Thomsett's  Instablog

Candlesticks involve a lot of terminology, and in the mix of jargon it is easy to overlook the significance of some subtle indicators. There is more to a candlestick than opening and closing price and the session's price direction.

For example, tails - also known as long shadows - may be among the most important parts of a session's candlestick. Most focus is on the real body, the rectangular middle of the formation. A white real body is found in a day that moves upward, and a black real body signifies a downward-moving day. But most days also have upper and lower shadows. The real body's top and bottom are the opening and closing prices for the session; the shadows give you a glance at the full trading range, representing price movement above or below the open and close.

When upper or lower shadows are exceptionally long, they are called tails. As a general rule, the longer the tail, the more important it is. A long tail reveals that either buyers (on the upside) or sellers (on the downside) tried to move price further during the day, but the effort failed. The loss of momentum or inability to rally price is very significant. A buyer-led effort (an upper tail) is a bearish sign, because buyers were unable to gain any momentum for greater price appreciation. A seller-led effort (a lower tail) is bullish because sellers were not able to gain any momentum for a larger downward price trend.

Tails imply overbought or oversold conditions, but they are most significant when they show up after a sustained trend. So when you see an uptrend and then a session with an upper tail, it might signal the end of the uptrend and a coming reversal. When a lower tail shows up after a strong downtrend, it often signals a turnaround and the start of a new uptrend.

Tails can show up in the middle of a trend; they do not always mean reversal, but may also work as continuation indicators. It is difficult to interpret signals; but when you see a lower tail within an uptrend, or an upper tail in a downtrend, it probably is not foreshadowing reversal. There is nothing to reverse with a bullish signal in an uptrend or a bearish signal in a downtrend.

Because tails, like all indicators, cannot be relied on alone, always seem confirmation. When tails are found immediately after other candlestick formations, the tail is likely to confirm what the other signal tells you (assuming the indication points in the same direction). You may also be able to use tails to confirm Western signals, including volume spikes and tests of resistance or support. They also have greater significance when appearing immediately before or after strong gaps.

Tails, as single-session signals, may be strong indicators. But remember, all charting is a combination of interpretive skills and the ability to spot early signs and confirm them. Without confirmation, it is just guesswork. With confirmation, strong signals like candlestick tails are powerful timing tools.

To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. As a new member, if you buy a one-year subscription, you also get a free copy of one of my books, including this new one just released.

I also offer a weekly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. All it requires is your e-mail address. Join at Weekly Newsletter I look forward to having you as a subscriber.

A variation of the short call butterfly is the short call condor. Instead of one middle range strike price, this volatility strategy has two.

In the short call condor, you combine one in-the-money short call with one in-the-money long call; and one out of the money long call and one out of the money short call. The position is neutral in terms of the direction of the underlying price movement.

Example: The underlying stock is trading at approximately $36.50 per share. You expect the price to either rise or fall substantially. A rumor is out that the company may be acquired. If true, the offer is expected to be far higher than current price; if it falls through, you believe the stock price will tumble many points. This is a perfect situation for the short call condor. Volatility in either direction will create profits.

You set up the position by selling one 30 strike call at 7 and buying one 35 strike at 3.50; you also buy one 40 strike at 1 and sell one 45 strike at 0.50. Your net credit (before transaction costs) is $300. All of these calls expire on the same date three months away. The outcome at various prices demonstrates that with movement of the stock in either direction, profits are going to be realized. The maximum profit is $300 if the stock price ends up at $30 or lower or at $50 or higher by expiration:

Value at expiration

Stock short long long short

Price 30 35 40 45 total

20 700 - 350 - 100 50 300

25 700 - 350 - 100 50 300

30 700 - 350 - 100 50 300

35 200 - 350 - 100 50 - 200

40 - 300 150 0 50 - 100

45 - 800 650 400 0 250

50 -1,300 1,150 900 - 450 300

55 -1,800 1,650 1,400 - 950 300

As long as the stock price remains within the middle zone, losses are minor. The advantage to this strategy is that you collect premium for opening the combined short and long, and you can close the short calls at any time. As long as volatility is high, you will profit whether the stock moves up or down. The disadvantage is that returns are small compared to some other straddle positions, but risk in those alternatives is likely to be greater as well.

All complex option strategies have to be judged based on their overall merit, limited risk and exposure to loss. In addition, a broker will require margin maintenance for positions like the short call condor, which ties up capital until either expiration occurs or then position (or the short portions of it) are closed. The elegance of limited profits in exchange for limited losses has to be judged with these factors in the balance.

To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. As a new member, if you buy a one-year subscription, you also get a free copy of one of my books, including this new one just released.

I also offer a weekly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. All it requires is your e-mail address. Join at Weekly Newsletter I look forward to having you as a subscriber.

The trader's dilemma: Even when you see a strong reversal pattern on a chart, how do you know it's the real thing? The answer is that any indicator needs to be independently confirmed. This is where East (candlesticks) meets West (traditional technical analysis).

One of the favorite reversal signals used by day traders and swing traders is the volume spike. This applies especially on sessions with an unusually small trading range, the so-called narrow range day (NRD). So an NRD with heavy volume is viewed as a strong two-part signal that the current trend is about to turn around.

The problem with these signals is that they do not always come through. Failed signals are fairly common, so astute swing traders have to look for separate confirmation. But this raises a second dilemma: If you wait for confirmation, it's probably going to be too late to make an entry decision before the new trend begins. This is where the Marubozu comes into the scene.

In Japanese, Marubozu means "with little hair." It is called this because it is a long session but with little or no upper or lower shadow. A long session means a bigger than usual gap between opening and closing prices; and the lack of shadow means trading for the day remained mostly within the range between the opening and closing price.

A white Marubozu (meaning price opened at the bottom and closed at the top) is one of the most bullish single-session candlesticks. Of course, the black variety (seen when price opened at the top of the rectangle and closed at the bottom) is one of the most bearish single-session indicators.

The Marubozu is extremely valuable as a confirming session because it often precedes the traditional NRD and volume spike. So confirmation is given to you before the better-known turning point. When a downtrend ends, you see three signs:

1. The white Marubozu.

2. An NRD in the following session.

3. A volume spike in the same session as the NRD.

When an uptrend ends, you see the same three developments, but with a black Marubozu. In both cases, confirmation takes place in anticipation of the turn, and before the NRD/spike session.

Candlesticks are enjoying great popularity today, but they often are misunderstood. They are not effective as a replacement for the older Western technicals, based on price action and trading range analysis. The core of the Western approach is support and resistance and how price patterns work within the range, or when price breaks through above or below that range. This core continues to provide you the best insight to price action and candlesticks do not replace that. Rather, candlesticks work best when they confirm what traditional technical signals forecast. Used together, East and West create a powerful and effective method for timing entry and exit as part of a swing trading strategy. The single-session candlestick is only the starting point. Two-session and three-session indicators provide equally important insights to coming price tendencies - never as 100% guarantees, but tools to vastly improve your timing success.

To gain more perspective on insights to trading observations and specific strategies, I hope you will join me at ThomsettOptions.com where I publish many additional articles. I also enter a regular series of daily trades and updates. For new trades, I usually include a stock chart marked up with reversal and confirmation, and provide detailed explanations of my rationale. Link to the site at ThomsettOptions.com to learn more. As a new member, if you buy a one-year subscription, you also get a free copy of one of my books, including this new one just released.

I also offer a weekly newsletter subscription if you are interested in a periodic update of news and information and a summary of performance in the virtual portfolio that I manage. All it requires is your e-mail address. Join at Weekly Newsletter I look forward to having you as a subscriber.