Candlestick Filtering

Candlestick Anatomy

A candle is made up of two primary components:

  • The Body (the rectangular part): Represents the difference between the open and the close price.
  • The Upper and Lower Shadows: Show the difference between the body and the high and low prices reached.

Key Elements for Analysis

When analyzing a candlestick, three elements are important:

1. Color of the Body

  • A Green Candle is bullish.
  • A Red Candle is bearish.

2. Size of the Body

  • A Large Body indicates that either buyers or sellers were clearly winning (e.g., a large red candle shows sellers were in control).
  • A Small Candlestick represents a consolidation of price where there was no clear winner.

3. Length of the Shadows

The longer the shadows, the more volatile the price action.

The various combinations of color, body size, and shadow length can be analyzed to predict future price movements.

Using Candlesticks as a Trade Filter

Candlesticks are often used as an extra filter for further confirmation before entering or exiting a trade.

When an entry signal is present:

  • For a Long Position (Buy): The execution can occur above the high of the candle that generated the signal.
  • For a Short Position (Sell): The execution can occur below the low of the candle that generated the signal.

The same filtering technique applies when setting stop losses and when exiting an existing position.

Reversal Candles

Reversal candles are useful triggers because they indicate a shift in momentum.

Bearish Reversal Candle Definition

A bearish reversal candle is a candle that closes below 50% of the body of the last big bullish candle, reversing the price action of that green candle.

If a bearish reversal candle forms during a rising price action, the short position should be executed below the low of this candle.

Bearish Reversal Pattern Examples (The 50% Rule)

  • Pattern 1 & 2: The bearish candle closes below 50% of the previous big bullish candle and is therefore confirmed as a bearish reversal candle.
  • Pattern 3: The candle does not manage to close below the midpoint (50%) of the previous significant bullish candle and cannot be considered a reversal candle.
  • Pattern 4: The reversal candle does not need to be immediately adjacent. The second bearish candle acts as the reversal because it managed to close below 50% of the green candle's body, indicating the market failed to continue higher.

Bullish Reversal Candle Definition

A bullish reversal candle is a candle that closes above 50% of the body of the last big bearish candle.

Bullish Reversal Pattern Examples (The 50% Rule)

  • Pattern 1 & 2: The bullish candle closes above 50% of the previous big bearish candle and is therefore confirmed as a bullish reversal candle.
  • Pattern 3: The candle fails to close above the midpoint (50%) of the previous significant bearish candle and cannot be considered a reversal candle.
  • Pattern 4: The second bullish candle is the reversal candle because it is the candle that managed to close above 50% of the previous big bearish candle.

Detailed Summary

The provided text outlines the structure and analytical use of financial candlesticks, particularly focusing on how they function as a filtering tool for trade entry and exit. A candlestick comprises a body (representing open/close prices) and shadows (representing high/low prices). Analysis hinges on three elements: color (Green=bullish, Red=bearish), size (large=clear winner, small=consolidation), and shadow length (longer=higher volatility). Candlesticks are used to confirm signals, with execution points set above the high for long positions and below the low for short positions. Crucially, the text defines reversal candles using the 50% Rule: a reversal is confirmed when a candle closes beyond the 50% midpoint of the prior significant candle's body, indicating a shift in momentum.

Key Takeaways

  • A candlestick consists of the Body (open/close difference) and Shadows (difference between body and high/low prices).
  • Key analytical elements are Color (Green/bullish, Red/bearish), Size (large indicates control, small indicates consolidation), and Shadow Length (indicates volatility).
  • Candlesticks serve as a trade filter for confirming entry and exit signals.
  • For a Long Position, execution occurs above the signal candle's high; for a Short Position, execution occurs below the signal candle's low.
  • Reversal candles signal a shift in momentum.
  • A Bearish Reversal Candle must close below 50% of the body of the last big bullish candle.
  • A Bullish Reversal Candle must close above 50% of the body of the last big bearish candle.
  • The 50% Rule does not require the reversal candle to be immediately adjacent to the significant prior candle.