Candlestick charts are the oldest form of technical analysis, but they only became popular in western countries in the 1980s. Before then, other technical indicators were used as standard tools by traders, with varying degrees of success. Candlestick charting – and technical analysis more generally – is not without critics, but practitioners include highly successful traders, most of whom understand multiple technical strategies. One common strategy involves combining candlesticks with one or two other indicators to create a system that gives stronger buy (or sell) signals based on how many align. Candlestick charts provide a good base strategy, and other indicators such as oscillators, retracements or even fundamental metrics can be combined fruitfully. The main benefit of doing this is to improve your trade win rate – this is important for scalability, the ultimate measure of whether a given strategy is practical given your real circumstances.
Why use combined strategies?
You may have read about combining technical and fundamental signals and its potential benefits to your trading portfolio. Within each of those broad categories there are many different indicators, trading styles and methods to choose from, and skilled traders will normally blend these to create an overall method that is both effective and scalable in volatile markets.
For a trading strategy to be effective, it must do two things: work, that is by providing returns in excess of chance, and be scalable – the strategy must work with the amount of capital you have available, and on a timeframe that is acceptable. Trading is a real world activity, not an abstract mathematical one, so traders need to be aware of their own situation and the real limits this puts them under.
Scalability
For example, a strategy that fails 99% of time losing 10%, but with a risk reward ratio of 10,000 may well see enormous returns over 100 trades, as a single win (before you hit zero) will catapult your portfolio balance so high even a run of dozens of failed trades will leave a profit. On the other hand, if you have the mathematically quite likely scenario of 90 failed trades before your first win, the balance will be reduced to zero and the strategy a dead loss. The failure of this strategy then is it is not scalable: it does not work within the time limits (100 trades) and with a reasonable amount of starting capital. Many strategies that are mathematically attractive fail in this manner, with the most famous being the martingale.
The martingale is a betting strategy on a 50/50 probability, such as a coin flip. If the player doubles his stake each time, mathematically he is certain to eventually make a small profit: the doubled up stake will create gains sufficient to erase previous losses. So long as the gambler can continue doubling his stake indefinitely, the strategy works; in practice of course this is impossible. Because all gamblers (like all traders), have limited overall capital, they will eventually incur a loss that would require a doubled stake they cannot afford. This is also more likely than intuition suggests, because even a coin flip is more likely to produce long runs of one or the other than people expect. This is an example of a cognitive bias that impacts traders.
Relevance to day traders
You may be forgiven for wondering what the relevance of the martingale or highly improbable, highly rewarding trade strategies is to your portfolio. Though both of these are exaggerated examples, they show how the win rate strongly influences overall portfolio returns. Any marginal improvements in this percentage can radically improve your strategy, and this is exactly what combined candlestick strategies aim to achieve.
Strategies using a single indicator tend to have a lower percentage hit rate then those combining multiple signals. This is for a simple reason: single-indicator strategies produce more hits, whereas it is rarer to see multiple indicators indicating buy. This isn’t a guarantee that a trade will work, especially not with something as subjective as candlestick charting, but it does give additional assurance. If you can improve the win rate of your trades, more and more strategies will be scalable to your current funding and leverage situation.
How to use candlesticks in combined strategies
Candlestick charts are much-loved by their adherents, but require practice and a certain ‘eye’ for pattern formation. Critics say this subjective angle makes it imprecise, but the long history of successful use shows that these strategies can succeed. The important thing to remember with candlestick patterns is they reflect the market sentiment during a single session. Familiar patterns such as the Doji Star or Hammer rely on specific events during a single session, driving prices first in one direction and then another.
When you identify a continuation pattern, confirm this by checking with an oscillator. If oscillators are trading below the overbought and above the oversold range, then this confirms the continuation pattern. If by contrast you find the RSI is at 95, you should be more sceptical about the power of your continuation pattern.
Traders can select one or two additional indicators to verify patterns they see, and only enter trades when these confirm the pattern. By using two additional indicators – for example support and resistance lines alongside the RSI, traders can choose whether to enter slightly more risky trades when 2/3 indicators align, or only enter the most solid where all 3 confirm the signal. The latter strategy should improve your win rate, but may come at the cost of reducing the total trade opportunities to enter, and also potentially decreasing the profit levels of trades.
Trading psychology with complex strategies
When using the 3 indicator strategy, inexperienced traders sometimes fall into a trap of always assuming the most conservative strategy is the best, refusing to enter any trades where all indicators do not align. This is perfectly fine if it aligns with your overall strategy, but for some traders is a mistake that results in a strategy with too few trades to become profitable. Because traders prefer winning trades to losing ones, they sometimes choose strategies that maximise the hit rate without thinking of the most important metric: overall P&L. In a way, this is another scalability problem, since sufficiently large trades made occasionally would be a viable strategy, but the trade size required is too great for small portfolios.
Keeping ahead of your own mindset is vital for any strategy, but especially so when combining multiple sources. It is easy to become overwhelmed by the sheer volume of information, with multiple indicators giving conflicting information. To manage this, traders should understand thoroughly the indicators they do use, and not overload charts with extra lines or indicators they are uninterested in. Sometimes the simplest, least cluttered view is the best for clearly seeing patterns, and this visual clarity can help ensure you retain a healthy trading psychology.
How Rakuten can help
If you are comfortable with candlestick charts, and want to use them alongside other technical or fundamental strategies, running a strategy on paper is a great place to start. With that in mind, why not open a free demo account and start trading today without risking any of your capital?