UNIT B| Analytical Tools

4. East Meets West

A major advantage of candlestick charts is that, since they are made up of the same information as bars charts (that is, Open, High, Low, Close data), all of the western charting techniques can be integrated to reinforce the candle signals.

By the time the Japanese created the candlestick technique, it was probably powerful enough to be used as a single analytical method. But today most analysts agree that the best results are achieved when combined with western charting and technical analysis. We would recommend at least to take horizontal support and resistance levels into consideration as explained in the previous section. But you might also add technical indicators to your chart such as an oscillator or some moving averages for further confirmation.

There are surely a myriad of ways by which traders can use western tools in conjunction with candlesticks. We suggest you to continue using whatever indicators you like to use and confirm or filter the indicator's signals using the candles. The other way around is also possible: to filter or confirm reversal candlestick signals with the use of, let's say, MACD.

For example, if there is a bearish regular divergence in the MACD indicator, which means price made a new high, but the oscillator didn’t, and a bearish shooting star and a dark cloud cover emerge on the candle chart, that increases the likelihood of a market turn. For detailed information on how to trade with divergences, please refer to Chapter B01.

As seen in the above example, candle charts revealed reversal signals earlier than lagging indicators. By the way, MACD divergences are great, aren't they?
Although the MACD bearish cross happened at the same price level as the close of the bearish engulfing pattern, the technical indicator triggered the signal nine hours later. Candlesticks are not lagging indicators, they are a visual expression of price action!

There is still another way to use signals provided by candlesticks: to exit positions. Imagine you are in an open trade and a reversal signal or a doji emerges. You might want to reduce the position size or exit completely in anticipation of a market turn against your initial position.

One way to increase the likelihood of a candle signal calling a reversal is to read an oscillator for overbought and oversold market conditions. The chart below illustrates a trade set-up using the Stochastic oscillator. The candlesticks printed two reversal signals at a resistance level. But while at the first candlestick signal the technical indicator was at 42%, the second time it was at 82% - that is to say overbought. This is a clear case where both tools converged at the same signal.

The use of Bollinger bands is also very compatible with the candlesticks because they are used to measure when the market reaches extreme price levels. The below set up shows the USD Index printing a hammer at a major support area. Notice also how the hammer candle is completely out of the lower band, adding more evidence that a change in the direction of price was about to occur.
Yet, to enter the trade, this triple confirmation is not enough - what else is of vital importance? The answer is: the risk to reward ratio. The bearish engulfing pattern could have been used as a first target offering a good ratio.

Using charting techniques, you would have said a double-bottom was forming. But it took 32 hours for that chart formation to break through the confirmation line. The market printed the bullish candlestick pattern at the prior support zone, providing an early entry signal.

This chapter has geared you with valuable analytical knowledge which, together with all the knowledge and insights provided along Unit B, has laid down a solid foundation for your career as a currency trader.