The Big Shadow

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The big shadow is a two-candlestick, reversal formation and an important catalyst for the naked trader. The big shadow appears on support and resistance zones, precisely where the naked trader looks for high probability trade set-ups. Once the big shadow prints on a zone, we have a valuable hint that the market may soon turn around.

Two candlesticks make up the big shadow formation. As with most naked trading catalysts, they must print on zones to be valid trade set-ups. Big shadows are only valid when they appear on zones. A big shadow may print on top of the zone (the market is finding support on the zone, a bullish big shadow), or the market may print below the zone (the market is finding resistance on the zone, a bearish big shadow). The important thing is this:The big shadow must print on a zone.

What dose it look like

Some traders may refer to the big shadow as an engulfing candlestick,but it is more than that, as there are specific rules associated with the big shadow, including how to trade it, and specific optimizers for the trading set-up. The big shadow is essentially a two-candlestick formation in which the second candle completely dwarfs the first candlestick. This second candlestick is known as the big-shadow candlestick. The defining characteristics of the big-shadow candlestick are as follows: The bigshadow candlestick is much larger than the previous candlestick, the big-shadow candlestick has a wide range, and the big-shadow candlestick is the largest candlestick the market has seen for some time.

Figure 6.2 shows another example of the big shadow. This one is another bearish big shadow, this time on the EUR/GBP daily chart.
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FIGURE 6.2 The bearish big shadow here is on the EUR/GBP daily chart. Notice how the range of the big-shadow candlestick is much larger than the previous candlestick.

Dose bigger equal better

If you spend some time watching the charts, you will notice that some shadows are larger than others. The ideal big shadow will have a wide range. Look at the examples in Figure 6.1 and Figure 6.2; both big shadow candlesticks have a very wide range.
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FIGURE 6.1 This bearish big shadow on the CAD/JPY daily chart has a much larger range than the previous candlestick.

Both of these big shadows are the largest candlestick the market has seen in some time. In Figure 6.1 the bearish big shadow is the largest candlestick the market has seen in several weeks. Likewise, the big bearish big shadow in Figure 6.2 is a very large candlestick, the largest candlestick in over one week of trading. Ideally, the big shadow should have the greatest range of the previous five candlesticks. Smaller big shadow candles may be tempting because the stop loss is closer to the entry price, but historically, the very large big shadows have a much higher success rate. Back-test this for yourself to see if the very large big shadows you trade have a higher success rate.

The stop loss

The big shadow stop loss is placed beyond the big shadow. For a bullish big shadow, the stop loss is placed a few pips below the low of the big shadow candlestick (see Figure 6.3).
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FIGURE 6.3 This is a bullish big shadow on the daily GBP/CHF daily chart. The stop loss is placed a few pips above the high of the bearish big-shadow candlestick.

For the bearish big shadow, the stop loss is placed a few pips above the high of the big-shadow candlestick (see Figure 6.4).
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FIGURE 6.4 This is a bearish big shadow on the daily GBP/AUD chart. The stop loss is placed a few pips above the high of the bearish big-shadows candlestick.

Entering the Trade

The safest way to enter a big-shadow trade is to wait for the market to push into an expected direction. This will mean using a buy stop for bullish big shadows, or a sell stop for bearish big shadows. For example, if you would like to enter a sell trade on a bearish big shadow, you may consider placing your sell stop below the low of the big-shadow candlestick. Likewise, for those bullish big shadows, place a buy stop a few pips above the high of the big-shadow candlestick. If the market moves in the expected direction, your buy stop order will be triggered (see Figure 6.5).

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FIGURE 6.5 A buy stop entry is the safest way to enter a bullish big-shadow trade. Here, the market triggers the buy stop of the bullish big shadow on the daily USD/CHF chart.

Many traders look to enter a trade on retracements, when the market moves against a trading set-up. Although this may seem like a good idea, because it enables an entry at a “cheaper” price, it is also risky. Remember that most traders find it difficult to achieve consistent profits. One of the reasons for this may be because all failed trade set-ups will retrace in the opposite direction, but very few failed trade set-ups, such as the big shadow, will take out a new high (for bullish big shadows) or a new low (for bearish big shadows). This is why sell stops and buy stops are recommended for trading the big shadow (and all naked-trading strategies).
See Figure 6.6 for an example of how a sell stop avoids a losing trade on a CAD/JPY four-hour bearish big shadow.
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FIGURE 6.6 A sell stop entry on the CAD/JPY four-hour chart avoids a losing trade. The market trades higher and never triggers the sell stop entry. Selling this bearish big shadow at a higher price would have resulted in a losing trade.

It may seem counterintuitive to enter a trade at a poor entry price, but if you decide to use buy stops and sell stops to enter your trades, you will eliminate many losing trades from your record. This is an extremely simple method for avoiding losing trades.

Importance of the closing price

The closing price is the most important price for the big-shadow candlestick.A big shadow may completely engulf the prior candlestick. A big shadow may print on a brilliant zone. A big shadow may even be the largest candlestick, with the widest range for a particular market in a very long time. However, if the closing price is not in the correct location for the big-shadow candlestick, the trade may fail miserably.

The ideal closing price for a bullish big shadow candlestick is the high. The big-shadow candlestick has a very good chance of success if the candlestick closes on the high. Obviously, it is rare for the closing price of a bullish big-shadow candlestick to be equal to the high. The closer the closing price is to the high for the bullish big-shadow candlestick, the better the trade signal. Bullish big shadows with closing prices near the midpoint of the candlestick are very poor trading set-ups. The naked trader is only interested in high-probability trade set-ups, so if the bullish big shadow has a closing price down near the midpoint of the candlestick, the trade set-up is probably not good enough to take (see Figure 6.7).
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FIGURE 6.7 This bullish candlestick on the daily USD/JPY chart has a closing price down near the midpoint of the candlestick. This is not a bullish big-shadow candlestick formation. Notice how this trade is a loser; the market trades below the stop loss.

Figure 6.7 is an interesting bullish candlestick, but it is not a bullish big shadow because the market never trades higher than the high of the candlestick.Recall that one of the rules of the big shadow is that the market must trade higher than the high to trigger the buy stop which is placed a few pips above the high. Applying this entry rule would have meant avoiding this losing trade.

Therefore, the trade in Figure 6.7 has two faults: The market fails to trade higher than the high of the bullish big-shadow candlestick, and closing price of the bullish big-shadow candlestick is too low.For bearish big shadow set-ups, the closing price of the bearish big shadow candlestick is also important. The ideal bearish big shadow will have a closing price down near the low of the bearish big-shadow candlestick.

A bearish big-shadow candlestick with a closing price near the midpoint is a subpar set-up and should be disregarded (see Figure 6.8). The very best bearish big-shadow set-ups will have a closing price down near the low of the candlestick .
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FIGURE 6.8 This bearish candlestick on the AUD/NZD daily chart is not an ideal bearish big shadow because the closing price is not near the low of the candlestick. This trade ends up a loser. The market pushes lower than the low of the big shadow to trigger the trade, but three candlesticks later the market takes out the stop loss.
by Alex Nekritin and Walter Peters