trading period.   Right out of the gates, the price went in one primary direction, with the highs and lows also being the close and open.

From these two patterns, you can have variations all in between.  Then you can start to combine multiple periods, usually 2, 3 and 4 period patterns.  Most of the popular patterns are 1 and 2 period, followed by 3 and 4 period patterns that are more complex.

Here is a relatively complete list from Wikipedia of the most common candlestick patterns below:

 

First of all…that’s a daunting freaking list of candlestick patterns, isn’t it?!  I know some people memorize and recite the names of all of these patterns like the Rainman and can draw them from memory.  I can’t.  Honestly, I could care less about knowing EVERY.  SINGLE. PATTERN.

However, you really do need to understand the basics behind these patterns, because then you know the psychology behind them.  That is critical.  Once you have that understanding, you can look at any chart and start to understand who might have control, bulls or bears.  You can determine the likelihood of whether a reversal might occur or the whether the prior trend will continue. 

You can also focus on a few patterns that really “speak” to you and incorporate them in your trading strategies.

I’m not a Candlestick Nazi with a rigid focus on 80+ candlestick patterns, but I do use almost 10 specific patterns in some of my screens for trading opportunities.  I also use other screens for trading opportunities that do not have rigid candlestick patterns within their triggers.

But even with those screens that don’t use candlestick patterns, I then look at the prior candlesticks to determine where the potential pricing action will head.

What are the GOOD candlestick patterns to use for swing trading?

Here’s my answer…they are all good.  None is really better than any other.  There is not a one single silver bullet that works.  If there was a “good” pattern that worked all the time, by definition it would not work because then everyone would be using it!  A holy grail candlestick pattern like this doesn’t exist because it would be arbitraged away to the point where it wouldn’t work anymore

Trading is essentially a zero sum game.  Someone wins, someone loses.  It’s actually less than a zero sum game because brokers are in the middle winning on every transaction because they are in between the bid and ask!

This is covered in a book that I highly recommend by Greg Morris, Candlestick Charting Explained, emphasizes that there are no such things as “good ones”.  Each pattern has a purpose, which is to show you the psychology and trading action and where the next set of prices could go.

What is also eye-opening about his book is his actual analysis of how candlestick patterns performed by examining TONS of historical price data.

The vast majority of candlestick patterns have a very narrow win percentage rate of barely 50%.  Some patterns that are very popular, actually have a NEGATIVE win percentage rates! 

The value of the patterns come with understanding the underlying psychology behind the pattern and the context.  Using that knowledge, you can incorporate candlesticks to drastically increase your win rate.

He actually shows this by combining candlestick patterns with indicators to create buy and sell signals.  It’s an eye-opening book and I recommend it if you want to use candlesticks as a part of your swing trading strategy.

I like to focus on three main areas when looking at candlestick patterns:

First, think about each candlestick as a mini-battle between bulls and bears…buyers and sellers.  Remember the Doji and Marabozu.  Who is in control?  Who won that battle?  Remember that a candlestick represents one period.  For swing trading I’m mostly looking at charts where 1 day represents 1 candlestick.  In that context, looking at a single candlestick you can say to yourself “who won today’s battle?”  Was it a draw (doji), or did bulls (Bullish Marabozu) or bears (Bearish Marabozu) win?

Second, look at the properties of the individual candle.

  • Wicks properties: Did it have long wicks? Short wicks?  A long top wick?  A long bottom wick?  No wick?  You get the idea…
  • Body properties: Did it have a tall body? A short body?  Was it an up or down body?
  • Ratio between the body and wick: Was the body very large, with small wicks? Was the body very small with large wicks?

All of these 3 properties are telling you something…

Let’s just look at this candlestick here:

 

This sucker is telling us that:

  1. The close was higher than the open
  2. The close was near the high of the day
  3. The price at one point traded significantly lower during the day

Think about it some more.  What does that long lower tail really show us?  I would say that it is showing a strong REJECTION of those lower prices.  Buyers stepped in.  It dipped, but then aggressive buying occurred and sellers lost control.  The close was also higher than the open, showing again the buying pressure.

Third, where is the pattern occurring?

If a reversal pattern occurs right at a support line, do you think that’s more significant than if it occurred in the middle of a trading range?  Yes, it would!  Take the pattern above with the long tail.  If that long tail, signifying rejection occurred right at a significant support line, your confidence in that support holding are greatly increased!

Remember what I had mentioned earlier about the analysis that Greg Morris performed on actual historical data…that candlestick win rates are very low and often negative?  Well that’s because he looked at the action of ALL instances when they occurred.   You should not be trading candlestick patterns blindly.  Just because a pattern occurs, does not mean you should take the trade.

The win rates are DRASTICALLY increased when you combine them with other methods, such as western trendlines and/or other indicators.  As they say in the real estate business, it’s all about LOCATION, LOCATION, LOCATION!

Believe me, it’s exciting how you can use this knowledge to increase the reliability of your swing trades!

Putting it all together:  How I use candlestick patterns for swing trades

I use candlestick patterns for my swing trading in two ways:

  1. With trendline support analysis
  2. With indicators.

I primarily trade positive swing trade reversals.  Buying a stock that has been in a short downtrend that is likely to reverse and move higher.

First, let’s look at the use of bullish reversal patterns with trend and support lines. 

Here is a chart showing a Bullish Matching Low (right before the shaded area that shows the results AFTER the signal occurred on the right side of the chart.)

Look at the candlesticks for the last 2 days before that shaded area.

  • The Bullish Matching Low is a 2 day pattern. This stock has been in a downtrend since around the middle of January.
  • It has been below the 10 day exponential moving average for the last 6 trading days.
  • Day one of the pattern a down day, a rather large candlestick with hardly any wicks. It opened below the prior close and went down all day and close near the low.
  • Day two of the pattern is an open above the close, traded all over the place but then closed at THE EXACT SAME PRICE as the prior day. Completely unchanged.

Here is what is significant…this pattern has occurred at an area that in the past had demonstrated rather significant buying support, represented by the BLUE support line.

Look at the two areas I circled.  The first circle on the left showed the end of a rather long downtrend, where PEGA bounced higher.  The second circle occurred after the bounce came back to the same support line.  What happened?  It bounced strong with a very strong day…look at that tall white candle.  This is a significant support line!

Remember this: a candlestick pattern has a much greater success if has something to back it up, which in this case is the fact that this pattern occurs at a prior, verified, support line.  If it occurred somewhere in the middle of the prior downtrend, I would not have taken this trade.  That is in no-man’s-land.  The fact that it is a bullish pattern, and occurred at the perfect area of support is significant.  Picture perfect!

Ok, let’s look at another chart!

Here is another Bullish Matching Low reversal pattern (the two red candles in the BLUE circle).

  • We have had a sharp downtrend, well below the 10 day exponential moving average.
  • The first day of the matching low is a huge red candle, with no wicks. That sucker opened down and went down all day to close at the low.
  • The second day opened higher and traded well below the open (the bottom wick), then moved up to close at THE EXACT SAME PRICE as the prior days close, to end the day unchanged.

There are three things to look at with this chart.

  • First, look at how this pattern is occurring right at a pretty decent support line that had 3 prior confirmed bounces at the end of October, and twice more in November.
  • Second, take a look at the RSI indicator (RED circle) in the banner along the bottom. It didn’t reach the oversold territory of 30 until the exact time that the Bullish Matching Low candlestick pattern emerged.
  • We have a matching low pattern

At this point, we have three different pieces of evidence pointing to a potential reversal!

Combining an indicator such as RSI with a candlestick pattern greatly increases your chances.  The RSI didn’t give an oversold reading at any point along that nasty downtrend.  If you bought this stock anywhere along that downtrend, you would have suffered a loss right from the start.

Ok, onto the next chart!

Here, I want to show you why you should not blindly jump on a candlestick pattern, unless you are combining it with other methods that provide confirmation, such as indicators and support and trendlines.

Take a look at the RED circle.  Wow, a Bullish Matching Low pattern!  Let’s take the trade right?!  Nope.

Ugly.

Yes, that is a reversal candlestick pattern that occurred.  But it is occurring in an area that doesn’t hold any significance to me at all.  It’s I don’t see strong area of support.  Look at what happened after the signal occurred…the stock continued to move lower.

But now look.  In the blue circle we have a Doji pattern.  That is the “cross’ with two long wicks and an open and close that are practically the same.

The Doji is an indecision signal.

  • The bulls pushed the price well above the open.
  • The bears pushed it well below the open.
  • The bulls pushed it back up to the open, where it closed.

Now what?  The next day, it could go lower and it could go higher.

However, this Doji Candlestick pattern occurred at an area of horizontal support.  Look at the blue horizontal line.  We have 3 prior touches.  It was an area of resistance on the far left where twice it was touched and pushed back.  Then it broke higher.  It was again confirmed towards the end of December, where it bounced higher after a downtrend.

And here we are again, with this Doji candlestick pattern occurring right at the horizontal support line.

Take a look at that upward trendline.  You can see why it is there when you look at the same chart with the longer term view below:

Here is the same chart, but with the longer view.  That upward sloping trendline has now been touched 3 times.

So we have two support lines (horizontal and upward sloping trend) that are occurring at the EXACT SAME price as the Doji Candlestick pattern.

The odds are saying that we could have a nice reversal here…and that’s what happened!

Swing Trading with Candlestick Patterns: Key takeaways

  • There is no such thing as “good” candlestick patterns. Stop searching for the best, secret weapon candlestick pattern that is going to unlock profits for you.
  • Candlestick patterns are a useful way to see the psychology behind the trading action. Learn to understand the fundamentals behind a particular pattern so you can get a feel of what is really happening.
  • LOCATION, LOCATION, LOCATION. Don’t rigidly follow candlestick patterns blindly.  Take a look at the context of the pattern.  Where did it occur?  Is it occurring at a significant area of support or resistance?  Is another indicator also giving the same signal?

I hope this was helpful to you.  I’ve used candlestick patterns to drastically increase the success rate of my swing trades.

Let’s stay in touch!  If you haven’t signed up for my mailing list, you can do that below.

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Happy trading!

Greedy

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