History Tends to Repeat Itself – The Big Assumption
As mentioned earlier, one of the key assumptions in technical analysis is that we rely on the fact that history tends to repeat itself. This is probably one of the most important assumptions in technical analysis.
It would make sense to explore this assumption in greater detail at this juncture, as candlestick patterns are heavily dependent on it.
Assume today, the 7th of July 2014, a few things are happening in a particular stock. Let us call this factor:
- Factor 1 – The stock has been falling for the last 4 consecutive trading sessions
- Factor 2 – Today (7th July 2014) is the 5th session, and the stock is falling on relatively lower volumes
- Factor 3 – The range in which the stock trades today is quite small compared to the last four days.
With these factors playing in the background, let us assume that on the next day (8th July 2014) the fall in stock gets arrested and the stock rallies towards a positive close. So, as an outcome of the 3 factors, the stock went up on the 6th day.
Time passes and let’s say after a few months, the same set of factors is observed for 5 consecutive trading sessions. What would you expect for the 6th day?
According to the assumption – history tends to repeat itself. However, we need to make an addendum to this assumption: when a set of factors that have played out in the past tend to repeat themselves in the future, we expect the same outcome to occur as was observed in the past, provided the factors are the same.
Therefore, based on this assumption, we can expect the stock price to go up on the 6th trading session even this time around.
Candlestick Patterns and What to Expect
Candlesticks are used to identify trading patterns. Patterns, in turn, help the technical analyst to set up a trade. The patterns are formed by grouping two or more candles in a certain sequence. However, sometimes powerful trading signals can be identified by just a single candlestick pattern.
Hence, candlesticks can be broken down into:
Single Candlestick Patterns:
- Marubozu
- Bullish Marubozu
- Bearish Marubozu
- Doji
- Spinning Tops
- Paper Umbrella
- Hammer
- Hanging Man
- Shooting Star
Multiple Candlestick Patterns:
- Engulfing Pattern
- Bullish Engulfing
- Bearish Engulfing
- Harami
- Bullish Harami
- Bearish Harami
- Piercing Pattern
- Dark Cloud Cover
- Morning Star
- Evening Star
Of course, you must be wondering what these names mean. As mentioned in the previous chapter, some of the patterns retain their original Japanese names.
Candlestick patterns help the trader develop a complete point of view. Each pattern comes with an in-built risk mechanism. Candlesticks give insight into both entry and stop-loss prices.
Few Assumptions Specific to Candlesticks
Before we jump in and start learning about the patterns, there are a few more assumptions that we need to keep in mind. These assumptions are specific to candlesticks. Do pay a lot of attention to these assumptions as we will keep referring back to them later.
At this stage, these assumptions may not be obvious to you. I will explain them in greater detail as we proceed. However, do keep these assumptions in the back of your mind:
- Buy strength and sell weakness: Strength is represented by a bullish (blue) candle and weakness by a bearish (red) candle. Hence, whenever you are buying, ensure it is a blue candle day; and when selling, ensure it’s a red candle day.
- Be flexible with patterns (quantify and verify): While the textbook definition of a pattern may state certain criteria, there could be minor variations due to market conditions. One needs to be flexible, but within defined limits — always quantify the flexibility.
- Look for a prior trend: If you are looking at a bullish pattern, the prior trend should be bearish; likewise, if you're analyzing a bearish pattern, the prior trend should be bullish.
Key Takeaways from This Chapter
- History tends to repeat itself – we modified this assumption by adding the factor angle.
- Candlestick patterns can be broken down into single and multiple candlestick patterns.
- There are three important assumptions specific to candlestick patterns:
- Buy strength and sell weakness.
- Be flexible - quantify and verify.
- Look for a prior trend.