CANDLE STICK FORMATIONS

Candle sticks are a powerful tool used in charting and technical analysis. They deconstruct the share price data by displaying four different sets of data in one “candle”. The candle can be seen below. The four sets of data displayed are: high, low, open, and close. Candle sticks can cover different time periods - daily, weekly, monthly, etc - as long as the consistency of representation is the same. The placement of each can be seen in the pictures below. The green candle is termed a bullish candle and the red candle is termed a bearish candle.

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Bullish Candle

A bullish candle occurs when the closing price of a share closes higher than the opening price. This means that the share price increased on a particular day or period. This can be seen in the picture where the close is above the opening price.

Bearish Candle

 A bearish candle occurs when the closing price of a share closes below the opening price. This means that the share price decreased on a particular day or period. This can be seen in the picture where the close is below the opening price.

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Bullish Engulfing Pattern

The method to identify a Bullish Engulfing pattern is to ensure that the following entities are present: The first red bearish candle must be fully enclosed in the body of the green candle. There must be a confirmation candle to follow the middle bullish candle with a close above the close of the middle candle.

Bearish engulfing pattern.

The method to identify a Bearish Engulfing pattern is to ensure that the following entities are present: The first green bullish candle must be fully enclosed in the body of the red middle candle. There must be a confirmation candle to follow the middle bullish candle with a close above the close of the middle candle.

Bullish Harami Pattern 

The method to identify a bullish harami pattern is to ensure that the following entities are present: Two downward movement candles with the third being a bullish candle with a body located within the second candle's body. There must be a confirmation candle to follow the second bullish candle with a close above the close of the third candle.

Bearish Harami pattern 

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The method to identify a Bearish Harami pattern is to ensure that the following entities are present: Two upward movement candles with the third being a bearish candle with a body located within the second candle's body. There must be a confirmation candle to follow the second bearish candle with a close below the close of the third candle

Shooting Star pattern

A Shooting Star pattern is a bearish pattern that indicates downward movement. The method to identify a shooting star pattern is to ensure that the following entities are present: The share price must be moving on an upward trend. The wick of the candle must be at least 2 times the body of the candle. A confirmation candle is needed with a close below the close of the close of the middle candle"

Bearish Hammer pattern

A Bearish Hammer pattern is similar to a the shooting star pattern and indicates downward movement but is less bearish than a shooting star formation. The method to identify a bearish hammer pattern is to ensure that the following entities are present: The share price must be moving on an upward trend. The tail of the candle must be at least two times the body of the candle. A confirmation candle is needed with a close below the close of the close of the middle candle.

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Bullish Hammer pattern

A Bullish Hammer pattern indicates upward movement. The method to identify a bullish hammer pattern is to ensure that the following entities are present: The share price must be moving on a downward trend. The tail of the middle candle must be at least two times the body of the candle. A confirmation candle is needed with a close above the close of the middle candle.

Inverted Hammer Pattern 

An Inverted Hammer pattern indicates upward movement but is slightly less bullish than a bullish hammer pattern. The method to identify an inverted hammer pattern is to ensure that the following entities are present: The share price must be moving on a downward trend. The wick of the middle candle must be at least two times the body of the candle. A confirmation candle is needed with a close above the close of the middle candle.

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Rising Sun 

The way to identify a Rising Sun is by looking at the following things and ensuring that they are present. The left most candle must have an opening price above that of the middle candles closing price. The left most candle must have a closing price within the middle candle and with the closing price no lower than half of the middle candles body. Lastly there must be a confirmation, this is where the candle on the right has a closing value above the body of the middle candle.

Morning Star pattern

The way to identify a Morning Star pattern is by looking at the following things and ensuring that they are present. 1st, a long red candle stick. 2nd, a small green candle stick, comprising of a small body or open equal to the close, which is below the close of the 1st candle. 3rd, a long green candle stick with an open above that of the middle candle stick which closes at or above the center of the first candle stick.

Evening Star pattern

The way to identify an Evening Star pattern is by looking at the following things and ensuring that they are present. 1st, a long green candle stick. 2nd, a small green candle stick, comprising of a small body or open equal to the close, which is above the close of the 1st candle. 3rd, a long red candle stick with an open below that of the middle candle stick which closes at or below the center of the first candle stick

Stochastic Indicator tutorial

This technical indicator measures a shares momentum. What momentum means is, what is the share price doing, in relation to past data. This is one of the most popular indicators that traders make use of, and can be highly effective if used in the right way. The indicators output can be seen below.

The stochastic oscillator its self is bound between 0 and 100 and moves within this range. In the picture above one can see two horizontal lines one red and one blue. These indicate the overbought and oversold regions. They are placed at the 20 and 80 mark on the vertical axis. When the stochastic oscillator moves below the blue line at 20 on the vertical axis a potential buying region is indicated to the investor as the share is becoming oversold. Likewise when the stochastic oscillator moves above the red line at 80 on the vertical axis, this indicates to a potential investor that the share is becoming overbought and this is not a good opportunity to enter into the trade.

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The first technique that will be discussed is the application of the moving average to the stochastic to find potential trade entries and exits. In essence the moving average provides a smoothed version of the stochastic data as it takes the average of several values and uses that to create points which form the moving average version of the stochastic. The chart below makes use of a slow stochastic with a 7 day moving average applied. The different types of stochastics will be discussed in the latter of this page

The moving average is used to show the investor if the stochastic is increasing or decreasing relative to the past data. In an upward trend of the stochastic when the share price is above the moving average this indicates that there is an increase in momentum relative to past data, likewise when the stochastic data is below the moving average for an upward trend this indicates that the momentum is decreasing relative to past data. In the case of a downward stochastic movement. If the stochastic is below the moving average this means that the downward movement is strengthening relative to past data. However, if the stochastic is above the moving average this indicates that the momentum is decreasing relative to the moving average.

Thus far we have established what the buy and sell zones are and where they are placed, as well as establishing the application of the moving average to the stochastic. Using these tools the output is as seen in the graph below. 

As previously established when the stochastics are below the moving average in a downward trend this indicates that there is a strong movement down but when the reverse is in play where the stochastic is above the moving average this indicates that the momentum is increasing relative to the moving average. Using this logic, the buying points seen in the graph are selected where the stochastic intersects the moving average this is the point at which the decreasing momentum is changing to increasing momentum. Looking at “BUY ZONE 1” and “BUY ZONE 3”, this method worked very well in finding a good entry point into the trade however the method does not always deliver optimal entry points which can be seen in “BUY ZONE 2” where the buy signals were triggered, but the share price continued a sideways movement.

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Now to use the same logic but to identify potential sell regions. Using the moving average method the selling price was chosen when the stochastic moves from a position above the moving average intersects the moving average and moves below the moving average. This is because when the stochastic is above the moving average the share momentum is still increasing upwards relative to past data but when the stochastic intersects and cuts through the moving average the momentum is decreasing relative to the past share data. Looking at “SELL ZONE 2” and “SELL ZONE 3”, this method worked very well in finding a good exit point out of the trade. Like the buy trigger the sell trigger to is not always triggered at the optimal sell point as seen in “SELL ZONE 1” with the red vertical line in the first sell trigger. Here a sell was triggered but the share continued to move upwards with the optimal sales point being triggered at the second sell trigger.

Changing the Stochastic settings can have a significant effect on the results that the stochastic displays. Knowing what settings to use can make a significant difference to the buy and sell signals that are displayed to the user. The three settings that will be discussed will be fast, moderate and slow moving Stochastics.

The slow stochastic is used to give a less sensitive reading of the momentum. Slow stochastics will usually provide less buy and less sell points as opposed to the fast and moderate stochastics, but the points at which the potential buys and sells are triggered will tend to be better entry and exit points. The potential problems with the slow stochastic is that it can sometimes show a buy or sell signal that its slightly too late or later then the optimal point. The settings that have been proven to work well are to set the stochastic to a 21 period with a 7 day moving average.

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The medium setting is used to get a balance between the fast and the slow stochastic, traders will use this if they want a little more sensitivity in their stochastics as this will give more potential buy and sell signals. The settings that have been proven to work for a medium outlook are to set the period to 14 days with a 3 day moving average. An example of the 14 period stochastic with a 3 day moving average can be seen below

The last setting that will be discussed is the fast setting, this is used when a high sensitivity is desired. The setting will give the most potential buy and sell signals. The points at which these signals will be triggered is geared to faster trading, especially day trading where a high volume of signals is needed.

MACD and Into to ratio analysis

MACD stands for moving average convergence divergence. This is a momentum indicator that track trends and is one of the most widely used and trusted. The standard MACD settings are 12-26-9 meaning, a fast exponential moving average of 12, a slow exponential moving average of 26 and a signal simple moving average of 9. The MACD makes use of two moving averages where it subtracts the longer period moving average from the shorter period moving average. The MACD moves above and below the zero line as shown in the example below. Unlike the Stochastic indicator, this indicator is not bounded, thus it does not signal overbought and/or oversold conditions. The blue line shown below is the MACD line which makes use of a 12 day exponential moving average, given standard MACD settings. The red line shown below is the signal line and makes use of a 9 day moving average. The green bars shown is the MACD histogram. The MACD is a very powerful indicator due to the fact that copious amounts of information can be read from this one indicator.

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The crossover method is the most common method use for the MACD. It applies similar principles that create and operate moving averages and stochastic moving averages. Using the example shown below, this principle will be explained. The crossover method indicates to a trader potential trade entries and potential exits depending on what is displayed. If the MACD line moves from below the signal line and crosses the signal line, this indicates potential bullish movement upwards and is thus is a buying signal. Likewise if the MADC line moves from above the signal line and comes down and crosses the signal line, this indicates potential downward movement and a potential selling zone. An application of this method is shown below.

The second method discussed is the center line cross over. This method is used by traders to also indicate potential trade entries and exits. The application of this method is simple: trades are entered or exited based on the MACD line's position relative to the center line. Using the example shown below the application will be explained in further detail. A bullish buy signal is triggered when the MACD line moves from below the center line and intersects the center line. A bearish sell signal is triggered when the MACD line moves from above the center line and intersects the center line. From the results shown, this method can be known to lead or lag the optimal positions slightly but still provides a good buy and sell method which is geared for longer term trading.

This method can also be combined with the previous method detailed to provide added bullish and bearish buy and sell signals. This is done by looking at where the crossover positions occur. If a bullish crossover occurs above the center line this gives added confidence that the share price will move positively upwards. Likewise if the share price has a bearish crossover underneath the centreline this can if more confidence in the share price moving downwards.

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We have now established two methods that can be used to determine potential trade entries and exits using the standard MACD settings. However, for traders wanting more responsive signals the standard settings will not suffice. This is because the standard settings usually lag the optimal trade entry or exit point. Using the established buy and sell triggers we will apply this to a more responsive MACD setup. This setup is a 5-14-3 MACD setup as opposed to the standard 12-26-9 setup. Below one can see how these two methods compare with the top graph being the more responsive 5-14-3 MACD and the bottom graph being the standard MACD. Its very easy to see that the first settings gave better buy and sell signals than the second. If one had traded the MACD in both going long on the buy signals and shorting on the sell signals the profit margins would have been an amazing 83% for the 5-14-3 MACD and 15% for the 12-26-9 MACD. The negative aspect to the more responsive 5-14-3 MACD is that is has a greater chance of a mixed signal as seen in the graph with the narrow crossover labels. For this method it’s better to act on strong crossovers.

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Intro to ratio analysis 

A Du Pont analysis is a fundamental model that aims to measure how well a company is managing its finances to maximize wealth. This model determines success by the return on equity that a company generates. What makes this a strong financial model is that it combines several confusing financial ratios into three main categories. These are: income, investment and capital structure.  

The equation is shown below with the input variables being:

1) Net profit: the profit after working expenses. Calculated by taking revenue generated – cost of goods sold – all expenses – interest – taxes).

2) Total assets: sum of all current and non-current assets.

3) Sales: total revenue generated through sales of a product or services provided.

4) Ordinary equity: this is the total value of a company’s ordinary shares on the market (excluding preference shares). Thus if a company’s stock is trading at $10 and there are 3 000 shares then the ordinary equity is $30 000.

The interpreting of the results is simple. When comparing companies or comparing a company to its sector the one with the highest ROE percentage value will be the most favorable. The individual parts of the formula can also be broken down. A higher (net profit/sales) means that, that company is more profitable. A higher (sales/assets) means that, that company has a better asset turnover. A higher (assets/equity) means that, that company has better financial leverage.

Financial ratios can be subjective in their interpretation. This is where financial distress models come in, as their results are objective in how there are interpreted. The financial distress model that will be explained will be a multivariate discrimination analysis (MDA), this calculation will classify a company as either “failed” or “successful”.  This is done by the equation using predetermined ratios dealing with the input data. The output of this calculation will state if a company is in financial distress or not with a company in distress being “failed” and a company not in distress being “successful”. The Model used is the Altman model which is one of the most well-known financial distress models.  

The equation is as shown below with the input variables being:

1) Working capital: this is the capital a company uses in operations. Calculated as the current assets – current liabilities

2) Total assets: sum of all the current and non-current assets.

3) Earnings before interest and tax (EBIT): this is a company’s profit before interest and taxes. Also known as the difference between the operating revenues and operating expenses.

4) Market value of equity: This is the total value of a company’s shares on the market. Thus if a stock is trading at $10 and there are 3 000 shares, the market value of equity is $30 000.

5) Book value of total liabilities: this is the total value of liabilities on a company’s financial statement.  

6) Sales: this is the total revenue generated through sales of a product or services provided.

The interpreting of the results is very simple. Companies with a Z value greater than 2.99 are deemed successful and companies with a Z value lower than 1.81 are deemed unsuccessful. If the company lies between these values then it is considered to be in a grey zone in danger of becoming an unsuccessful company.