While most patterns on the candlestick chart can show you possible up or down trends, certain patterns can also indicate when traders should slow or stop trading and wait for clearer market signals. These are called wait and see patterns; two of the best known are the inside range and tweezers.

When an inside range occurs, the market movement is slight and provides little indication of its direction. For traders, this pattern usually means securing their positions and waiting until a new pattern in the market emerges.

The tweezers refers to two consecutive candlesticks that have matching highs or lows. When the consecutive candlesticks have matching highs, the pattern is called a tweezers top. When candlesticks have matching lows, the pattern is a tweezers low.

The tweezers pattern indicates that a currency is rising to a specific price, falling to a lower price, and then repeating the rise and fall. As with the inside range pattern, traders who can see a tweezers pattern in the charts should slow and even possibly stop their trading until a clearer trend in the market emerges.

Source: GFT

The appearance of the candlestick body and its shadows provide a lot of information about the state of the market and where it’s going.

The length of the candlestick body shows where the majority of the trading took place. A long body suggests that the market is trading heavily in one direction, while a small body indicates lighter trading.

In our examples, you’ll notice that green candlesticks appear in an ‘up’ candle; in other words, the currency closed higher than the previous candle’s close. Red candlesticks show a “down” candle or that the currency closed below the previous candle’s open.

Traditionally, up trends were represented by white candlesticks, while down trends were depicted by black candlesticks. Today, traders can normally  select any color combination they want. For our purposes, we’ll continue to use the green and red colors to show ups and downs.

Identifying Candlesticks Patterns

Being able to read the candlesticks in a candlestick chart can help you see the current state and direction of the market. This can help you make decisions about the market now, but how about what the market will do in the future?

Candlestick charts can also display specific bullish (strengthening) and bearish (weakening) patterns that cannot be seen on other charts. These can help you find potential market opportunities and make decisions about what to do in the future. Let’s look at a few patterns that may help you.

Doji

The Doji often marks the end of a trend. It is the candlestick that has virtually no body, which means that the opening price was very nearly the closing price, which implies that the market may be undecided where the price is going. It’s a danger signal, as well as an opportunity to find a change in direction.

On its own, the doji can’t tell you much about the market trend. It’s neutral, and gets more meaning when you consider the surrounding candles. However, the length of the shadows does have some meaning, which I will cover later.

Engulfing

The engulfing pattern is exhibited by two opposite colour candles, where the body of the second one ‘engulfs’ the first body. For instance, a small white (bullish) body may be engulfed on the next day by a black (bearish) candle, where the open (top of body) is higher than the previous close (which was also top of body, on the bullish candle), and the close is lower than the previous open. There is no or little ‘wick’ above or ‘tail’ below. This is a bearish engulfing pattern. A bullish engulfing signal is the opposite, when the day starts out low, and the close is high, giving a candle that engulfs the body of the previous day and showing that the bulls are winning.

Shooting Star

This quite often happens near the top of a upward trend. It is a small body, with a long ‘wick’, or upper shadow. What it shows is that higher prices were tried during the day, but none of them stuck, which suggests that the bullish run is getting tired. There are several other candlestick formations that are called ‘star’ patterns, and they are all powerful reversal signals. To qualify to be called a star, the pattern appears at the top or bottom of a trend, and is a small or Doji candle gapping above (below) the previous, followed by a reversal candle closing well into the previous real body.

Hanging Man / Hammer

Hanging Man and Hammer are very similar in shape, having a short body at the top of the shadow – and a ‘shaven head’. The body can actually be either colour, but should be less than half the length of the tail. The hammer can appear at the bottom of a downtrend, and may signal time to hammer the price back up – the bears failed to make the intraday lower prices stick at the close. The hanging man appears after a rising trend, and often signals that the trend is stalled, and you should probably take your profits. This is an example of how the surrounding candles can make a difference to how you interpret the signals, the same shape is interpreted as either the Hanging Man or the Hammer, with totally opposite meanings.

There are many more named candlestick patterns, and it’s worth getting to know the main ones, but the meanings flow from consideration of what they represent, as demonstrated above.

Another type of candlestick reversal pattern is the two-day reversal pattern. Again, this kind of reversal signals that the general direction of the market is changing, but the change occurs over two days. These patterns appear at an extreme up or down trend in the market, so many traders watch for these patterns so that they can manage their own position in the market.

Like one-day reversal patterns, a two-day reversal pattern can be either bullish or bearish. In this section, we’ll look fi rst at bullish and then bearish reversal patterns.

The most common bullish reversal patterns are the bullish engulfing pattern and the piercing line pattern.

In contrast, the two most common bearish reversal patterns are the bearish engulfing pattern and the dark cloud cover pattern.

Again, recognizing these reversal patterns in a trend helps traders make decisions about their position and prepare for movement in the market.

Source: GFT

One pattern that traders frequently look for is a candlestick reversal pattern. You may already know that a reversal indicates a sudden change in the market direction. For example, a bullish reversal means that the market may move up from a down trend while a bearish reversal indicates that the market is shifting down from an up trend.

A one-day reversal is usually a signal that the general direction of the market for that day is changing. While one-day reversals are significant to traders for short term trading, they know this pattern can also be the starting point of a more long term market reversal.

When a doji appears on a chart, it usually means the opening and closing prices of the candlestick were identical. This means that the market reached the end of the trend and temporarily balanced. Usually, the markets tend to reverse after a doji appears, although significant market pressure on one side may postpone the reversal briefly.

There are many variations of the doji. For example, the long-legged doji has long upper and lower shadows that show the level of trader indecision in the market.

When a doji appears midway through an up or down trend, the pattern is called a rickshaw man. Often, the appearance of this doji means that the trend is about to reverse suddenly.

A doji may also appear with other patterns that indicate reversal trends in the market. Whenever a doji appears, traders should watch the market and prepare for a reversal.

Source: GFT

Before Homma developed candlestick charting, traders in his hometown of Sakata, Japan followed a set of rules and methods called Sakata’s Constitution. Homma later used a set of patterns in this constitution, called Sakata’s Five Methods, as the basis of his candlestick charting principles. Today, these patterns still help traders identify simple trends in the market.

Sakata’s Five Methods consist of five specific patterns: three mountains, three rivers, three gaps, three parallel lines, and three methods. What’s the significance of three? Japanese culture at the time believed three to be a significant, even divine number. Homma also believed that when traders found a promising trade, they should wait for three days. If the trade still looked good after three days, it would then be profitable.

As you read the description of these patterns, some may already sound familiar to you. Nonetheless, these candlestick formations can help you predict simple trends in the market.

The three mountains pattern shows three candlesticks moving up or down in a trend. Usually, this pattern indicates that the trend is about to end. If the middle candlestick is higher than the other two, the formation becomes a three Buddha formation or a head-and-shoulders pattern. Traders should plan for the market to reverse its direction.

The three river method also indicates a reversal pattern. This pattern looks different depending on if the reversal is bullish or bearish. The bearish version of this pattern, called a three river evening star, shows a long bullish candlestick, a short, bullish candlestick (also called an island or a star), and a bearish candlestick where the low is below the midpoint of the candlestick body on the first day. The bullish version, called a three river morning star, shows a long bearish candlestick, a short, bearish candlestick, and a bullish candlestick where the low is below the midpoint of the candlestick body on the first day.

The three gaps pattern appears when the trading is high. A gap happens when the opening price moves significantly higher or lower than the close of the last candlestick and creates an empty spot on the chart. The three gaps pattern usually means a trend is over and is about to change. After the third gap of this pattern appears and the market reverses, the market moves enough to close the length of the second gap.

The three parallel candlestick pattern refers to three consecutive candlesticks that are going the same way and have a similar height. This means the ongoing direction is expected to continue and traders should plan accordingly. When the three candlesticks are bullish, the formation is known as the three soldiers; when bearish, the pattern is called the three crows.

In the figure above, you can see a bearish rising three: a bearish candlestick is followed by three bullish candlesticks and then another bearish candlestick. This pattern usually means there is inactivity in the market and that a lot of tight trading is happening.

Summary

While candlestick charting may seem like a lot to learn, don’t worry. As you read candlestick charts, these common patterns will become more familiar to you. Over time, you’ll learn about other patterns and combinations of patterns that you can use to determine the state of the market, anticipate its possible direction, and identify market patterns.

One of the best ways to analyze candlestick charts and test your knowledge of patterns is by opening a GFT practice trading account. If you already have a live account with GFT, you can also view candlestick charting on historical data.

Source: GFT

What’s your Problem? Let Me Guess!

You’re not alone if you feel you need to improve your trading. As many as 90% of would be traders find they can’t make a profit and give up in the first six months of trying. The general issues you face are the prospect of easy money, the excitement, and the lack of reality. Each of these has its effect on you. Imagine that someone offered $1 million for the fastest lap on a race circuit. You would get lots of people applying to try, but how many would be well prepared? In fact, how many would fail to complete the lap? Wouldn’t you like to be well-prepared?

We’ve covered in this brief report some of the reasons that so many fail. One of the main ones is a failure to control the risk, and this stems from a lack of discipline, or from a lack of a trading plan or knowing what to do. Tied into this is using too much leverage with derivative trading. Let’s just run through the major issues.

Controlling Risk

In any other endeavor, you would check that you had minimized the risk. Say you wanted to go motorcycle racing, I expect you would check the machine out, making sure it was tuned up and that the brakes worked. Yet in trading novices take much less care to ensure they are equipped to face the challenges. Often it’s the idea of “easy money” that started the thought in first place.

Yet many beginners don’t have a real plan for controlling risk, because they concentrate on the upside of their trading, and don’t consider the downside thoroughly enough. They read the books, it seems straightforward enough, so away they go. But the point is, if you don’t control the risk rationally you probably won’t be trading for very long before running out of money.

Often it’s a lack of discipline that’s the problem. You may even know the best advice, but in the emotion of trading you tend to ignore it. Fear and greed are often cited as the emotions to watch out for, and they are powerful, but that’s to assume that a human being is two-dimensional. You will fi nd many more different emotions play on you where the real money is at risk.

Cutting Losses

The problem I always had was quitting a losing position quickly, particularly if the trade had just been placed. It just doesn’t feel right to admit you are wrong so quickly, and it certainly goes against your normal instincts. But unless you can do this, you won’t succeed at trading. Capital preservation is more important than the possibility of profit. With correct trading, the profit will come.

One way to think yourself out of this problem is to regard each losing trade as another step to your profits. Be eager to cut your losses. Say your trading plan tells you that on average you will have six winning trades for every ten you place. That means you need to make four losing trades. Each time you close a losing trade you progress your plan.

Yeh, right. But get used to it. I remember well ‘doubling down’ on one position I had. If it’s worth buying in the first place, then if the price falls it’s a better deal, isn’t it? I wasn’t thinking, as this was a recommendation from one of the financial newsletters I subscribed to, and I abdicated my responsibility to their “expert opinion”, which even included the advice to increase the position when the value fell.

Following Newsletters

This situation went well, as the shares kept dropping until they finished up at 2 cents a piece, and I think got de-listed too. I certainly didn’t get anything out of them, as they weren’t even worth the commission to cash in once I’d got my head around the fact that they REALLY weren’t going to recover. Why do I say it ‘went well’? Because the worst thing that can happen is that you trade badly and the market saves you. I should never have (and you should never) doubled down, and if I’d been rescued by the price coming up, it would have reinforced a bad action which I’d be likely to repeat. As it was, I learned the lesson.

That was a subscription newsletter, but another danger is the newsletter that you receive, either in an e-mail or in the mail, that you didn’t ask for. Often they look authoritative and contain extensive details and ‘research’ about a small company ‘expected’ to double or triple rapidly. Again, get caught once, and you would be wise to learn the lesson. While such unsolicited correspondence might occasionally give you a pointer to a stock that you may wish to independently research for your portfolio, usually it is a disguised advertisement, and part of a ‘pump-and-dump’ scheme.

Here’s the trick. Look to the end, where there is usually a mass of small print that proclaims the letter is not a recommendation, does not constitute an offer to trade, and the sender was compensated $25,000 or more for the work. I’ve often thought this would be a good line of work to be in, but considering how I feel about such deceptive letters, it would be very hypocritical of me!

Maintaining Discipline

A lack of discipline is failing to do what you should do. It might be failing to cut your losses on a losing trade, but it might equally well be taking your profits prematurely so you miss out on some of the move, or perhaps not even taking a trade after a succession of losses, or failing to “pull the trigger”. You can have the best trading plan in the world, but if you don’t stick to it the results are questionable.

What often happens is that you know that you made the right move, but it doesn’t work out. You try and rationalize the reason for it rather than just accepting it. The more intelligent you are the more you are open to this trap. Why it happened is irrelevant, you must just react, accepting the facts, and move on. The markets are bound to frustrate you again and again, but the trick is not to frustrate yourself. You can control your reaction to the markets, but you cannot control the markets.

Richard Dennis, one of the recruiters for the “Turtles” in the 1970s called doing what you’re supposed to when there are 1 million other reasons to do something else “doing the hard thing”. The Turtles were taught to “do the hard thing”, and that helped make them some of the most successful traders in history. Second guessing a trading decision is one of the simplest things to do, and one of the most destructive to your trading career, and if you find yourself doing it frequently you need to develop a new approach.

We’ve been through the reasons that a black box system is no way to trade, and why high yield accounts managed by people may not work out either. Then a cautionary tale about the risks of setting stops on the market, and a look at one of the latest technical tools that is starting to be recognized in the West. Now we look at one of the most useful techniques for would-be traders to master in order to prove their concepts before risking real money.

Backtesting is key to knowing that your system, however innovative and original, is actually going to work to make you a profit. If you think you have it right, you can always try it out in the market straight away, but that’s not much fun, and expensive, if it doesn’t work. You can paper trade for a while, and probably should so that you get used to the system, but that’s not very effective to prove and improve the system.

A few years ago, you might have done a backtest by hand, going through charts and marking on the trading points, but now there’s no question that you can do it easily with a personal computer. Testing your proposed system on historical data will let you see how good it really is, and perhaps find opportunities for improvement, all before you risk a penny.

Of course, a successful backtest, while important, is no guarantee that the system will make money in the future. But it should arm you with valuable information about what to expect – for instance, could your system have ten losses in a row, but still come out on top overall? If you know in advance, then you will not abandon using it after eight losses, thinking it’s not working.

Setting It Up

The way you program the system will depend on your software, whether TradeStation, MetaStock, AmiBroker or another. Once the basic system is encoded, you will then test on historic data, and try and improve the performance. There are two pitfalls to this.

The first is referred to as curve fitting, and that’s when you take pains to fi t the system to the data to come up with the best possible performance. The system finished up looking great, based on the set of data you wrote it for. What you have really done is match the system to the data. Sometimes traders will even just extract a part of the chart, and make the system work well on that. If you don’t have a system that can cope with different market conditions, then you probably shouldn’t use it.

The other pitfall is similar to this, and called over-optimization. You can take this too far, too, particularly as you may find that your software accommodates automatic optimizing. For instance, TradeStation can find the best parameters for any indicator you are using. You have to realize that, with a basically sound and effective system, there are a range of effective values for the parameters, and you cannot find one set that will perform perfectly in the future. The answer is to determine the range that works acceptably, and take a middle value. If your system results are particularly sensitive to small changes in one value, then you should go back and see why, as that suggests you have it too highly tuned in to the data set.

When you have tweaked the system sufficiently, but not too much, you can then try it out on a new set of data. You should never optimize the system using all the data that you have, as you need a new sample to give more results. This will show whether you have over optimized or curve fitted the system too much for general use. If your system is good, it should work well on the new sample; if it doesn’t, try to figure what went wrong on the new sample, but don’t make the mistake of optimizing on that set of data too – keep the data apart, so that it can be used in testing again.

When you are backtesting, look at the number of trades that the system makes. It should be at least thirty in order to be statistically valid. If it is less, you need more data points, otherwise a couple of extreme results could be distorting the outcome.

Finally when running the tests, you can put the system to work on different securities, and see the results. Again, a sound system should be consistent, and not tuned in to just one stock, otherwise you may well be disappointed with the performance in the future.

Interpreting It

All the results that you get from backtesting aren’t a lot of use if you don’t know how to use them. It’s not just a matter of seeing which set of results gives you the greatest bottom line, as there are other considerations that your test results will reveal to you. In fact, at this stage your results won’t even account for any commissions and slippage, so the positive return may be much less than you think.

Typically the software will give you a total net profi t. If this isn’t positive, your system has failed at the fi rst hurdle, and you need to develop another. But the number you see here is not that good an indication of how it will work out for you in practice. You need to look at the number of trades, the maximum drawdown, the consistency month after month, the size of gains and losses, and the other data.

First, if you are comparing the results of two systems you want to choose the system that gives you fewer trades. This keeps your commissions and slippage costs to a minimum. Bear in mind that you do want to see the results of at least thirty trades, though, as stated above, to get a good idea of the performance.

Second, don’t pay much attention to the percentage of trades that were profitable. Some traders worry about this, but it might be 50% or less and you can still have a good system. What matters is how large the wins are compared with the losses.

Look next at the size of the largest wins and losses. For instance, is the profitdue to just one trade, which may not happen again? If the largest gain accounts for a major part of the profit, then it’s not a good system. The largest loss should not be as much as the largest gain, as you are looking for a system that cuts your losses short, so if the loss is nearly as big as the gain you may need to reconsider how you define your stop loss level. Going by the general advice of reward to risk ratio being 2 to 1 or 3 to 1 you need to see a clear difference in the amounts.

I spoke about the number of consecutive losses previously. If this is a big number, you may find it hard to stick with the plan and keep trading. On the other hand, if you know it can happen because you have seen it in testing then you may be able to stomach it. The amount of the drawdown is very important, as it tells you what you have to be prepared for to use the system. It will tell you how much money you need to weather the worst period, at least of the test data. You should be able to go through a losing streak twice this size, in case one follows another, if you want to sure that you can continue trading. The size of the drawdown is an indication of the risk, so given an otherwise equal pair of systems you should choose the lower drawdown.

The profit factor is the gross profit divided by the gross loss. You want for this to be at least 1.5, and preferably more than 2. Anything close to one is not far from failing to make a profi t, and it wouldn’t take much to tip it into losing territory. Lastly, you want to consider the distribution of the returns. It’s preferable to have a system that gives steady small equity increases every month rather than wild swings over time. You can generate month-by-month charts of equity to be able to discern this.

Commissions and Slippage

Even after all this analysis of the results, you still need to figure in the costs of trading to see if the system you are proposing to use will be worthwhile. If you use a discount broker such as Scottrade you will know the costs of the trades accurately, at $7 each or $14 for a round trip – some other brokers charge according to the value traded. This is where a system that relies on trading frequently and making small profits will fail to prove profitable.

Finally, and depending on your chosen market, you need to make an allowance for slippage. This is the figure that represents the difference between what you thought you were trading for, and what the real numbers may be. At best this is a guess, but without accounting for this, you may find an apparently profitable system that does not work out in practice.

As you can see, there is a fair amount of work involved in testing and implementing a trading system. Those who tell you that you can just plug-in and go are trying to delude you, and anything worthwhile takes some time and effort. If you truly want the independence and security of knowing that you can trade successfully for a living, then you have to be prepared to do the homework. When you do, you will develop skills that will last for the rest of your life.

Ichimoku Charting

You may not have heard the term Ichimoku – it’s been used in Japan for about seventy years, but the West has only just discovered it. It literally means at a glance, and that describes how the Ichimoku chart is for the trained eye. For the untrained eye, it seems terribly confusing, but it can be broken down into pieces to help you understand it.

Now, because it’s so new on to the Western trading scene not all chart programs and providers will have it. You might think this would give you an unfair advantage if you happened to use it, and you would be right. Just as candlestick charting from Japan transformed the way we can look at charts, so Ichimoku is destined to transform the way we regard upper indicators.

If your charting program does not offer Ichimoku yet, then you can follow along by looking at www.stockcharts.com, as the free Sharp Charts allow you to plot all the Ichimoku indicators – just scroll down to the Overlays section and pick Ichimoku Clouds with the default parameters of 9, 26 and 52. Then click on Update.

At first glance, the Ichimoku chart seems very confusing. It has fi ve lines, and the area between two of the lines is filled in with color, and called the “Cloud”, or “Kumo” in the Japanese. In fact you’ll see it’s filled in with two colors, and the color used depends on whether the market is trending up or down. For this special report we’ll just look at the Cloud and its meanings, and the Masters course goes into the indications available from the other lines.

It’s interesting to note that none of these overlay lines is a moving average of any type, although some of them look very similar. Instead they are calculated and drawn from the extreme prices, and the Ichimoku method also uses an unusual scheme of time shifting lines to good effect.

The Lines

Here’s an Ichimoku chart so that you can see what to expect. The price candles are red and black. The shortest period line is called the Tenkan-sen, and is shown in blue on this chart. The line is drawn by taking the midpoint of the highlow range for the last 9 periods. The red line, the Kijun-sen, is drawn using the midpoint of the high-low extremes of the previous 26 periods.

This method of drawing the lines results in some horizontal sections, where there was not a higher high or a lower low on the day, and the 27th day back was also not an extreme day. In other words, the highest or lowest points in the last 27 days were not at either end, but somewhere in the middle. This means that the same high and low points are used from day to day for the next calculation.

Now we come to the cloud boundaries. The first, the Senkou Span A, is plotted by taking the midpoint of the two previous lines, then moving it forward by 26 days. This line is drawn in green above. The other cloud boundary, called unsurprisingly Senkou Span B, is calculated as the midpoint of the extreme high and low values of the previous 52 days or periods. This too is shifted forward by 26 days, and is shown in red. So the cloud lines reflect what happened 26 days ago, or around a month previously. As you can see from the chart above, the cloud runs ahead of the present day by about a month.

The fifth and final line is called the Chikou Span, and is simply the closing prices plotted 26 days previously. This is shown in green in the chart above, and as you can see finishes about a month before the current date, pending further price information.

Now if you are familiar with conventional technical analysis to the extent that you know about moving averages, you will see that the Tenkan-sen, based on 9 periods or days and the Kijun-sen, based on 26, are similar to and behave like 9 day and 26 day simple moving averages. There are differences, but it’s easiest to think of them in these terms.

But the two features that make Ichimoku a completely new development from conventional technical analysis are the idea of a cloud, and the idea of time shifting the indicator lines. In fact, time shifting is not such a big stretch when you think about it, as when you normally plot the moving average you put the value on the latest date for the previous however many periods. If you think about it, the average should really be in the center of those periods if you were to portray it in conventional statistical terms, in another context. But to apply time shifting both forwards and backwards is quite a radical idea.

The Cloud

The two Senkou lines defi ne the boundaries of the cloud. Whichever line is on top decides the color or tint of the cloud. Span A is derived from 9 and 26 period lines, so is a ‘faster’ line than Span B which is based on 52 periods or days, in the figure. This means in an uptrend the green Span A is on top, and the cloud is tinted green. In a downtrend the cloud is pink, in this default color scheme. But what it’s showing today actually reflects what happened 26 days ago due to the time shifting.

So how can we use the cloud? First, you can get an indication of the trend from looking at where the prices are in relation to the cloud. This is completely objective. If the price is above the cloud we are in an uptrend, and below the cloud signifies a downtrend. This is part of the “at a glance” idea – the way you can quickly assimilate information from looking at the charts.

If the cloud is green when an uptrend is indicated, it’s said to be a stronger trend – basically because it shows that the trend has been going on for a while. Similarly, a pink cloud when the price action is below, signifying a downtrend, reinforces the strength of the trend.

But what about when the price is IN the cloud? What does that say about the financial instrument you are tracking?

Well, some people take the route that this means the price is fl at, or not trending. Certainly that can be so, but really when the price hits the cloud it’s time to be alert. If nothing else, the price could pass right through, which would indicate a trend reversal, but often there will be more interaction than that.

You look to where the price came from to see the trend. If the price came down from above, and particularly if it’s a green cloud, that’s bullish. If it came up from below, it’s still bearish, at least at the moment. The best indication of a trend reversal is when the price crosses the Span B line, but there’s a lot more information available from the cloud, so we tend to look at the picture as a whole, rather than concentrating on one line.

What else does the cloud reveal to us? If you look at many Ichimoku Charts, you will fi nd that the cloud gives us some other indications of support and resistance levels – in fact, the price will often run along one of the cloud edges for a time. Unlike conventional technical analysis, where you sometimes have to wonder whether the projections are self-fulfilling because all traders use them – perhaps for Fibonacci levels, or for revisiting previous support or resistance – not enough Westerners are currently using Ichimoku charting for the predictions to be looked at that way, so the effects we see are actual market conditions.

As with conventional technical analysis, the resistance can become support and vice versa, so the cloud can be approached from either direction and may still rebuff the price. A solid indication of a trend change is for the price to be deflected by the Span B line at first, then to cross it and be deflected in the other direction.

As you can see, the support (and resistance) can occur on either edge of the cloud. What does the cloud thickness mean? Well, it’s thicker when the shorter term line is running away from the long term, which basically means that the prices are accelerating. At some stage, this has to stop, and the prices slow down, perhaps to a consolidation or even a reversal. When it thins down to the point where the Span lines cross, the cloud changes direction, and prices will also cross the cloud. The cloud is often thicker at reversal points, but it’s not usually used as a signal by itself.

It’s possible to trade when the price crosses the cloud, but it’s an early signal and a higher risk than some others. If you are prepared to cut your losses quickly if it goes against you, then it may just come down to a matter of style. Price action with the cloud is not always clear, and often the price will cross a few times before making its mind up about a trend change. Sometimes the best choice is to see how the price and cloud have interacted historically to find the most effective signal. Ichimoku works well with about 75% of securities, and you need to check whether the security you are interested in has reacted favorably previously.

A unique feature of the cloud is that it is projected forward in time by 26 sessions, and this can change your approach to trading. You no longer have the excuse that you didn’t see it coming, so you missed the opportunity. With the cloud projected forward beyond today’s date you can be more prepared to act when opportunities arise. It shows you exactly what the price needs to do so that the trend continues. If the price does not comply, and crosses the cloud, then you have a warning that the trend may be changing. There is not another analytical method that gives you a moving target for the price projected into the future, in order to maintain the trend.

Some proponents even suggest pushing the cloud out further, doubling the distance to 52 periods. The fi rst 26 periods are authentic, and the second part of the cloud can be drawn on the basis that prices won’t change for the next 26 periods. While this may be a stretch, it gives you a preliminary idea of what may happen, and the cloud can be corrected as time passes and real numbers are available.

The Variables

Up to now, the Western world has not explored changing the variables used in Ichimoku charting very much, preferring to continue with the ones used historically by the Japanese – and why not, if they are working well. But there is scope for experimentation and improvement. But as mentioned above, Ichimoku charting is successful in about 75% of cases, so it may be possible to improve this with careful period selection.

Of course, it’s always possible to improve on results in back testing, and no doubt you can tweak these periods for any particular chart and usually get improvement. The question is whether the changed numbers will work better in the future than the standard figures. Some people have experimented with using Fibonacci numbers instead, for example 8, 21, and 55. It’s not clear whether these give an overall improvement.

The original numbers were tested for many years in the 1930s, before computers were available to help with the process. Hosoda, the originator of Ichimoku charting, used a team of people to back test the values, and these were the results that they came up with. Generally, moving to shorter periods will give earlier signals but may result in more false signals. Other dynamics come into play, such as the width of the cloud, so it’s not a straightforward choice.

With such a new technique, changing the numbers is one of the hot topics amongst recent converts to Ichimoku. No one has yet proved that any other combination of numbers is any better, but it’s really far too early to tell. In fact, rather than optimizing the numbers it proves more effective to impose a signal delay which means you do not trade as soon as a signal appears, but wait for a few periods to see if it retraces. After all, the main purpose of optimizing the time scales is to reduce the number of losing trades, and putting in a delay before taking action is one way of doing this.

I purposely concentrated on the cloud price interaction, and haven’t elaborated on the other three indicator lines, the Tenkan-Sen, Kijun-sen, or the Chikou Span. There are many different ways of using and interpreting Ichimoku charts, and these are discussed in detail in the Masters Course in Technical Analysis at our sister site.

You have to consider each situation and your method of trading to see whether you should put your stop loss order in the market. Whether or not you do, you should always know the price point at which you can safely assume that the trade has failed, and should cut your losses. One of the difficult ideas for novices is that this can be thought of as a successful trade.

Think about it, no trading plan or system is going to produce 100% wins, in fact if your system makes as much as 70% good calls it is doing better than many profitable systems. You can even lose as often or more often than you win and still have a good profit, because it all comes down to money management. Van Tharp spoke in his book ‘Trade Your Way to Financial Freedom’ of a random stock selection system that still produced a modest profit because good money management was in place.

So one of the fundamental concepts that you must realize is that a losing trade exited in a timely manner is still a success, provided it was executed in accordance with your trading plan and not on a whim.

To Set or Not to Set

The required stop loss position is therefore clear at the start of the trade, and the only question is whether you reveal it to your broker and the market by placing the order. One of the factors to consider is if your broker is a market maker in your selected market, or whether the financial instruments are being traded on an exchange. With the Forex market, there can be a difficulty with some brokers, so even though the market, at more than $4 trillion traded per day, is large enough that it’s very difficult for traders to manipulate, you can still be exposed to the broker’s dealings.

That’s not to say that the overall Forex market can’t be manipulated by traders, but it’s infrequent. It’s most likely to happen at periods of low activity, when the major trading markets are asleep, and it requires a major financial institution to have the capital to do it. It’s not illegal, but it can be detrimental to you so is something to be aware of.

However, when considering trading in equities, the amount of cash flow is much smaller. If the shares you are interested in have a relatively small volume of trading, this is subject to manipulation with a big investor intentionally moving the prices by their actions. Some traders purposely choose to ignore the smaller stocks, both for this reason and because more heavily traded shares are more likely to behave rationally and predictably.

You may be alright placing your stop loss orders on the market if you make sure that you trade in periods of higher activity, and on more popular securities. You may not have a choice, if you are unable to keep a watch on the market movements frequently enough. If you are swing trading your plan might be to only look at the closing prices each day, and ignore intraday fluctuations, and in this case you would want to avoid putting orders on the market. Stop loss hunting is a real issue that can affect your trading, and you need to be mindful of it to avoid trouble.

You may have heard some conflicting information about setting stop losses, and be wondering what to do. Some people say to always set them, others say never do that, and sometimes you’re supposed to figure out for yourself if you need stop losses set.

Why You Need Stops

The reason to set them goes back to the idea that you can lose too much if you rely on your own discretion in the heat of the moment. This is a very real concern, as when you have just decided on a trade, taking however much time and care your trading system requires, it is very difficult to turn around and say straight away that you have to sell for a loss.

It feels like you have failed, and that is something that as humans we all try to avoid. Nonetheless, it is the ability to cut your losses quickly that is one of the keys to successful trading.

So if you can set an order in advance to close out the losing trade, then forget it, not worrying about any emotional feeling, for what reason would you not do this? There are several.

Why You Might Not Set Stops

Trader Manipulations

Firstly, for a thinly traded stock, there can be genuine large fluctuations in the price, and you may have made a good selection that suffers a spike which takes you out of an otherwise winning trade. If you have the benefit of what is called a Level II screen, you can see that it may not be misfortune alone that causes this.

A Level II screen shows the pending orders. There’s a buyers’ column and a sellers’ column, showing the stop and limit orders in place that are awaiting execution, if the price was to rise or fall to the required level. For instance, the buyers’ side might show on the top an order to buy 1000 shares at $1.63, and the sellers’ side might show that someone else is prepared to sell 5000 shares at $1.64. The columns are sorted so that the orders nearest to being fulfilled are at the top – there will be other pending buyers who want to pay less, and sellers who want to get more.

No trade can take place on the shares as described. It needs one of the existing parties to change their minds on what price they are happy with, or someone new coming in with a price that works, or a market order, to make the next trade happen.

Now if you are a big enough trader, particularly with a thinly traded stock, what you do can influence the prices. Hit the market with a big order to buy, and the price will go up, as each seller’s price must be reached to get the shares. Or by selling, you can reduce the price for the moment. So by manipulating the prices, you can force a stop loss to be triggered, and you know exactly how much you need to do this by looking at the Level II screen. If you are convinced that the stocks are going up, as is our hapless trader who has their stop loss order on the market, you can make the price go down to pick up his shares, and then you benefit from the subsequent rise in value, while the trader is left without any shares, but seeing that he was proved right in the end.

Broker Manipulations

That is one way you can lose by the simple action of putting your stop loss order on the market. There are more nefarious ways too. Contracts for Difference aren’t permitted by the Securities and Exchange Commission in the US, but are available in many other countries worldwide, and they seem to be particularly prone to fiddling. The CFD broker will often be a market maker, which means that they write their own price for the deal. It tends to follow the market, of course, but certainly there are times when it can be demonstrated that an unexplained blip in that broker’s chart, that didn’t occur in any other, took out some stop loss orders.

Contracts for Difference, which work on margin so you do not have to pay the full share price, give you the difference between the price when you take them out and the price when you close the trade. This can be profit or loss, depending on the share price move. The CFD broker gets his profit from a spread between the price for selling and for buying, and in theory hedges his position by buying the underlying shares, so he is neutral with respect to the trader. Too often it seems this does not happen, effectively meaning that the broker is betting against his client – and one way out of this is to spike the prices to trigger the loss for the trader.

Of course, not all CFD brokers are dishonest, and you can now also access CFDs traded on an exchange, which keeps the prices in line and not manipulated. But it is another way that placing a stop loss order on the market can work against you.

If you are in the US, you may be thinking that this couldn’t happen to you as you can’t buy CFDs. But the broker making the market is also a common practice in the Forex world, so you still should not feel safe in this market. To be sure you avoid the possibility of stop loss hunting by the broker spiking the price, you need to look for a broker who offers an ECN, which is short for electronic communication network. This gives you direct market prices.