Ask Colin

I read your recent article (Shares August 2002) in which you described the candlestick reversal patterns "Hammer" and "Hanging Man". Are they buy and sell signals respectively?

I addressed this issue the first part of the article in Shares magazine August 2002. There, I explained what a reversal signal means in Japanese candle charting. The key paragraph is:

Reversal signals in candle analysis tell us that the trend is likely to end. However, there is no way to know, other than in hindsight, whether this will be a short-term signal or a longer-term signal. The signal may presage a change to a new trend in the opposite direction, or simply a pause in the trend.

I must admit that I thought that I had made it fairly clear and even included arrows at right angles on the charts to reinforce the idea. Perhaps I have not succeeded.

They are not buy and sell signals. There is no such thing in candle charting. They are simply signals that the trend may change in the short term. They will often be present at market turns, but it is very tricky to pick when those signals occur as apart from the ones that just indicate a pause in the trend.

The correct way to use any chart signal, candles or bar charting-based, is to work through the possibilities and devise some tactics for dealing with the situation.

You may reduce your position. You may close it. You may even take a small opposite position. However the key thing in candlestick charting, and I think it applies to bar charting signals too, is to watch for confirmation.

So, if you see a hammer and the next candle is a big black one going lower, I would not take it as a buy signal. If I had closed a short and gone long, I would close the long quick smart.

However, if the next candle is a big white candle going much higher, I might consider increasing my long position.

If the candle after the hammer showed no direction, I would hold and wait to see what happened next before increasing or closing my long position. If it was another hammer, I would have a very close watch on the market. If it was a doji, which indicates uncertainty, I would be also watching for the market to tell me what direction it was wanting to go in.

The general conclusion of this discussion is that technical analysis is not simply a matter of seeing buy and sell signals. It was never intended to work that way, which is in fact a good way to lose money. Rather, technical analysis is a collection of tools that can help us to gain insights into what is happening in the market and around which we have to think out and constantly adjust our trading tactics to control risk and position ourselves for opportunities.