Candlestick patterns are not what you think.

Let me guess…

You spot a Bullish Engulfing pattern that looks more promising than my wife's cooking (which isn't saying much), and you go long.

Then BAM!

Your account engulfed in flames, and you wonder:

“WTF just happened? That Hammer looked perfect!”

The reason is that a candlestick pattern isn’t a strategy, but a tool.

What’s a tool?

Let me explain…

A hammer is a tool to hit nails. If your goal (or strategy) is to build a house, then you need more than a hammer, agree?

It’s the same with a candlestick pattern. It’s only a tool, and you need more than that to be a profitable trader.

So, what can you do about it?

Here’s the solution…

1. Know your trading strategy

A trading strategy is a method to profit from a repetitive “pattern” in the market.

For example…

• Trend following strategy profits from market trends (like riding a wave)
• Mean reversion strategy profits from market swings (buy low and sell high—revolutionary, I know)
• Momentum strategy profits from market momentum (buy high and sell higher—yes, this works too)

Once you know your strategy, you need to turn it into a trading system. And this brings me to…

2. Develop your trading system

You might be wondering…

“What’s the difference between a strategy and a system?”

The strategy is the idea (or concept). The system is taking the idea and turning it into an objective set of rules.

It's like the difference between saying "I want to get fit" and actually showing up at the gym at 6 AM.

In other words, a trading system tells you when exactly to buy and sell without second-guessing yourself.

So, how do you develop a strategy into a trading system?

By answering these 7 questions…

1. Which markets are you trading?
2. What timeframe are you trading?
3. How much do you risk per trade?
4. What’s the trading setup?
5. What’s the entry trigger?
6. When do you exit if you are wrong?
7. When do you exit if you are right?

Moving on...

3. What’s the purpose of your tool?

In this example, we’re talking about candlestick patterns.

So, what is the purpose of it?

This is where you must ask yourself…

“What is the purpose of the candlestick pattern?”

If you struggle to answer the question, then look at the 7 questions above.

Can you use candlestick patterns to…

• Filter for trading setup?
• Serve as an entry trigger?
• To exit a losing trade?
• To exit a winning trade?

Once you get your answers, then it’s time to…

4. Backtest your trading system

Backtesting refers to testing your trading system on past data to see how it has performed.

This is important because if you have a trading system that lost money over the last 20 years, then it’s likely to continue losing in the live markets.

However, if you have a trading system that’s profitable over the last 20 years, there’s a good chance it could work in the live markets.

As you can see, you’re already stacking the odds in your favour before risking a single cent.

So here’s the bottom line…

1. Have a sound trading strategy.
2. Develop a set of rules around your strategy (otherwise known as a trading system).
3. Understand the purpose of your candlestick pattern so you know how it fits into your trading system.
4. Backtest your trading system to know whether it works or not.

Cheers

Rayner "breaking-down-the-process" Teo

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