It’s Not the Size of the Candle, It’s the Motion on the Chart

A common error that traders make is to misconstrue the significance, or lack thereof, of candlesticks in technical analysis. While it is true that a “hammer” candle (click here for definition) can potentially signal a bullish reversal, it also crucial to understand the implication in that definition. In other words, in order to have a bullish reversal, you must first need a prior downtrend. Otherwise, there is no bullish reversal to be had. In fact, when the hammer appears after a prior uptrend, it should actually be construed as a potentially bearish omen, since the buyers are now exhausting themselves amidst uncertainty. The candle is referred to as the “hanging man,” in lieu of a hammer in this context.

While all of this may seem obvious now, when you have money on the line it can be awfully easy to succumb to confirmation bias and view any hammer, regardless of location on the chart and regardless of prior price action, as bullish. Obviously, this can be a disaster for several reasons, not only because you neglect the prior price action, but also because even if there is a prior downtrend, there is absolutely no guarantee that a hammer will mark the bottom without upside confirmation first.

Thus, context and perspective via location on the chart and objective analysis of prior price action are absolutely essential when it comes to candlestick analysis. Using Berkshire Hathaway as an example, a few important points jump off the daily chart. First, the April 18th candle should have been viewed as a bullish hammer, given the prior downtrend. Note the upside confirmation, offering up a solid short-term trading opportunity to the long side. Next, note the April 29th shooting star candle, which should have been viewed as a potential bearish omen here given the prior uptrend (if it had come after a prior downtrend, the candle should have been viewed as potentially bullish and referred to as an inverted hammer).

Finally, and this is a bit more of an advanced concept, note the bearish abandoned baby three candle pattern over the past few sessions (I profiled the opposite pattern, bullish abandoned baby, here). Now, June 13th’s candle needed to be more prominent for the bulls in order for this to be by the book, but the psychology is still the same. June 14th’s gap higher in the form of a long-legged doji served as a trap to lure in eager bulls, who were then punished badly on Wednesday with a high volume day of relentless selling.

Normally, this would be an incredibly bearish event after a prior uptrend, and signal that a highly reliable reversal is upon us. However, in this case we are seeing this pattern after a prior steep multi-month downtrend. Remember, we must respect the implication from the word “reversal.” Here, there is no prior uptrend to reverse. In other words, it is far more likely that we saw selling exhaustion on Wednesday than it is that Berkshire is about to commence a fresh leg lower at this time.

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