TRADING SYSTEM DEVELOPMENT

Types of Trading System

There are two types of forex trading systems, the mechanical and discretionary systems. The trading signals that come out of the mechanical systems are mostly based on technical analysis which were applied in a systematic way (technical indicators, chart patterns, etc). Meanwhile, discretionary systems use experience, intuition or judgment on entries and exits.

Mechanical System Strategy

The signals for trading that result from the mechanical systems are mostly based on technical analysis which is used in a methodical way. The rules are not flexible/rigid. It is only a choice of having a trade or not. The traders of the mechanical systems are not so much vulnerable to feelings and emotions unlike the traders of the discretionary systems.

Advantages: Easily automated Efficiently back-tested Have very rigid rules Less susceptible to emotion trading

Disadvantages: Susceptible to inaccurate data generation from incorrect back-testing Ever changing market behavior History of profitability does not necessarily means future profits

Discretionary System Strategy

The discretionary systems utilize experience, judgment or intuition on the exits and entries. The traders of this system Traders need to train to look at which signals for trading have a higher chance for success.

Advantages: Easily adaptable to new market conditions Trading decisions based on trader's experience

Disadvantages: Cannot be automated or back-tested More risks

Creating a Trading System

A trading system contains certain parameters that determine entry and exit points for a given kind of equity. Such points (signals) are often marked on a chart in real time and prompt the immediate accomplishment of trade. The main parameters that compose a good system are moving averages, relative strength, bollinger bands, stochastic, and oscillators. These indicators have their own composition that creates the rules of any trading structure. Most traders spend a lot of time in providing trading system optimization for it is very important in avoiding unnecessary risks and performing better results to get as much profit as possible.

Like any other system, a trading system has its own advantages and disadvantages. One of the pros is that a trading system takes an emotional factor away from carrying out any trade. It is in human nature: to worry, to hope, to be afraid of something, etc. This feature is absent in this kind of system. It makes all calculations basing only on facts and clear logic. Another advantage of this system is saving a good deal of time for the trading tools that are used in the system perform work that a human did before. It is very convenient and gives much time for a person to be engaged in other spheres that needs improving. Meanwhile, one of the main disadvantages of a trading system is that it has a complex structure. It needs many factors, points, parameters, and rules to perform good results. Therefore, development of such trading system demands much time, gathering information about the smallest details, taking into consideration all tips, and certainly, great attention.

Moreover, in creating a trading system, one should take into consideration one's personality in order not to have much difficulty following it and as for it to generate consistent results. Most traders have problems with the system they use because they did not develop it. A system that works for one trader does not necessarily mean that it will work for other traders. Nevertheless, how do we know if the system a trader uses is the right one for them?

Time Frame

This is the first step a trader needs to answer oneself.

• How many hours do I want to dedicate to trading?
• Would I prefer sitting in front of the monitor constantly for several hours trading short (5, 15, 30 minutes) time frames that would require constant market monitoring and quick reaction to price moves or would I be more comfortable with setting up charts once or twice a day and never turn the monitor on during the rest of the time?

This is pretty much about the comfort and free time a trader have on his/her hands that could be spend in the forex market, however, while testing new strategies a trader may want to find out about their performance in different time frames and then choose the most accurate and profitable option.

Trading Tools

There are plenty of trading tools and indicators available to forex traders, but not all of them could give the fastest signal about upcoming trading opportunities. And any trader, of course, would want to get into the trade as early as possible and take maximum advantage of price moves.

Among indicators that could provide traders with a fast signal about upcoming changes and possible trading opportunities are indicators such as EMA (Exponential Moving Average), SMA (Simple Moving Average), Parabolic SAR; Fast, Slow or Full Stochastic, MACD and etc. The key idea here is to fully understand the principles of their work to be able to take maximum advantage of signals from those produced indicators.

One of the common ways to spot a trend reversal as fast as possible is by using Moving Averages. Such simple strategy as using 5 EMA and 10 EMA crossovers will show trend reversal and new trading opportunity at its earliest stage.

Another example would be stochastic lines crossover or MACD lines crossover. The concept on this is that when two lines cross each other, it means that the trend is changing to the opposite direction and a new opportunity for entry arises. By combining indicators on the one chart and experimenting with indicators values, traders can create an optimal and fast way to spot early trading opportunities.

Currency Pair and Finding Its Active Trading Hours

Currencies have their own characteristics or behavior. Some are extremely active like the GBP/USD or GBP/CHF, while some are quite consistent and steady like the EUR/JPY or EUR/GBP.

Different indicator set-ups and different values may be used to achieve best results for each currency pair. In addition, one good scheme is to find the most active hours for a chosen currency pair. Those hours of the currency's highest activity are easy to spot on the chart and should be used to get maximum profits during the trading session.

Additional Trading Tools to Confirm Signals Received Earlier

Once a time frame has been found, indicators and currency pair(s) that respond the best, the next step in creating a trading system is to find additional tools/indicators that will confirm the received earlier signals and give out either, a green light for action or save the trader from fake-outs.

As a confirmation indicator, a trader can use again any indicator or trading tool he/she is well familiar with. It is recommended that a trader should be more intricate in choosing additional tools to confirm the prior signal. It could also be the same indicator but with different settings. For example, with our initial 5 EMA and 10 EMA crossover method, a trader could use additional 20 EMA line and wait until 5 EMA crosses 10 EMA (which is the first signal) and continues through 20 EMA (which would be our confirmation for action). Or instead, a trader could opt for a MACD indicator, which is a good forex indicator that can reveal a lot of useful signals. By finding the best working value set-up for MACD (that has initial settings of(12, 26, 9) ) that will perfectly match one's time frame and particular currency behavior, a trader can use it as a great confirmation indicator to separate most promising trades from fake, loosing ones.
**Note that a person can find an indicator that can produce the best results by improvising and by being a curious trader.

Entry and Exit Points

After choosing the right indicators so that one supply and another confirms the signal, it is time to test and see how far a trader may go and how much he/she could earn.

A trader can enter as soon as a signal is confirmed or in order to find the best entry point he/she can switch to a smaller time frame and enter at the most advantageous point. There are two major styles for entry. First is for aggressive traders, which consists of immediate entry without waiting for the current price bar to close. The second method is to wait until the current price bar is closed and then enter the trade with the next bar if conditions have not changed and if the signal remains valid. This method is safer and prevents additional false entries.

For exits, a trader can either set an amount he/she wants to earn per trade (ex. 25 pips per each trade), or use trading tools that helps set profit goals (Fibonacci tool, Pivot Points studying), or use trailing stop (usually after some profits have been achieved, instead of closing a current position a trader can wait longer to achieve possibly greater results. To secure already made gains, traders use trailing stop so when the price again makes another positive progress this stop will move the same amount of times up, securing additionally gained profits. If the price reverts against the open position, trailing stop won't move, and thus, if hit will close the trade in profit nevertheless. Another logical way to set protective stops is by placing a stop depending on the market volatility at any given time. For this purpose, traders use the Bollinger Band indicator which generates so called "corridors" around the price actions. The wider the corridor the higher is the activity on the market and vice-versa. Measuring the width of the corridor (in pips) at the moment of entering the trade, traders can easily set up protective stop out of the range of market fluctuation, and thus protect him/herself from so called market "noise".

When opening a new trade, it is also important to calculate in advance how much one is willing to lose if the trade goes against him/her. Although everybody's goal is to create the best working system, losses are inevitable and therefore being ready to tell where one will give up their trade and cut their losses is as important as starting any trading in forex at all.

Calculating Risks in Each Trade

It is an important rule in forex to know the risks and rewards in each trade. A careful trader will enter the trade only if risks are at least twice lower than the potential rewards (E.g. risk/reward ratio required is 1:2.). Some traders however, will only consider 1:3 risk reward ratio to be worth trading.

Therefore, before opening a new trading position, a trader should define the level/point at which they will close the trade if it turns to be a losing one. Some trading tools like the Fibonacci or Pivot Point studying can give an absolute clue where the profits could be taken and where to be prepared to close the trade. Having such information on the chart helps to calculate risks versus rewards prior to entering the trade.

If the chosen indicators are simple and do not give such hints, simply know how much one can afford to lose and don't forget to set a stop loss order once in the trade.

Demo Trade Own System to Check If It Works

After composing the system, one should test it first before using it in an actual trade. Test, improve and finally write down the steps, settings and rules that will be used for trading. Once the system has been recorded, it is time for it to be tested.

Open a demo account with any Forex broker that offers such accounts and demo trade the system to see how well it will respond. It is strongly recommended to do the demo trading for at least 1 to 2 months for the forex market naturally has several periods during which its behavior may change dramatically. For example, the market was trending well for several months while testing the system, then one makes a decision to open a real account but the market decides to convert to its next stage and starts ranging, going sideways for an indefinite period of time. One has not tested his/her system under such conditions and it would be very disappointing to discover that the system does not perform as well as it was doing during the trending market or is unable to bring profits at all. There are other reasons like experience and intensive practice that should motivate new traders to stick to Demo trading for a longer period of time.

Meanwhile, one could also set a goal of how much money he/she wants to make in trading forex. Then try to trade in a demo account with a realistic account size to reach the goal. Once the task is accomplished, it might be the right time to think about trading with real money. The trading style one chooses is directly correlated to the time that person is able to devote to trading.

TRADING STYLES

Short-term Trading Style Scalping

FX Scalping usually involves opening and closing a position in seconds or minutes for a few pips of profit. Even though scalping involves the use of leverage, in which case higher leverage means higher risks, the short period of time when a forex scalper is in a trade decreases risk exposure that's inherent in trading or investing due to holding a position. If done correctly, scalping provides this additional degree of "risk control" that is not even present in regular day trading.

Day-Trading

Day trading is the buying and selling of currencies with the goal of making a profit from the difference between the buying price and the selling price. Day trading differs slightly from other styles of trading in that positions are rarely, if ever, held overnight or when the market being traded is closed.

This kind of trading was originally available to financial companies such as banks exclusively, because they are the only ones who were able to access exchanges and market data. But with technology such as the Internet, individual traders now have direct access too, which enables them to make the same trades at very low cost.

Long-term Trading Style Swing Trading

Swing trading is a style that traders attempt to capture gains in forex within one to four days. Swing traders use technical analysis to look for currency pairs with short-term price momentum. These traders aren't interested in the fundamental or intrinsic value of currencies, but rather in their trends and patterns. At-home and day traders mainly use this trading. Large institutions trade in sizes too big to move in and out of the market quickly. The individual trader is able to exploit such short-term market movements without having to compete with the major traders.

Position Trading

Position trading is a long-term style of trading where trades are held anywhere from several days to several months. This style of trading is the style that most long term investors fit into, but many of them do not utilize position trading to its full potential. Position trading uses long-term charts, including daily, weekly, and monthly charts.

Hedging

Hedging is a way of reducing some of the risk involved in holding an open position. There are many different circumstances in which a trader might wish to hedge. When someone mentions hedging, think of risk protection. A hedge is just a way of insuring an investment against risk.

Much of the risk in holding any forex position is market risk (if the market falls sharply, your losses may escalate dramatically). So if one has an open forex position with good prospects but thinks the currency pair may reverse against them, he/she may be well advised to hedge their position.

A foreign currency hedge is placed when a trader enters the foreign currency market with the specific intent of protecting existing or anticipated physical market exposure from an adverse move in foreign currency rates.

In simplest terms, a trader who is long a particular foreign currency can hedge to protect against downside risk exposure (a downward price move). On the other hand, a trader who is short a particular foreign currency can hedge to protect against upside risk exposure (an upward price move). Both speculators and foreign currency hedgers can benefit from knowing how to properly utilize a foreign currency hedge.

MARKET BEHAVIOR OF COMMODITY CURRENCIES

A Commodity Currency is a name given to currencies of countries which depend heavily on the export of certain raw materials for income. These countries are typically developing countries, such as Burundi, Tanzania, and Papua New Guinea; but also include developed countries like Australia, Canada and New Zealand. In the foreign exchange market, Commodity Currencies generally refer to the Australian Dollar, Canadian Dollar, and New Zealand Dollar.

Predicting the next move in the market is the key to making money in trading, but putting this simple concept into action is much harder than it sounds. Professional forex traders have long known that trading currencies requires looking beyond the world of forex. The fact is that currencies are moved by many factors, such as supply and demand, politics, interest rates, economic growth, and so on.

More specifically, since economic growth and exports are directly related to a country's domestic industry, it is natural for some currencies to be heavily correlated with commodity prices.

The top three currencies that have the tightest correlations with commodities are the Australian dollar, the Canadian dollar and the New Zealand dollar. Other currencies that are also impacted by commodity prices but have a weaker correlation are the Swiss franc and the Japanese yen. Knowing which currency is correlated with what commodity can help traders understand and predict certain market movements.

AUD and Gold

In the financial world, gold is viewed as a safe haven against inflation and it is one of the most highly traded commodities. For many traders out there, trading the Australian Dollar is just like trading gold. Australia is one of the world's largest producers of gold and it exports comprise over 50% of commodities, including precious metals.

These commodities, such as precious metals and gold, account for a large portion of Australia's GDP; so many traders watch the rise and fall of commodity prices, especially gold, which can influence the direction of the Australian dollar.

Gold traders may also be surprised to hear that trading the Australian dollar is just like trading gold in many ways. As the world's third-largest producer of gold, the Australian dollar had an 84% positive correlation with the precious metal between 1999 and 2008. Generally speaking, this means that when gold prices rise, the Australian dollar appreciates as well. The proximity of New Zealand to Australia makes Australia a preferred destination for exporting New Zealand goods. Therefore, the health of New Zealand's economy is closely tied to the health of the Australian economy, which explains why the NZD/USD and the AUD/USD have had a 96% positive correlation over the same time period. The correlation of the NZD/USD with gold is slightly less than that of the Australia dollar but is still strong at 78%.

CAD and Oil

Oil is one of the world's most basic necessities for people in developed countries.

In February 2009, the price of oil was nearly 70% below its all-time high of $147.27 set on July 11, 2008. A decline in oil prices is a nightmare for oil producers, while oil consumers enjoy the benefits of greater purchasing power. This is a complete 180-degree change from the situation at the beginning of 2008, when record-high oil prices put a big smile on the faces of oil producers while forcing oil consumers to pinch pennies. There are a number of reasons to explain the fall in oil prices, including a stronger dollar (oil is priced in dollars) and weaker global demand. As a net oil exporter, Canada is severely hurt by declines in oil, while Japan, tends to benefit as a major net oil importer.

Between the years 2006-2009, for example, the correlation between the Canadian dollar and oil prices was approximately 80%. On a daily basis, the correlation can break, but over the long-term it has been strong for the value of the Canadian dollar has good reason to be sensitive to the price of oil. Canada is the seventh largest producer of crude oil in the world and continues to climb up the list, with production in oil sands increasing regularly. In 2000, Canada surpassed Saudi Arabia as the United States' most significant oil supplier. As most don't know, the size of Canada's oil reserves is second only to those in Saudi Arabia. The geographical proximity between the U.S. and Canada, as well as the growing political uncertainty in the Middle East and South America makes Canada one of the more appealing places from which the U.S. can import oil. But Canada does not service only U.S. demand. The country's enormous oil resources are beginning to get a lot of attention from China, especially since Canada stumbled upon a new stash of oil after a reclassification of its Alberta oil sands to the "economically recoverable" category. This makes the Canadian dollar extremely vulnerable in the event that oil prices continue to steadily rise or fall.

COMBINING ECONOMIC RELEASES AND TECHNICAL INDICATORS

Momentum Trade - Going with the News Monthly Employment

The Non-farm Payroll has a huge impact on the market if it is not close to the consensus estimate. It is an indicator released on every first Friday of the month, which is the first major economic indicator released each month. It forecasts the most basic states of the economy (no jobs, no money, no spending, bad economy and vice versa), adding to the effect the data has on the market and the economy.

Contrarian Trade - Going with the News Durable Goods

Headline number is generally misleading for two reasons.

• Usually the details following the headline explain the reason for an unexpected jump or decline. The possible reason, for example, could be a purchase of airplanes and the miscalculation of the timing of "booking" the purchase by economists.
• The revision to the prior month may completely offset this month's headline gain. The knee jerk reaction to the latest headline is an opportunity to buy or sell at a price that would not have been possible had the market not reacted until all the information was digested.

Like employment, economists are generally way off the mark on durable goods, making it an excellent vehicle to make money from other unprepared traders reacting instead of approaching the market with a well thought out of the game plan.

The following is a list of tradable U.S. economic indicators in order of potential profit from trading them in combination with fundamentals:

• Non-Farm Payroll
• Federal Open Market Committee interest rate change announcement
• Retail Sales
• Consumer Confidence
• ISM Manufacturing Index
• Gross Domestic Production (GDP)
• Philadelphia Fed Survey
• NAPM - Chicago
• Durable Good
• Industrial Production and Capacity Utilization
• Weekly Jobless Claims
• 15-YearNote Announcements
• 10-Year Note Announcements

These tradable U.S. economic indicators are tradable only if they are way out of line.

The strategy is to know the consensus. Determine what would be of great impact and react immediately upon the numbers release. To get in the trade, one better keep technical points in mind as well as limits of how much above or below the pre-release market price one is willing to deal at, though generally the response is muted.

Many of the following key indicators do not get the press coverage or attention they deserve, but smart investors and traders should be aware when they are coming out and scrutinize them closely. These less publicized indicators often provide important clues of those more publicized ones. In addition they sometimes provide great trade ideas.

• Beige Book
• Housing Starts / Existing Home Sales / New Home Sales
• International Trade / Current Account
• Chain Store Sales
• Consumer Sentiment
• Consumer Price Index / Producer Price Index
• Personal Income and Expenditures
• Business Inventories
• Index of Leading Indicators
• Factory Orders
• BTM-UBSW Store Sales / Redbook / Motor Vehicle Sales
• Challenger Job-Cut Report / Help Wanted Index / Employment Cost Index Consumer Installment Credit
• Construction Spending
• Mortgage Bankers Acceptance of Mortgage Applications
• Wholesale Trade

Most big moves occur after an important economic number is released. This is because long-term traders and companies tend to pay attention to these numbers and decide to open or close big positions based on the information. The long-term players in the market usually unbalance demand and supply, creating exaggerated moves that generally persists right through the entire session.

EMOTIONS MANAGEMENT

Emotion management refers to the ability to control emotions in the right place and time. It is the way in which people influence their own thoughts, feelings and expressions and the ways in which they influence other people’s feelings. In other words, emotion is a direct way to drive one’s performance; it can either enhance or weaken one’s competence if not managed well. As Carl Jang said, "There can be no transforming of darkness into light and of apathy into movement without emotion".

One can use their emotions as a means to advance their trade process. But one must learn to interpret them, guide them and reduce them.

Three Basic Ways to Change Emotions First

One can change his/her emotions by changing the object of their concentration. This brings great results. What a person thinks become reality. One may be considering taking a loss, or thinking about the chance of taking a profit.

Second

A person can change his/her emotions by changing one's beliefs. A person's beliefs act as filters of what he/she see, thus influencing the information that one admits to consciousness. one's beliefs influence the interpretation that one gives towards facts and events. If a person is confident that he/she will lay down the likelihood in their favor, that person will not go mad because of the individual losses; because he/she is confident that he/she will make money over time.

Third

One can change his/her emotions by changing one's psychology. This is generally true that breathing, facial expression, body position, tone and pace of voice impact on thoughts and emotions. What is usually not understood is that the psychology creates thoughts and emotions.

Importance of Concentration

Concentration is the ability to focus without the consenting any form of hindrance. It is the means of having specialization and setting one’s mind in its visions and goals.

"What do you think? You are looking at the possibility of loss? You see the chance of profit?"

Those that look only at the possibility of a loss, will hesitate too long at market entry and miss the deal, or book their profits too soon. While those who look only at the probability of a profit, cannot protect themselves from losses.

"You told a story about this deal? You told me a story about trade in general? Your story will affect your concentration."

A person will look for evidence of the truth of his/her history. He/she will have a tendency to underestimate or miss all the contrary evidence.

A particularly effective way to direct one's focus is on task. When a person asks a question, he/she set the perception of an object that requires a response and takes the truth question.

"What if I lose? What if I'm wrong? What if the transaction does not work?" - Now see where one's imagination should go. It should go to the effects of the loss. He/she will be in a negative mindset, lose his/her courage, and fluctuate.

"What if this deal will bring more profit? What if this deal actually goes to my goal? What if the market will do what I expect? "- You make a deal, and will feel confident.

The truth is: just thinking about winning is not enough. A trader can exceed the allowable size of the transaction. He/she cannot put the protective stop order. Instead, one should focus on probabilities. Ask oneself, "What is the likelihood with my methods?" - It will keep one up to start ringing. This will force a trader to act when receiving a signal.

When trading, a person must focus on profit and loss, and balance between them. He/she must focus on the probability of his/her methods. A trader must focus on information that enables him/her to market. And the only completely reliable information that one receive is the price action.

Yet, having all of that, it is really important to look optimistically to the future, even if a person accepts the validity of the current news and market action. What if a person could learn to control his/her concentration, so that one's emotional state supports his/her actions in the trade?

Importance of Psychology

One's thought affects the body, and vice-versa, the body affects the mind. The quickest and most straightforward way to change one's emotional state is to change his/her psychology.

Under the psychology, is the body position, breathing, facial expression, as well as the tone and pace of voice.

If one finds him/herself in a negative mental and emotional state during a trade, stand up and change one's psychology, for this emotional state can increase one's tension and nervousness. One should lift his/her shoulders, and take a deep breath to calm oneself.

Each person has the superiority of psychology, which is associated with creativity and flexibility. This psychology may change due to different situations, and it can also affect the situation of those situations.

In the midst of trading, a person will no doubt return to their old, sometimes harmful psychology. Once in this state, change one's psychology. The more a person does this, the sooner it will become a habit and their natural psychology. A simple physiological manipulation is an effective tool to manage one's internal state. As a trader, one's psychology affects him/herself. This is not just some lengthy reflection - an important part of one's general condition, which affects one's thoughts, feelings and actions. Use it for one's own success as a trader.

CANDLESTICK

History

The Japanese began using technical analysis to trade rice in the 17th century. While this early version of technical analysis was different from the U.S. version initiated by Charles Dow around 1900, many of the guiding principles were very similar:

1. * The "what" (price action) is more important than the "why" (news, earnings, and so on).
   
2. * All known information is reflected in the price.
   
3. * Buyers and sellers move markets based on expectations and emotions (fear and greed).
   
4. * Markets fluctuate.
   
5. * The actual price may not reflect the underlying value.
   

According to Steve Nison, candlestick charting first appeared sometime after 1850. Much of the credit for candlestick development and charting goes to a legendary rice trader named Homma from the town of Sakata. It is likely that his original ideas were modified and refined over many years of trading eventually resulting in the system of candlestick charting that we use today.

Formation

Real Body

In order to create a candlestick chart, a person must have a data set that contains open, high, low and close values for each time period that person wants to display. The hollow or filled portion of the candlestick is called "the body" (also called as "the real body"). The long thin lines above and below the body represent the high/low range and are called "shadows" (also called as "wicks" and "tails"). The high is marked by the top of the upper shadow and the low by the bottom of the lower shadow. If the price closes higher than its opening price, a hollow candlestick is drawn with the bottom of the body represents the opening price and the top of the body representing the closing price. If the stock closes lower than its opening price, a filled candlestick is drawn with the top of the body representing the opening price and the bottom of the body representing the closing price. Compared to traditional bar charts, many traders consider candlestick charts more visually appealing and easier to interpret. Each candlestick provides an easy-to-decipher picture of price action. Immediately a trader can see and compare the relationship between the open and close as well as the high and low. The relationship between the open and close is considered vital information and forms the essence of candlesticks. Hollow candlesticks, where the close is greater than the open, indicate buying pressure. Filled candlesticks, where the close is less than the open, indicate selling pressure.

Long vs. Short Bodies

Long Body

Short Body

Generally speaking, the longer the body is, the more intense the buying or selling pressure. Conversely, short candlesticks indicate less price movement and represent consolidation. Long white candlesticks show strong buying pressure. The longer the white candlestick is, the further the close is above the open. This indicates that prices advanced significantly from open to close and buyers were aggressive. While long white candlesticks generally bullish, more are left depending on their position within the broader technical picture. After extensive declines, long white candlesticks can mark a potential turning point or support level. If buying gets too aggressive after a long advance, it can lead to excessive bullishness.

Marabozu

Long black candlesticks show strong selling pressure. The longer the black candlestick is, the further the close is below the open. This indicates that prices declined significantly from the open and sellers were aggressive. After a substantial advance, a long black candlestick can foreshadow a turning point or mark a future resistance level. After a substantial decline, a long black candlestick can indicate panic or capitulation. The more potent long candlesticks are known as the Marubozu brothers, either Black or White. A White Marubozu forms when the open equals the low and the close equals the high, which indicates that buyers controlled the price action from the first trade to the last. Black Marubozu forms when the open equals the high and the close equals the low, which indicates that sellers controlled the price action from the first trade to the last.

Long vs. Short Shadows

The upper and lower shadows on candlesticks can provide valuable information about the trading session. Upper shadows represent the session high and lower shadows the session low. Candlesticks with short shadows indicate that most of the trading action was confined near the open and close. Candlesticks with long shadows show that trading extended well past the open and close.

Candlesticks with a long upper shadow and short lower shadow indicate that buyers dominated during the session, and bid prices higher. However, sellers later forced prices down from their highs, and the weak close created a long upper shadow. Conversely, candlesticks with long lower shadows and short upper shadows indicate that sellers dominated during the session and drove prices lower.

Long and Short Shadows

However, buyers later resurfaced to bid prices higher by the end of the session and the strong close created a long lower shadow. Candlesticks with a long upper shadow, long lower shadows and small real bodies are called spinning tops. One long shadow represents a reversal of sorts; spinning tops represent indecision. The small real body (whether hollow or filled) shows little movement from open to close, and the shadows indicate that both bulls and bears were active during the session. Even though the session opened and closed with little change, prices moved significantly higher and lower in the meantime. Neither buyers nor sellers could gain the upper hand and the result was a standoff. After a long advance or long white candlestick, a spinning top indicates weakness among the bulls and a potential change or interruption in trend. After a long decline or long black candlestick, a spinning top indicates weakness among the bears and a potential change or interruption in trend.

Doji

Doji

Doji is an important candlestick that provides information on their own or as components of numerous important patterns. Doji form when a security's open and close are virtually equal. The length of the upper and lower shadows can vary so that the consequent candlestick would look like a cross, inverted cross or plus sign. Alone, Doji is a neutral pattern. Any bullish or bearish bias is based on preceding price action and future confirmation. The word "Doji" refers to both the singular and plural form. Ideally, but not necessarily, the open and close should be equal. While a Doji with an equal open and close would be considered more robust, it is more important to capture the essence of the candlestick.

Doji convey a sense of indecision or tug-of-war between buyers and sellers. Prices move above and below the opening level during the session, but close at or near the opening level. The result is a standoff. Neither bulls nor bears were able to gain control and a turning point could be developing. Different securities have different criteria for determining the robustness of a Doji. A $20 stock could form a Doji with a 1/8 point difference between open and close, while a $200 stock might form one with a 1 1/4 point difference. Determining the robustness of the Doji will depend on the price, recent volatility, and previous candlesticks. Relative to previous candlesticks, the Doji should have a very small body that appears as a thin line. Steven Nison notes that a Doji that forms among other candlesticks with small real bodies would not be considered important. However, a Doji that forms among candlesticks with long real bodies would be deemed significant.

Bulls vs. Bears

Bullish Bearish

A candlestick depicts the battle between Bulls (buyers) and Bears (sellers) over a given period of time. An analogy to this battle can be made between two football teams, which we can also call the Bulls and the Bears. The bottom (intra-session low) of the candlestick represents a touchdown for the Bears and the top (intra-session high) a touchdown for the Bulls. The closer the close is to the high, the closer the Bulls are to a touchdown. The closer the close is to the low, the closer the Bears are to a touchdown. While there are many variations, I have narrowed the field to 6 types of games (or candlesticks): Long white candlesticks indicate that the Bulls controlled the ball (trading) for most of the game.  Long black candlesticks indicate that the Bears controlled the ball (trading) for most of the game.  Small candlesticks indicate that neither team could move the ball and prices finished about where they started.  A long lower shadow indicates that the Bears controlled the ball for part of the game, but lost control by the end and the Bulls made an impressive comeback. A long upper shadow indicates that the Bulls controlled the ball for part of the game, but lost control by the end and the Bears made an impressive comeback. A long upper and lower shadow indicates that the both the Bears and the Bulls had their moments during the game, but neither could put the other away, resulting in a standoff.

Candlestick Positioning Star Position

Spinning Top

A candlestick that gaps away from the previous candlestick is said to be in star position. The first candlestick usually has a large real body, but not always, and the second candlestick in star position has a small real body. Depending on the previous candlestick, the star position candlestick gaps up or down and appears isolated from previous price action. The two candlesticks can be any combination of white and black. Doji, hammers, shooting stars and spinning tops have small real bodies, and can form in the star position.

Harami Position

Bullish Harami

Bearish Harami

A candlestick that forms within the real body of the previous candlestick is in Harami position. Harami means pregnant in Japanese and the second candlestick is nestled inside the first. The first candlestick usually has a large real body and the second a smaller real body than the first. The shadows (high/low) of the second candlestick do not have to be contained within the first, though it's preferable if they are. Doji and spinning tops have small real bodies, and can form in the Harami position as well.

Long Shadow Reversals

Long Shadow Reversals

There are two pairs of single candlestick reversal patterns made up of a small real body, one long shadow and one short or non-existent shadow. Generally, the long shadow should be at least twice the length of the real body, which can be either black or white. The location of the long shadow and preceding price action determine the classification. The first pair, Hammer and Hanging Man, consists of identical candlesticks with small bodies and long lower shadows. The second pair, Shooting Star and Inverted Hammer, also contains identical candlesticks, except, in this case, they have small bodies and long upper shadows. Only preceding price action and further confirmation determine the bullish or bearish nature of these candlesticks.

The Hammer and Inverted Hammer form after a decline and are bullish reversal patterns, while the Shooting Star and Hanging Man form after an advance and are bearish reversal patterns.

Hammer and Hanging Man

Hammer

Hanging Man

The Hammer and Hanging Man look exactly alike, but have different implications based on the preceding price action. Both have small real bodies (black or white), long lower shadows and short or non-existent upper shadows. As with most single and double candlestick formations, the Hammer and Hanging Man require confirmation before action. The Hammer is a bullish reversal pattern that forms after a decline. In addition to a potential trend reversal, hammers can mark bottoms or support levels. After a decline, hammers signal a bullish revival.

The low of the long lower shadow implies that sellers drove prices lower during the session. However, the strong finish indicates that buyers regained their footing to end the session on a strong note. While this may seem enough to act on, hammers require further bullish confirmation. The low of the hammer shows that plenty of sellers remain. Further buying pressure, and preferably on expanding volume, is needed before acting. Such confirmation could come from a gap up or long white candlestick. Hammers are similar to selling climaxes, and heavy volume can serve to reinforce the validity of the reversal.

The Hanging Man is a bearish reversal pattern that can also mark a top or resistance level. Forming after an advance, a Hanging Man signals that selling pressure is starting to increase. The low of the long lower shadow confirms that sellers pushed prices lower during the session. Even though the bulls regained their footing and drove prices higher by the finish, the appearance of selling pressure raises the yellow flag. As with the Hammer, a Hanging Man requires bearish confirmation before action. Such confirmation can come as a gap down or long black candlestick on heavy volume.

Inverted Hammer and Shooting Star

The Inverted Hammer and Shooting Star look exactly alike, but have different implications based on previous price action. Both candlesticks have small real bodies (black or white), long upper shadows and small or nonexistent lower shadows. These candlesticks mark potential trend reversals, but require confirmation before action.

The Shooting Star is a bearish reversal pattern that forms after an advance and in the star position, hence its name. A Shooting Star can mark a potential trend reversal or resistance level.

Inverted Hammer

Shooting Star

The candlestick forms when prices gap higher on the open, advance during the session and close well off their highs. The resulting candlestick has a long upper shadow and small black or white body. After a large advance on the upper shadow, the ability of the bears to force prices down raises the yellow flag. To indicate a substantial reversal, the upper shadow should relatively long and at least 2 times the length of the body. Bearish confirmation is required after the Shooting Star and can take the form of a gap down or long black candlestick on heavy volume.

After a decline, the long upper shadow indicates buying pressure during the session. However, the bulls were not able to sustain this buying pressure and prices closed well off of their highs to create the long upper shadow. Because of this failure, bullish confirmation is required before action. An Inverted Hammer followed by a gap up or long white candlestick with heavy volume could act as bullish confirmation.