Thomsett, Trading with Candlesticks

The prolific Michael C. Thomsett, probably best known for his books on options, has a new release: Trading with Candlesticks: Visual Tools for Improved Technical Analysis and Timing (FT Press, 2011). He describes the key single-stick signs, double-stick moves, and complex stick patterns. For those unfamiliar with the intricacies of candlestick charting, this is a clear, well-illustrated account.

It is also a sobering book for anyone who thinks that candlestick charts in and of themselves provide entry and exit signals. As Thomsett writes in what is perhaps an overstatement, “By itself, the chart—candlestick or other type—has limited value. … The candlestick chart is the easel, and the broader indicators are the paint.” (p. 18)

Over and over again Thomsett illustrates false signals, especially in single sticks—the marubozu that is followed by a downtrend, the dragonfly doji where price breaks below the doji’s lower shadow. Even complex candlestick patterns are often unreliable. In brief, it is insufficient to recognize a candlestick pattern; the pattern must be analyzed. In the case of reversal patterns, “the analysis should include judgment about whether the signal is true or false, the degree of strength or weakness in the reversal, and whether or not it confirms another indicator (or is confirmed in turn). Confirmation can include additional candlestick patterns, moving averages, and traditional technical signs.” (p. 91)

Candlestick charts monitor price. But “focusing solely on price trends is a mistake because changes in volume indicate changes in trading activity, and such changes often accompany or even anticipate changes in price trends. The same is true for changes in volatility levels; broadening trading ranges or repeated violations of support and resistance indicate coming price changes.” (p. 119) Combining such indicators as on-balance volume or Chaikin money flow with candlestick price trend analysis can “improve timing and bolster an initial indicator.” (p. 126) Recognizing changes in volatility as evidenced in such chart patterns as triangles and wedges is also an important part of a trader’s analysis.

Added to the mix are trendlines, Bollinger bands, MACD, overbought and oversold indicators (RSI and stochastics), support and resistance levels, and traditional patterns such as the head-and-shoulders formation. The rationale for all this “paint” is that a system with a series of confirming signals is more accurate than a single-indicator system. Thomsett does, however, warn against ending up with a canvas that uses so many colors that it becomes an unintelligible mess.

Thomsett is writing for the novice who wants to learn about candlestick patterns and who aspires to join the legions of chartists and technicians. His book is a reasonable place to start, especially since he dampens enthusiasm, stressing the ever-present possibility of false signals, no matter how many indicators confirm.