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Candlesticks

Ranges and day trading

Candlesticks give us five basic bits of information.  Where price opened, where it closed, the high and low of the range, and if the close was higher or lower than the open.

If the candle is green, price closed the time frame higher than it opened, if it’s red it closed below the open.

hammer candle

This example candle also shows us the expected relationship to the candles around it.  The hour before this was a big green candle that closed way above it’s open, and didn’t explore much higher.  Our example candle therefore did explore higher, as expected.

However, before it did that, it took back the entire range of the hour before it, then rapidly rejected back up.  If you looked at this as a mini range trade, you would say, when it left the range of the hour before, then quickly re-entered, you could go long, expecting the 80% rule, to retrace the entire range of the previous hour, which it did.

The quick rejection of the low left a long “tail.”  The tail, combined with a close higher than it opened, makes a very nice hammer candle, which is a bullish sign.  Sure enough, in the next hour, it did explore higher than the high of this hour.

And actually, we can see that it even gave almost exactly a 50% pullback on the next hour, before it proceeded to complete the impulse wave, which a hammer represents.  So once again, we happen to have a micro fractal of the phenomenon discussed “Initiative and Response.”

50% of hammer candle

In fact, in this two hour period, we had both types of trade, both a response, and an initiative trade.

First, when our example candle came back in to the range of the hour before it, it completed the 80% rule, by retracing the range of the hour before it, that was a responsive type trade.

Second, our example candle was an initiative move, by completely engulfing the range of the hour before it, and ending up well on top.  So in the next hour, the pullback to 50% of our hammer candle, provided an entry for a completion of the initiative wave.

Time frames

Candles can be used on any time frame: minutes, hours, days, weeks, months, even years.

Basically reading candle sticks is super simple.  They give us an indication of the sentiment of that time frame, and where the next candle stick is likely to explore, on the same time frame.

There are plenty of books or info sites about the meaning of candles, and a series of candles.  It’s very simple at its most basic, but can become very nuanced to a skilled reader.

Candlesticks were supposedly invented by a Japanese rice trader in the 1500s.  So lots of them have Japanese names.  It doesn’t matter what they are called.

Candlesticks are just part of the puzzle. “Man” does not trade by candlesticks alone.  But as a starting point, I’ll explain candles in a nutshell.

Here is a basic reading from a single string of hourly candles.

series of hour candles

  1. Starting with the first big red candle I highlighted with the grey oval. We can see price was still coming down hard, continuing from the hour before that.  Price did not explore much higher above where this hour opened, and then moved far down, and did not explore much below where it closed.  Therefore we expect it to continue lower.
  2. In the next hour, that I did not highlight, we can see the pace slowed. The range got smaller, and price did go lower.  But it was a red hammer candle, the reverse of the green one in the example above.  So again, we expect lower levels.
  3. Sure enough, in the next candle, price got a little lower. The second highlighted candle is slightly a hammer candle.  So it’s slightly bullish.
    (But the tails are almost the same length.  When they are exactly the same length, and price opens and closes at exactly the same level, it’s a perfect doji.  That is often said to indicate indecision.  It’s an equal power of buyers and seller, or equal lack of power, or interest.  If often occurs at the end of a big impulse, before price corrects in the other direction. )

In this case, both the hammer candle aspect of it, and the indecision played as expected, and price began to wander up in the next two hours.

  1. The next candle I highlighted is a lot like a doji. The tails on either side are give it a bigger range than the four hours before it.  That shows us interest is picking up in both buyers and sellers.  And sure enough, the recent uptrend starts to reverse.  The sellers start to gain control.
  2. The next candle I highlighted is a doji in the sense that open and close are at exactly the same level. But the tail on top is bigger than the one on the bottom.  And sure enough, from there price rolls over to the down side, over the next few hours.
  3. The second to last candle I highlighted is like a bull candle, in the sense that price tried lower, and rejected, leaving a tail. So that shows the buyers are starting to assert themselves.  But they couldn’t get it higher than the open of the hour.  So it ends up needing to explore lower.
  4. The next candle leaves and long tail, and closes exactly at it’s open, so again, it acts like a hammer candle, and so on.

Btw, at the end of the sequence, I just happened to capture a candle with a very long tail.  That was a dramatic moment.  I was there, and traded it.  So I happen to know the guts of that candle intimately.

Can you guess what happened in that candle, and what happened next?  It’s detailed in my post, Crude, In the Zone.

Would you have had the concept and confidence to take and hold a position based on that big tail, while your account value wildly fluctuated?

In my case, it’s taken a long time.  It’s one thing to look at charts historically.  It’s another thing to trade them on the “hard right edge,” as the candle is forming, burning.

I have needed to live though it many times, before I could begin to believe that I can make predictions that come out right more often than not, as well as how to put my money on the line, and set targets and stops based on those predictions.

Daily candles

A candle stick is a range of a time frame.  A day is by definition a range.  A daily candle graphically represents that range.  But not all ranges are created equal.

Some of the most important information in day trading are the five elements of a day, defined in a candlestick.

The opening and closing of a day, and the high and the low, and if the day closed above or below it’s open.

Everyone knows, or can learn in a minute, that this is the information a candle stick conveys.  But, for me at least, the significance of this data, and how to use it profitably, has been a slowly unfurling realization that continues to flower over years.

The candle stick, in fact, conveys more than 5 pieces of information.   It tells us how far above the closing and opening range (body of the candle) price explored.  How far above or below the opening it closed.  And it tells us how this time frame reacted to the same time frame before it.

I randomly selected the day 8-1-16, in oil futures, as an example.

CL 8-1-16 daily candle

Days are also broken in to a day session, and an overnight session.  The chart above is a candle that represents just the day session.

If you include the overnight session in your chart, the day will appear to open at the beginning of the overnight session the day before, and may give different highs or lows.

Leaving the same lines on the chart, but including the overnight session, the candle looks different.

CL 8-1-16 daily candle with overnight session

All of this information can seem confusing, but is valuable and useful, once you get to know your product.

How price behaves in response to previous levels, highs, lows, closes, opens, and ranges within the day or night, gives us clues about what it will do next.  Who is in control.

Different participants in different time slices of the day and night have different characteristics.  As we train, we get to know them, and the anatomy of our product.  The various participants are like organs, and we get to know how they each tend to behave.

Later, we see signs of how the organs are functioning, at a glance, in the simple daily candle.

But as we learn, we need to look deeper.  And in fact, we will always look deeper.  The candle is only short hand.  It is like the finger pointing at the moon.  We don’t want to focus on the finger, but on the object it’s indicating.  Then we get out our telescope, or microscope, stethoscope, metronom…whatever we find useful.

Looking at this this candle, including the overnight session, this is what the information is actually telling us.

CL 8-1-16 daily candle with overnight session levels marked

If we then zoom in to an hourly chart, dissect the day candle, and see how the overnight action took place, this is how it played out.

CL 8-1-16 hourly candles with overnight session

The main thing I want to convey, is that price reacts to the day before it, the range before it.

The earlier simplistic explanation of the hour long candle sticks gives us a rudimentary idea of how one time frame might behave relative to the one before it.

In this daily Crude example, we had a big red daily candle, and price closed near the low of the day.  So from our hourly candle study, we know it is likely to explore lower the next day, which indeed it did.

So if we had this idea, this was our hypothesis, that it would somehow take out Monday’s low on Tuesday, how could we have tried to find an entry?

Let’s look at the Tuesday open, in relationship to the Monday action.  Also, we should consider any history before Monday, where it was recently in this range.

The easiest thing for me to do is measure half of the entire Monday move, from high to low, including the overnight session.  As we can see, price topped out 4 cents above that level.  (I used Think-or-Swim’s handy dandy fib tool to get this measurement.  Probably my single most used tool.)

cl Tuesday in relation to Monday

So clearly, $40.86 was a great short entry.

We can also see that there was some back up above this level.  Places where price goes sideways and forms a range,  volume consolidates, and acts like a wall.  Price tends to move quick where it moved quick before, and slow where it moved slow before.

There is a reason for this.  Price is a reflection of market participants.  Where price went back and forth, it indicates that there were a lot of buyers and seller in that area.  When price comes back to that area, the same two-way interest tends to reappear, and slow price down.

Relationships to the day before

Where price opens in relation to the previous range gives us clues about how it might act next.

Price can open inside of the previous range or outside of it.  If it’s inside, it can be right in the middle, or near the top or the bottom.  If it’s outside of the previous range, it can be far outside, or very close.

If it is outside of the previous range, that is called a gap in day trading.  It only exists due to the overnight session.  There are no gaps in a series of 1 hour candles.  However, price moving very quickly is similar to a gap.  It moves quickly through an area where there are few buyers or sellers, auctioning higher or lower, to find a range the market values.

There are rules of thumb for how price is likely to behave, depending on it’s relationship to the former range.

  1. If it gaps far away from a range, or moves quickly away, it’s likely to go father in that direction. That is like an initiative move.  In a gap situation, Peter the Shadow trader calls this “gap and go.”  The rule for how to play this is similar to how to play an initiative move.  It might come back to 50% of the overnight range, but not back to the former day’s range, then continue away from it.
  1. If it moves slightly outside of a former range, it’s more likely to come back in to the former range. Then there are two choices, it either completely retraces the former day’s range, or it comes back to somewhere in the middle, then continues back out of it, in the direction it started outside.
    These two situations are subdivided like so:

    a. If price spends more time outside of the former day range before re-entering, it’s more likely to only move back to the middle of the former range, then reject away.
    b. If price is only slightly outside of the former range, and quickly re-enters, it’s more likely to either retrace the former day range, or get stuck inside it all day.

    3. If price opens inside the former day range, it’s likely to be choppy. That means it’s still tangled up with the same set of buyers and sellers who batted it around in this area before.  In this case, we have to either try to scalp tiny moves, or wait to see if one side takes control, and pushes it with conviction.  This is called an “inside day.”  The choppy action is also called an open auction.

As we can see from the oil example above, price did indeed, in this case, open inside the former day range.  But it did not act very choppy.  It only moved up 18 cents from the open, then sellers firmly took hold, and it trended down all day, right through the former day range, and through the bottom.  Why?

In this case, the former day range was not back and forth.  It was not an open auction.  It was one continuous down impulse.  So this is an example of how “not all ranges are created equal.”  Even though Monday was by definition a range, it was the range of an impulse.

If Monday had been a sloppy, two way day, that went back and forth, covered the same ground over and over….then Tuesday had opened inside of that noise, Tuesday would have been more likely to be similar.  Instead, Tuesday was simply a continuation of Monday.

In a nutshell, the next day is most likely to complete whatever action the day before it appeared to telegraph.

Time slices, and the messiness of actual trading

Lastly, we’ll take a brief look at time slices within a 24 hour period.  This is an area of nuance that, for me at least, required a not only theory, but some life experience, before I started to get the hang of it.

Additionally, various products have slightly different time slices.  Oil opens a half hour before the US stock market, and closes an hour and a half before stocks close.

In oil, like many products, the opening and closing hour trades are often seen as important.  Bigger players trade during those times, and the smaller players that follow tend to follow through with the directions the bigger players initiated.

The first hour tells us a lot about how the rest of the day will play out.  And the last hour gives us clues what the over-night session will do, and what will happen the next day.

The high and low of the first hour are called the Initial Balance.  It’s the first hour candle of the day.

So on our Tuesday chart, which we’re trying to trade, based on the Monday candle, range and action, I’ll mark the initial balance with IBH and IBL.

Tuesday IBH and IBL

In this case, we don’t get an easy read.  It looks like a bull candle, right?  If I had cherry picked this day, to show how the first hour can give you a lot of confidence, this would not have been the day.

The only way you could have held a short, from that exact top, was by keeping a much bigger picture in mind (the mid of Monday, including the overnight session.)  That is, you would have entered short at the 50% level, and said to yourself, “I will hold this hell or high water, unless it gets x cents above that level, in which case I’ll stop out.”

If we zoom in further, we see, on this day, the sellers did not appear until 7:10am PST.  10 minutes after the first hour ended.  So the only way you got this trade was, shorting the big picture idea, or on a break down below initial balance mid, 1.5 hours in to trade.  That gave a perfect 50% pullback of the down move off the high of day, which then of course continued down the rest of the day.

Tues 710am selloff

$40.60 was the open.  The first move was down, to $40.30.  Over the next 45 minutes, price moved up to $40.94.  That was an impulsive move.  It is defined as impulsive if it is more than one standard wave length (standard deviation) in that product for the time frame.  We are looking at the smallest time frame, and the smallest standard wave size in oil is 30 cents.  Anything smaller than that is noise.

So the up move was impulsive, and the mid of that move was right at the open, $40.60.

And if we look closely at the impulsive up move, it paused briefly at $40.83, pulled back, then continued.  That little pullback, and continuation, technically “finished” the move.

The next expected move was corrective.  The corrective wave should have two parts.  We see it pulled back from $40.94, then bounced.  Then the second part of the correction came.

If that second part had stopped at $40.60, it would have been expected to continue up.  In fact, $40.60 was a reasonable long entry.  If taken, it was obviously a loser.

But $40.60 broke, the down move had become the new impulse.  So a quick witted trader would have stopped out, and begun looking for a short, to continue the down move.  The perfect entry came at 7:30 am, when price touched 50% of the down move, continued down, and never looked back.

All this could easily confuse a trader.  And mis-interpreting this kind of action leads to “getting chopped up.”  Thinking, “It’s a long.  No.  It’s a short.  No.   Etc.”  Repeatedly stopping out and losing.  That’s why it’s said, “trading is simple, but it’s not easy.”

One of the things that is not easy is to process all this in real time.  There is information on various time frames.  Why did this confusing action make sense, and not?

Price opened inside of yesterday’s range, so chop is common.  We often go back through the open, and back through mids of impulses, while in range.  However, there was the bigger impulse of Monday to lean against.

On the other hand, the actual trade of the day contradicted the first hour traders, who are usually relatively big, compared to the rest of the day.  But on this day, they were smaller, compared to the scale of Monday.  Plus, since price went through the mid of the first hour up impulse, what reason could we have to think it would hold the mid of the down impulse?

We couldn’t know for sure, and might have lost twice, if we’d gone long on the first mid, then short on the second mid, and the second mid didn’t work.  But it did, so if we didn’t take the second trade, because we were sulking about the first miss, we’d have lost money on the day, rather than vice versa.

Which is one reason that some people discipline themselves to take every trade that fits their plan, on principle.

And one thing the second mid trade had going for it was, that the down impulse had been one wave, it hadn’t completed yet.

This discussion took us in an unexpected direction from the time slice idea.  A cherry picked chart would have showed how the first hour traders set the tone of the day, rather than end up getting run over.

So, let me briefly outline the time slices.  The first hour and last hour, bigger traders tend to come in.  The middle of the day tends to get slow.  After close, the Asian session starts, in oil or Indices.  The Asians often complete the action the day suggested.  At midnight Pacific Time the European session starts.  Sometimes news in Europe will reverse the Asian action….or accelerate it.  Often there is an abrupt move at midnight.

And of course, news days trump all these phenomena, and often spur trends.  In oil, inventories almost always do.

The main point of the time slice discussion is that time slices exist, and it’s helpful to get to know them for products you trade.

And it’s also the conclusion of looking in to the guts of a candles.  Like human bodies, candles on charts have internal organs.  Sometimes they fart, or their hearts race, or a mood moves them.  Sometimes bigger candles eat smaller candles.

 

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