Candlesticks are a method of viewing the open, high, low and close values for a charting interval; the same data used in the construction of bar charts. The prices between the open and close of the specified interval are represented by the body of the candlestick, and the highs and lows are shown as thin wicks above and below the candle body.
Traditionally, hollow candlesticks show times when the close is higher than the open for that charting interval (“up” bars), and filled candlesticks signify that the close is lower than the open (“down” bars). Traders also can use candlesticks of different colors to represent the up and down bars; one popular approach is to use green candlesticks for the up bars and red candlesticks for the down bars.
While individual candlesticks illustrate the price activity that occurred during a single period (for example, one five-minute bar), a series of candlesticks can provide important clues about where price is headed next. Candlestick patterns can help traders identify a variety of continuation and reversal signals in the markets, which can be used to locate trade entry and exit points.
One good candlestick pattern is the “inside day,” which traders can use to predict market reversals. Here, we take a look at how traders can use the inside day — along with a technical indicator for confirmation — to identify higher probability trade entry points.
The inside day pattern forms when a candlestick’s high is lower than the previous candlestick’s high, and the candlestick’s low is higher than the previous candlestick’s low. Essentially, an inside day occurs when one candlestick falls completely within the candlestick before it, as shown in “Inside days.”
An inside day often signals uncertainty and indecision because neither the bulls nor bears have been able to push price beyond the previous period’s range. When this candlestick pattern emerges, it can indicate that momentum has stopped, and any preceding rally or downtrend is losing steam.
If an inside day forms at the bottom of a downtrend, for example, it can signal a reversal to the upside; if the pattern appears at the top of an uptrend, the rally may be losing its breath, and price may soon reverse to the downside.
When basing a trading system on price patterns, it is common to apply additional technical analysis tools to confirm trades, and it’s possible to test virtually any technical indicator with the inside day price pattern. For our system, we’ll look for inside day patterns, while using the relative strength index (RSI) to form a directional bias.
The RSI is a momentum oscillator that compares the magnitude of recent rises in price to recent drops. It’s commonly used to spot overbought and oversold conditions in the market. The RSI typically appears below a price chart as a curving line, which oscillates between values of zero and 100. It typically measures momentum over a 14-period timespan, which serves as the default measure over most charting services, but technicians can set it for any look-back period they think is relevant. A trading instrument generally is considered overbought when RSI moves above 70 and oversold when RSI falls below 30.
We start with a trading system that enters a long trade if:
- An inside day pattern forms, and
- The RSI (14) value is below 30
The system enters a short trade if:
- An inside day pattern forms, and
- The RSI (14) value is above 70
Because we have no money management rules yet (no profit targets or stop-losses, for example), we have a stop-and-reverse system: One trade is closed out and a new one is entered as soon as the system generates an opposing signal, and so forth as long as the system is active (see “Trade signal,” right). We tested the system on the daily British pound futures contract, using one standard lot on 10 years of historical data. At this point, the results, while in the black, are somewhat unremarkable, as shown in “System profits” (below). We can improve the performance by optimizing the length of the RSI and its overbought/oversold thresholds.