Context is everything

If you remember only one thing from this book, let it be this: a candle without context means nothing. A hammer in the middle of a choppy range is just a candle. The same hammer, formed at daily support after a prolonged decline, with a rejection of liquidity below a previous low – that is a signal with a real chance.

The four pillars of context

• Trend: reversal patterns need a trend to reverse. A bullish reversal pattern only makes sense after a decline, a bearish one – only after a rise. Continuation patterns work best in the direction of a strong trend.
• Level (location): support and resistance, previous highs and lows, round numbers (for gold – levels like 00 and 50), daily opens, supply and demand zones. A signal at a level > a signal in mid-air.
• Confirmation: the next candle must confirm the direction. Most false signals are filtered out simply by waiting one candle.
• Volume and timing: a pattern with increased volume or in an active session (London, New York) is more reliable than a pattern in a quiet Asian session.

How to identify the trend

The simplest method is price structure: uptrend = higher highs and higher lows (HH/HL); downtrend = lower highs and lower lows (LH/LL). In addition, you can use the 50- and 200-period moving averages: price above both and sloping up = uptrend.

The principle of confirmation

The Japanese say: “Wait for the close.” A candle isn't finished until it closes. A hammer that looks perfect 10 minutes before the end of the hour can turn into a bearish marubozu. Never trade an unclosed candle. On top of that, for most patterns it's sensible to also wait for the next candle to close in the direction of the signal.

The three-question rule. Before every candlestick trade, answer: 1) Where am I – is the pattern at a level? 2) What is the trend on the higher timeframe? 3) Is there confirmation? If any answer is “no” – skip the trade.