What You Don’t Know About Candlesticks

In writing my latest book, Encyclopedia Of Candlestick Charts, I made some startling discoveries. I used more than 4.7 million candle lines (price bars) for the research with data going back as far as the 1980s in hundreds of stocks, but not all stocks covered the entire period.

Reversals win
One famous technical analyst wrote that continuations perform better than reversals. That would make sense, since it is easier for price to swim with the tide than against it. There is just one problem: That’s wrong. I tested this on thousands of chart patterns and candlesticks with similar results for each. Reversal candlestick patterns outperform continuations 59% to 41% of the time.

One explanation is that the price trend in a candlestick continuation is tired and doesn’t move far. After a reversal, however, traders are excited and power the stock in the new direction, leading to an extended move. Those caught on the wrong side of the trade exit their positions and then jump on the new trend, powering it even more.

I don’t know if that explanation is correct, but I do know that reversals beat continuations.

Trade with the trend
If you’re a serious candlestick player, then you’ll want to know when candles work best. Since we know that reversals work better than continuations, make sure that the breakout direction agrees with the primary trend.

Technical Analysis Adapts And Thrives by Michael J. Carr, Cmt, and Amber Hestla

To begin thinking about the philosophy of technical analysis, first of all, we must consider why traders believe it works. The major textbooks in the field acknowledge that technical analysis rests on three basic precepts:

1. Market action discounts everything.
2. Prices move in trends.
3. History repeats itself.

These core beliefs date back at least into the 1800s and are a part of Dow theory. Some would argue that technical analysis can trace its roots to 18th-century Japan and the use of candlestick charts on rice futures contracts. There may be even earlier instances of technical analysis, but these three precepts lie at the core of any study of charts.

It’s all in the charts
Relying on candlestick patterns meant that the trader believed everything he needed to know was in the price chart. This meant that traders were considering the impact of weather on the crop, the possibility of disruptions in supply related to war or epidemics, and any other possible input to supply or demand. Economists quantified this belief into the efficient market hypothesis, and the first precept of technical analysis — “Market action discounts everything” — was recognized as an idea worthy of a Nobel prize.

Trends were a central theme in the idea behind candlestick charts and in the formulation of Dow theory. Technical analysis is grounded in the idea that trends exist and trend reversals dictate a need to change the ongoing investment strategy. Many indicators are designed to identify the direction and strength of a trend, and most research on technical analysis are dedicated to the second precept, “Prices move in trends.”

No investment methodology would work if the third precept, “History repeats itself,” weren’t true. Long-term investors and short-term traders attempt to find characteristics that worked in the past and assume they will work with some reliability in the future. Candlestick traders noticed certain distinctive shapes that occurred over and over again. When point & figure charts became popular, it did so because certain patterns proved to repeat themselves and these patterns offered clues to the future direction of prices. The same was true about bar charts, as repetitive patterns again proved to offer useful trading ideas.

Identifying Cup Formations Early

In my article “Identifying The Cup (With Or Without The Handle),” which appeared in the February 2006 Stocks & Commodities, I introduced a simple mechanical algorithmic method for identifying cup formations (also known as rounding bottoms) in their late phase. The core part of the algorithm was based on the idea of using a virtual grid on the chart. Since then, I have been asked by technical analysts to provide an algorithm for identifying possible cup formations in their early phase. This time I will show you how you can easily use the grid technique for spotting possible cup formations during their development.

The cup formation
In Figure 1 you can see a typical cup formation. I will not elaborate on the technical details of the cup formation (see “Related reading”). I will say that the identification method I introduced in my previous article on the subject was able to spot cup formations in their late phase (to the right after point C in Figure 1). The goal of the algorithm I will describe is to identify the development of such a formation before or near point C. “But are you sure a cup is being formed at point C?” you might ask. No, we are not. We can’t be sure that a specific formation is going to take place. However, if the price is about to form a cup, it has to form a half-cup before integrating the formation in its entirety. You might want to be informed that the price shows such intentions.

Hurst’s Cyclic Analysis by David Hickson

In the 1970s, an American engineer named J.M. Hurst published a thesis about why financial markets move the way they do. His expounded theory was the result of many years of research, and it became known as Hurst’s cyclic theory. Hurst claimed a 90% success rate trading on the basis of his theory, and yet his work has remained largely undiscovered and often misunderstood.

An almost-forgotten theory
Hurst published two seminal works: The Profit Magic Of Stock Transaction Timing, followed a few years later by a workshop-style course that was called the Cyclitec Cycles Course (now available as JM Hurst’s Cycles Course).

A number of enthusiastic advocates, prominent traders, and writers proclaim Hurst as the “father of cyclic analysis” and confirm the efficacy of the theory (including the late Brian Millard, who wrote several books about Hurst’s theory), but why isn’t it better known and more widely used by technical analysts? There are two possible reasons:

• First, Hurst’s cyclic theory is not easy. While it is beautiful and elegant in its essence, it is not a simple theory to understand or apply. The Cycles Course is more than 1,500 pages long, and most people take several months to work through it.
• Second, although the theory presented in both the Profit Magic book and the Cycles Course is the same, there is a vitally important distinction between the analysis processes presented in them. Hurst claimed his success on the basis of the process presented in the Cycles Course, whereas many people read the Profit Magic book and go no further, with the consequence they never discover the more effective process presented in the Cycles Course.
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Today’s K-Wave And Beyond by Koos van der Merwe, Cfp

When Nikolai Kondratieff developed his wave theory, he had never heard of technical analysis. He had also never met Ralph Elliott of Elliott wave theory fame, a man who lived in the same generation that he did, a man who expressed in a book he had written about Latin America: “There is a reason for everything and it is one’s duty to discover it.”

In 1946, Ralph Elliott published Nature’s Law: The Secret Of The Universe, and sold the first 1,000 copies quickly to financial analysts. I have often wondered whether he had read about Nicolai Kondratieff and his cyclical theory, which came to international attention in Kondratieff’s 1925 book, The Major Economic Cycles (also translated as Long Wave Cycle). Tragically, Kondratieff’s conclusions were seen as a criticism of Josef Stalin’s intentions for the Soviet economy, causing him to be sentenced to the Soviet gulag and ultimately executed in 1938.

Joseph Schumpeter in his 1939 book Business Cycles was the first to use the term “Kondratieff waves,” which means that Ralph Elliott could have been aware of them. However, there is no evidence that he ever tied his wave counts to the K-wave.

Source- http://www.traders.com