I love trading using price action and candlestick patterns. If anyone, with any exposure to trading, were to look at my charts it would be the first thing they would notice and they would rightly conclude that I am a price action trader.
Again, let me say I love trading using price action and candlestick patterns. I really do! So why does it frustrate me so much when I read articles purporting to teach price action trading using candlestick patterns?
The articles are endless: “Top Ten candlestick Patterns for Trading” or the “8 Candlestick Pattens Every Trader Should Know” or “Getting Rich using Pin Bars, or “3 Secret Patterns of the Smart Money” or “The Best Candlestick Patterns for 2020” or “Powerfully candlestick Patterns for Trading Success”
Anyone who has an interest in price action trading has read some variant of these articles and there is a lot of solid basic information contained within in them. The great thing about candle stick patterns is that there is pretty much a consensus on how each pattern looks so it’s fairly hard to mess up an introduction to candlestick patterns article.
So what bothers me about these articles? It’s the lack of context that drives me crazy.
Too many times I have a read an article showing how easy it is to have huge winners using such and such pattern. This article is usually accompanied with a chart showing the pattern leading directly to a huge price move. If only trading was that easy.
What kills me is that if you look closely on the same chart there are usually several other examples of the exact same candlestick pattern, but without the corresponding price move the author so proudly highlights in his article.
Articles about trading pin bars are the most infamous for this. The author highlights the one pin bar on the entire chart that lead to a reversal or continuation which ignoring the 7 or 8 other pin bars on the chart which would have led to losing trades.
So what’s your point you ask? My point is that these articles lack context or importantly, lack content on the importance of context.
Candlestick patterns are only as useful as the context within which they occur
This is my issue with most of these articles, they ignore context and without context trading candlestick patterns is a losing proposition.
Its not enough to learn the 10 most common reversal candlestick patterns or the 5 patterns to use in a trend or the 8 most reliable candle stick patterns.
Yes, its great to learn these patterns, but that is just the beginning. Unfortunately, too many traders stop there. They prioritize candlestick patterns and undervalue if not completely ignore context.
As my Grandfather would say, that’s As$ backwards!”
Context comes first and the candlestick pattern is the confirmation or entry trigger. Without proper context a candle stick pattern is simply random noise with no probability advantage.
If you don’t believe me go back and review the chart of your last trading session. Pick a pattern, it can be anything from a single candle single pattern such as a pin bar to a multiple candle pattern such as a head and shoulders pattern. Look through your chart and notice how many times this pattern appears and how often the following price action DOES NOT perform to expectation.
Once you spend some time doing this you realize more often than not a given candlestick pattern does not perform as we would hope. We often blind ourselves to this truth because we both overvalue the instances when the pattern was successful and discount the patterns that don’t have the desired result. When the pattern fails we nitpick the pattern, “Oh now I see, the tail on this engulfing candle was slightly too long” or “the body of this pin bar was too small” or some other such nonsense.
In truth, its only when you add context that candlestick patterns become something other than random noise on the chart. Or more correctly its only when you start with context and overlay candle stick patterns that you start to put the probabilities on your side,
Teaching Candlestick Patterns is Easy, Teaching Context is Hard
Candlestick patterns are easy to teach and to learn, that’s why you can find a million article on candlestick patterns, but not so many on context. Articles on candle stick patterns are easy to write and easy to package to eager learners.
Context on the other hand… Context is hard to write about and hard to package into a easily digestible top ten list you can sell. Context is hard so new traders looking for quick success would much rather buy a course or read an article on candle stick patterns than do the hard work of learning context.
The truth is I can tell you about context, but I cannot teach you context. Context is something learned through hours of screen time and study.
What I can do it teach you how to study context.
Before you can really start studying context you need to understand what context is.
What Context is
For purposes of trading context is everything that happened before the current price action or candlestick pattern, with some prior events have greater importance than others. I realize that is about the most generic and general statement you have ever heard so let’s break this down into something useful for your trading.
The “everything that happened before” is all the prior price movement. The current price and any candle stick patterns must be viewed through the lens of how it relates and interacts with past price movement.
A good example of this is the double top pattern. Initially, there is simply a price extension above the highs of some period of prior price action. It is only when current price pulls back and then returns to this high and then pulls back that we call this pattern a double top.
It’s the context which creates the pattern. But in and of itself that’s still not enough. Remember earlier when I said you can go back through your charts and find many examples of double tops that failed to perform as expected? That’s still true.
We need to look deeper into the context to determine if we should act on this particular double top pattern. Other forms of context we can use are support and resistance. A double top pattern is a much stronger signal if it is occurring at an area of resistant and a much weaker signal if it is occurring at an area of support.
Other context clues would be things like the slope of the price movement and the speed of the price movement prior to forming the double top. Was the angle of the price movement sharply angled or was the angle much flatter?
Did price move up into the pattern in a few large bars or did it take many small over lapping bars to reach the level where the double top occurred?
A sharper angle and larger bars leading into a double top could be a sign of a buying climax, where a sharp uptrend is then often followed by an equally sharp downtrend. However, if the move up is very strong then there is a good possibility that the double top will actually be part of a double bottom as price breaks through resistance and continues onward.
This is why context is so important and also why it is so difficult. Price action is often like Matryoshka dolls, with patterns within patterns.
Also, notice how all these questions can only be answered relative to (or in the context of) the price movement around it.
You can’t answer whether the angle was sharp unless you are comparing it to the angle of the price action around it. Likewise, whether the candles are considered big or small is dependent upon the surrounding candles to which you are comparing it.
This is a taste of context. Mastery of this skill is a large part of what separates profitable traders from struggling traders.
Learning Context
That all sound totally complicated and confusing. How can someone learn to understand and use context in their trading?
Well to start, context, much like driving a car is learned by doing. Much like driving, we learn the basic rules of the road in a driving course but we only learn to be proficient drivers through experience.
Its only through repetition and experience that we go from the nervous and terrified beginner driver death-gripping the steering wheel and wholly focused on the road to the experienced driver who zips through traffic while drinking our morning coffee and talking on the phone.
Its only through experience behind the wheel that we know how fast is too fast in what weather conditions or seem to sense what drivers to avoid when merging.
With trading it is screen time instead of road time that teaches us how price will act given the context. Through observing the market and watching day after day we start to develop a feel for the market and price action.
After a while you as a trader start to see the same things happening again and again. This is why it is helpful to become an expert in a single market instead of jumping from market to market.
However, passive learning is not the best nor fastest way to develop your feeling for context. You can take an active and deliberate approach to learning context which will greatly increase your rate of learning.
Active and Deliberate Learning
The best way to learn about context and candlestick patterns is to start by picking a pattern. Since we have been talking double tops, lets stick with double tops.
Now stroll back on your charts. If you are a scalper or day trader a month back will be sufficient to start. Swing traders will probably need several months to a year.
Starting a month out find every double top pattern that were successful. For purposes of this exercise “successful” means from where your trade entry would have been price continued short for a number of ticks equal to or greater than the number of ticks your stop would have been.
For example, if from your trade entry you would have needed a 20 tick stop than the trade would only be considered successful if price continued 20 tick or more without pulling back to hit your stop.
Finding the successful examples of the double top pattern is just the beginning. Your job after you have found all of the double tops that were successful is to do a detailed study of the price action to the left of the double top patten, the price action leading into the double top pattern and finally the price action immediate following the double top pattern.
Pattern Recognition
What do you notice? How does price act prior to a successful double top? Does price tend to move into the pattern aggressively or weakly? Is there a minimum number of bars between the tops or is there a maximum number of bars? Do successful double tops form at support and resistance levels or is the first top all the resistance the second top needs to form a successful double top? What is the average size of the move in a successful double top? Are most moves the same size or is there great variance? If so, can you discover a commonality between the larger moves? And on and on.
Now repeat this exercise with all the double top patterns that were not successful. Is there anything that unsuccessful double tops have in common? is there anything in the price action prior to the double top pattern itself that is different than the price action before successful double tops? What about support and resistance, does failure of the pattern happen more or less often with prior support and resistance? And so on and so on.
I cannot stress enough how important to dig deep here. Really sharpen and utilize your observational skills. Do not do this exercise halfheartedly. This is one of those occasions where you get out of this exactly what you put into it. This tedious and monotonous exercise is where your growth as a trader will occur.
Your observations here will shape and inform your expectations when you actually trade this pattern. From your studies you will now have a feel for how price will act before forming a successful double top and just as importantly you will start to notice when price does not act as it usually acts before a successful double top.
Once entered in a trade based upon a double top pattern you will have an expectation of what is a realistic target for price to reach and a feel for when price is not acting as it should so you can exit a trade with partial profit or less than a full loss.
Now that you have developed a contextual understanding for double tops pick another pattern, maybe its bullish engulfing candles or the Morning Star pattern. For each pattern repeat the exercise.
This is how you actively learn context. The bad news is learning context is much harder and complex than simply learning candlestick patterns. The good news is that with focused and deliberate practice you can greatly increase your feel for context. The great news is that once you understand context and how to use it your trading will go to a level you only dreamed of.