Often in trading we have a situation when market makes a large move, one that breaks support/resistance triggering orders and then retraces. At this point we don’t know if this is a fake breakout, which will turn around, or a small correction within market, normal price fluctuation. After all it is relatively rare when move is straight and directional, reaching targets without without some adverse action. It doesn’t really matter how the objective is estimated, more often than not price will behave in a “wavy” pattern.
Breakouts on fast action for the chart we are watching can create a problem with estimating risks. Even if we are convinced that market should move in one direction, taking a trade can be difficult because there is no clearly defined stop for our intended transaction, or if it is, could be too big. Here I refer to previous highs/lows as the most popular and easily noticed risk qualifiers, and something I use very often. This is especially difficult for traders using very tight stops, but even those who are willing to take a little bigger risks per trade in term of pips, allowing for larger price movement (like me), can find themselves passing on a high probability trade, because potential drawdowns are too big.
There are ways to deal with this problem. For example a moving average could be used as stop, something I do sometimes. Another one is using Fibonacci numbers, very popular, although best if given number corresponds with existing support/resistance. One more such less used risk definer method is single large candlestick. My charting is done exclusively using candles, but this particular concept applies also to bar charting, so for this post candle is synonymous to bar.
“Single large candle” is one that stands out in the look back period. What is a look back period? It is a price history that we have on a working chart, without scrolling it back. Depending on settings, most full screen charts contain 80-100 candles. For smaller charts it will be less. “Large” candle is a dominant one on the chart we are looking at and want to trade. It doesn’t have to be the biggest (would be nice), but must stand out among the ones surrounding it, with a price range clearly wider than the others. Middle part of such candle often acts as a support/ resistance and can be used as an additional stop level for those looking to control risks better.
One could use the exact middle of this bar as a fixed number, but, just like with Fib levels, it is better to judge general price behavior at this point. Middle body mass of candle should used as a support/reversal zone, rather than fixed point. Going to one magnitude smaller time frame might be useful, but is not necessary. Few of my recent trades happened on charts and during times when single large candles behaved in a way described here.
Chart covering my AUD-CHF trade not that long ago shows several of these large candles forming, getting bigger as the time goes on. The most recent one always takes precedence. First couple of them the provide enough resistance to keep the trend down. The last one painted when I closed my trade. Anybody being in the trade at this point has the nearest resistance at about 0.9380, rather large. Using middle of this of the candle would greatly reduce the risk.
Apart from providing smaller stop/loss, one could use this principle for an entry to trades. This was demonstrated in Yen trades from the same time, including this NZD-JPY short. My entry happened to be a little early, but implied resistance held, at least for a while. This resulted in a decent transaction. Trade in AUD-JPY was very similar.
Eventually resistance was broken and the trade reversed. This chart shows how far away next logical stop/loss was, at about 64.70. Using large candle rule would save a lot of pips for somebody still holding short position.
This doesn’t happen all the time, middle of these out of proportion bars do not always provide additional support or resistance. But it takes place often enough to keep in mind, especially when it comes to limiting risk. Single large candle principle shouldn’t be used as a stand alone system. It is rather a supplemental price behavior observation, another small part to solve the puzzle that markets are. One more weapon in trading arsenal.
Mike K.
I read these piece with great interest. Ever since starting to follow your blog, candlesticks became very important to me and I managed to put good size library on the subject. Frankly, I can’t recall reading about about what you covered here. If it was included somewhere, not much details were provided, otherwise I’d remember it. Educational. Thanks!
“Going to one magnitude smaller time frame might be useful, but is not necessary.” I didn’t get how this followed the previous sentence.
“Middle body mass of candle should used as a support/reversal zone, rather than fixed point. Going to one magnitude smaller time frame might be useful, but is not necessary.”
I’d say you don’t think about the exact middle of the candlestick, but use smaller charts to see if the price is reversing in general area of that mid part. Even if not necessary.
Yes, that about sums it up.
[...] rebound was pathetic and reached only the middle of large candlestick during which original sell off happened. That proved to be sufficient resistance for the rally to [...]