It’s a sobering thought that one of the most common forms of technical analysis, the candlestick, has been used in ‘markets’ since the 18th century. This cornerstone of analysis has stood the test of time since adopted by modern day traders to attempt to predict which way the markets will move with a degree of certainty. Originally used by Japanese merchants, to determine the demand and supply/the buyers and sellers of rice and other commodities, the indicator is irreplaceable for many traders. However, the candlestick, when used as a price action indicator, is not infallible. Similar to any other indicator it can’t predict the future, only give an indication as to which way a security may move.
Candlestick charts are thought to have been developed in the 18th century by Munehisa Homma, a Japanese rice trader of financial instruments. They were introduced to the Western world by Steve Nison in his book, Japanese Candlestick Charting Techniques. The candlestick chart is principally a style of bar-chart used primarily to describe price movements of a security, derivative, or currency over time. It is a combination of a line-chart and a bar-chart, each bar representing the range of price movement over a given time interval.
In Beyond Candlesticks, Nison says; “However, based on my research, it is unlikely that Homma used candle charts. As will be seen later, when I discuss the evolution of the candle charts, it was more likely that candle charts were developed in the early part of the Meiji period in Japan (in the late 1800s).”
Combined with the introduction of candlesticks we’ve experienced a huge surge of indicators being invented, many of which we refer to in our trend trading analysis published each week on our Traders’ Corner blog. In which blog entry we always explain that the indicators are not predictive, all indicators lag, none lead and that includes candlestick where many traders can be fooled by what they perceive as price action, which is no more than random market noise. Once traders accept that they can’t predict price with any degree of certainty, but can make a reasonable prediction (based on previous patterns) where price may be headed next, they can begin to overcome one of the major hurdles to their trading success.
The educated guess arrives after many periods of education
We use the phrase “educated guess” regularly in the English speaking world, and without a doubt we take educated guesses when attempting to predict which way price will go next. The simple truth, which many traders fail to accept, is that whatever method we choose to determine price movements none are infallible. But as the title suggests, once we accept the randomness of price movement we can begin to regard the market in a different light and make rapid progress as we develop our ‘edge’.
What is an edge in trading and how it can be applied
Many readers will be familiar with the writings of Mark Douglas, a trading psychologist who specialises in shifting traders’ market perceptions. His book, “trading in the zone” has become folklore in the trading community. In this book Mark cites his five fundamentals of trading, for any in our community who haven’t read these before you could do a lot worse than printing them off and positioning the words close to your trading station.
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- Anything can happen.
- You don’t need to know what is going to happen next in order to make money.
- You need an edge.
- There is a random distribution between wins and losses for any given set of variables that define an edge.
- Every moment in the market is unique.
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Points number 3 and 4 are the aspects we want to concentrate on in this article, firstly what is an edge? Perhaps the most concise description is a nugget of brilliance I came across several years back from an old contact that’s as ‘true’ today as it was when first discovered;
[quote]”A Trading Edge is a repeating circumstance, or set of circumstances that suggests there exists a greater probability of price moving one way, versus the other way, based on historical precedents. If the edge does not suggest a greater probability of price moving one way over the other, then based on historical precedent to that point in time, it suggests that more profit is available when it succeeds versus when it fails, sufficient to make a net gain over any given sample.”[/quote]
So what does that mean in plain trader language?
Repeating ‘patterns’, whether individual candlesticks action, or combinations thereof, are graphical representations of repeating market behaviour. The basis of successful technical trading is accepting none of us can predict anything (with any degree of permanence), we’re accepting that the best we can achieve is to develop our edge. Our edge is quite simply a greater probability of price moving one way over another based on previous market behaviour. But there’s another key aspect to making your edge work that inexperienced traders can often overlook, the edge must be repeated time after time.
Take your set up again and and again and again…
Point number four builds on the the probability traits of the edge we’ve defined for ourselves. In order for our edge to work we have to enact it continuously. What we can’t do is ‘pick and choose’ based on ‘gut feeling’ or a ‘sixth sense’.
We’ve all done it at times; you’ve lost two trades in a row, your set up appears for the third time and you don’t take it. You’ll either commend yourself for having the wisdom to see the opportunity wasn’t right, or be left cursing because you didn’t follow the plan. You have to follow the plan.
For your edge to work as outlined in point 3 you have to slavishly follow the point outlined in point 4. There can be no deviation. You either enter when your set up occurs manually, or you’ve already put the set up into your trading platform by way of an expert advisor. Whatever method you choose you must take each trade as the set up occurs. If you don’t you’ll find that you’re inevitably skewing the probabilities of your edge working.
Simplifying trading, by finding an edge that you can work in the markets time after time, will undoubtedly set inexperienced traders onto the correct path. It must be noted that many edges will work, but there isn’t that ‘Holy Grail’ that will work 100%, time after time. If your edge has has win loss ratio of 50:50 or above you’re on the right path. By exercising patience and applying that edge to the market, traders are giving themselves a terrific opportunity to build on their success.
