Candlesticks And The J-Hook

01/04/06 02:10:15 PM PST

by Stephen W. Bigalow

Combine candlestick signals with technical patterns.

Candlestick signals provide a tremendous advantage to investors when evaluating market trends. The implied logic built into the signals creates a platform that always places the probabilities in the candlestick investor's favor. Not only do the signals work well on their own, but applying candlestick signals to easy-to-recognize trading patterns also creates a platform for taking advantage of high-profit moves.

Ever hear of the "Santa Claus rally"? It's the statistically expected rally that appears during the last few trading days of the year, but it doesn't happen every time. So how do you prepare an investment strategy that could take advantage of a strong, expected year-end move that may not occur? Candlestick signals and trading patterns provide a format with which to position a portfolio to exploit situations like the Santa Claus rally.

HUMAN EMOTIONS
In the financial markets, fear and greed are the predominant factors when it comes to making investment decisions. That is why large-volume days are seen at reversal points: panicked investors sell out at the bottom, while the irrationally exuberant buy at the top. But who buys when the panicked sells, and who sells when the world looks great?

Once you understand that candlestick signals capture emotions in a graphic depiction, you can take advantage of a crowd's known weaknesses. The knowledge you gain from examining candlestick charts can ultimately help you eliminate that same weakness and profit in your own investment decisions. Combining the candlestick technique with other technical methods increases your chances of success.

THE JAY-HOOK
Let's see how we can use candlestick signals to help identify chart patterns. One powerful pattern that can help you predict trend and crowd emotions is the Jay-hook pattern, a variation of a 1-2-3 wave price move. Simply, the J-hook pattern is a pullback with a rounded bottom that starts a move back up, forming a hook (Figure 1). The J-hook starts with a strong uptrend that produces stronger than normal returns in a short period of time. This strong upmove is significant enough to create the normal wave pattern, followed by a reversal caused by profit-taking, followed by a declining trajectory of the pullback, and then the continuation of the uptrend. Most investors have difficulty understanding when to sell after a price has made a strong move, but — when used with candlestick signals — adding the J-hook pattern makes it easy to identify.

Figure 1: AN EXAMPLE OF A JAY-HOOK PATTERN. Note the pullback that eventually rounds out at the bottom and starts resuming the upmove.

The J-hook provides some simple profitable applications. The first uptrend usually shows candlestick sell signals when the initial upmove comes to an end. You could confirm this with other indicators such as oscillators. The top will form with the oscillator in the overbought area. When a J-hook sell signal becomes evident after the strong initial uptrend, you take your profits.

IDENTIFYING THE J-HOOK
The J-hook can be identified by analyzing market trends. For example, if a stock price had a strong runup while the market indexes had a steady uptrend, but if the market indexes do not appear to be ready for a significant pullback, then a strong stock move could warrant some profit-taking. After a few days of pullback, use the candlestick technique to watch for buy signals. Candlestick patterns such as doji, hammers, inverted hammers, and bullish harami can all warn that the selling is starting to wane. These signals indicate it's time to get out of the trade.

Taking profit when the first sell signals occur eliminates the downside risk. Even though the strength of the initial move may indicate that a J-hook pattern may be in the process of forming, there is no guarantee the pullback could not retrace 20%, 40%, 60%, or more. When it is time to get out, don't hesitate! Get out!

Suppose that small candlestick buy signals start to form after four days. There is nothing wrong with buying back into the position, as the trade's second entry now has clearly defined targets. The first target should be the of the recent high. Although it may not be a huge percentage return moving to that level, at least the probabilities indicate it should be profitable.

Candlestick signals can also be applied if that recent high is tested. If another sell signal occurred as the price approached the recent high trading level, that would indicate that the recent high was going to act as resistance. In that case, you would take quick profits and get out of the trade. On the other hand, if you saw strong signals as the recent high was breached, that would indicate the high was not going to act as a resistance level; a new leg of the trend could be in progress.

After a strong rally, we can expect a profit-taking period. Candlestick signals will allow you to better decipher whether the rally has ended. A full-scale reversal may have occurred, but seeing some candlestick buy signals after a few days of pullback allows you to formulate a strategy. That strategy should involve deciding whether to short in that market or reestablish long positions.

TRADING WITH CONFIDENCE
Understanding how to utilize candlestick signals and chart patterns allows an investor to prepare trade executions with confidence. As illustrated in Figure 1, a J-hook pattern was forming into the last trading days of 2005. Candlestick buy signals confirmed an uptrend probability after a strong rally occurred from mid-October into the end of November. This was a clear setup for a possible breakout, confirming the J-hook pattern.

Figure 2: LOOK OUT BULLS. The Jay-hook pattern that you see forming in the Dow toward the end of the year is indicative of a year-end rally.

Once there is a possibility that a J-hook pattern could appear, you can get ready to move one way or the other. If short positions were established at the first sell signals, then you can prepare to cover those positions when the time comes.

Individual stock positions can be evaluated with respect to the market trend when it comes to identifying a potential J-hook pattern. If, during a market uptrend, a stock price has moved up with greater magnitude than the trend in general, that becomes the first alert, since that stock trend is inordinately strong. A pullback occurring in that stock, when the market trend appears to be continuing, also gives rise to watching for a J-hook pattern to occur.

The ability to correctly project the current market trend makes long-term investing, swing trading, and daytrading much more accurate. Being able to implement candlestick signals into established chart patterns dramatically enhances the accuracy of trend analysis.

Stephen W. Bigalow is an author and the principal of www.candlestickforum.com, a website that provides information and educational material about candlestick investing.

RELATED READING
Bigalow, Stephen W. [2005]. High Profit Candlestick Patterns: Turning Investor Sentiment Into Profits, Profit Publishing.
____ [2001]. Profitable Candlestick Investing, John Wiley & Sons

Stay In The Market With Stop-And-Reverse

01/15/02 04:40:43 PM PST

by Rudy Teseo

If you hate being out of the market, you should take a look at this system.

The parabolic time/price system indicator was developed by J. Welles Wilder. Often referred to as parabolic SAR or simply SAR (for "stop and reverse"), the term comes from its appearance as a parabola when viewed on a chart.

A SuperCharts help file describes SAR as "a system designed to allow more leeway or tolerance for contratrend price fluctuation early in a new trade, and then to progressively tighten a protective trailing stop order as the trend matures." The indicator is a stop-setting entry and exit trading system designed to keep the investor in the market at all times. The idea is that if a trade is not continually producing profits, then it should be liquidated. But instead of waiting for the price to bottom and then re-entering with a long position, why not take advantage of the profit opportunities on the way down?

USING SAR

The SAR indicator displays as a series of dots one dot for each price bar, regardless of the time frame being used. In a long position the dots are below the price, and in a short position the dots are above the price. Using SAR begins with exiting your long position and entering a short position when the price falls below the SAR, and the dots switch from below to above the price. Likewise, you exit your short position and enter a long position when the price crosses above the SAR, and the dots switch from above to below the price. (If you have a very sophisticated charting program, it may be possible to have the trades entered automatically for you if you have the guts to follow any system blindly.)

CALCULATING SAR

The formulas used to calculate this indicator are:

SARb = SARp + AF(H-SARp)

SARs = SARp + AF(L-SARp)

Where:

SARb = The long-side sell stop price, at which you exit long and enter short

SARs = The short-side buy stop price, at which you exit short and enter long

SARp = The previous bar's SAR

H = The new highest price, since the current long trade was opened on a stop buy order

L = The new lowest price, since the current short trade was opened on a stop sell order

The SAR = The value returned by the parabolic function of your program.

AF stands for an acceleration factor that begins at 0.02 when the trade is opened, and increases by 0.02 each period that the price rises toward the highest level (H) since the trade was opened. The SAR moves up each period regardless of the price action. Thus, as the price starts to flatten, the price approaches the SAR until it crosses and creates the switch signal. You may anticipate the impending switch by monitoring the rate of change of the distance between the price and the SAR. You can make your trades several bars before the actual crossing and thus pick up a few extra points.

Naturally, you will not use this indicator by itself. The first rule in technical analysis: A good money management system is more important than a trading system. The second rule: Never use an indicator without confirmation.

In the following charts, I have used the directional movement index in the form of DMIp (plus) and DMIm (minus). More often than not, DMIp crosses above DMIm within a day or two of the SAR going long.

SOME EXAMPLES

In Figure 1 you can see a display of the SAR on a chart of International Business Machines (IBM). Note the short position as the market was falling on its way to the low of April 4, 2001. On April 9, IBM went long, coincident with DMIp (green) crossing above DMIm (red). Prior to this date you will see some whipsawing between March 26 and April 6. (No system is perfect!) The four bars flattened out before the SAR went short on May 7, foretelling a closure with the SAR. You could have gotten out at 118 instead of at 111 if you had heeded this warning.

Figure 1: International Business Machines (IBM). Here four bars were relatively flat, signaling a reversal in trend.

Figure 2 displays a chart of AOL Time Warner (AOL), with SAR and DMI. AOL went long one day after IBM, and the DMI followed two days later. SAR went short on May 29 and DMI also went south three days later. Again, several bars before the SAR went short, we saw the price approaching the SAR rather than moving away from it, signaling a closure with the SAR.

Figure 2: AOL Time Warner. Using the SAR with the DMI triggers some worthwhile signals.

Figure 3 displays a chart of JDS Uniphase (JDSU) with SAR. This is a good example of how the SAR can keep you out of trouble. JDSU is the kind of stock many traders would jump into as soon as the market appeared to be reversing. But after an initial long position on April 11 followed by DMI crossing six days later, you can see that SAR would have kept you out of any sustained long position.

Figure 3: JDS Uniphase (JDSU). Here's another example of how SAR can keep you out of trouble.

Parabolic SAR is not a panacea, of course, but if you haven't been using this unique tool, you owe it to yourself to at least try some paper-trading with it.

Rudy Teseo is a retired communications and computer consultant. He has also taught courses in investing, technical analysis, and options trading. You can e-mail him at rftess@juno.com.