Confirmation for candlesticks

There are successful stock traders who base all of their trading decisions upon candlesticks alone. But most candlestick traders prefer the peace of mind provided by external confirmation, from at least one source, and such filtering can reduce whipsaw losses.

As an example, note the (created) stock chart, below:

The price action has sustained a nice downtrend from two resistance levels, its 20-day exponential moving average (EMA-20) trailing above the decline while the relative strength index (RSI) has remained beneath the midpoint 50 level. Such a situation is a lovely short sell, and in this example, it will be assumed that a candlestick trader entered the short at the gravestone doji, atop the dotted vertical line on the right side of the chart.

But two months into the trade, the selling momentum begins to fade and buying pressure enters the market. At first it’s only a few longer ascending (white) candlesticks, quickly reversed. Another gravestone doji forms, the first candle to the right of the third vertical dashed line, but it’s nullified by another long ascending candle the next day.

At this point the candlestick trader goes on holiday, leaving a close order should the market reverse against him. When he returns, he finds the market has indeed reversed, and the price is hovering near the stop loss he placed at his entry point, but not quite sufficiently high to trigger it. The price is also breaking above the 200-day moving average, often viewed as a dividing line by the bulls and bears and not a good sign for the stock’s future price movement.

He’s almost ready to close the position and take his remaining earnings off the table. But the second ascending candle, while substantial, is half the size of the first, and it’s followed by a descending candle, which in turn is followed by a long-legged doji in the harami position. As well, the RSI descends from the overbought level. The market is clearly indecisive with the stock’s current level. He decides to wait a bit and see if he can recover some of his lost profits.

The brief uptrend does reverse, the price ducking back beneath the MA-200 and the RSI descending. But then it threatens to reverse yet again, spiking through the pink bearish trendline and even closing outside it.

Should this trader close the position at this point?

The last candle is a hanging man, a bearish reversal signal and a clear sign of selling pressure still in the market. The RSI is still descending, and volume has decreased since the spike that formed the large ascending candle.

Despite the close beyond the downtrend line, all other signals still support the short sell. The trader adjusts the trendline to reflect the close and holds his position.

The trader is rewarded by recovering a chunk of his lost earnings. He exits the trade at the third consecutive long ascending candlestick, when it breaks the bearish trendline.