From the May 01, 2007 issue of Futures Magazine • Subscribe!

Burning at both ends

Japanese candlestick charts date all the way back to the eighteenth century Japanese rice markets, but don’t think for a minute that today’s electronic traders can’t learn a trick or two from this earliest form of technical analysis. Despite the amazing array of charting applications, indicators and oscillators available out there, candlesticks may be at the height of their popularity because of their ability to help predict where trend reversals are likely to occur.

“Candlesticks are a tool, not a system,” says Steve Nison, founder and president of Candlecharts.com. He says that candlestick charts offer a graphical representation of the bulls and bears battling for control and the overall trend of the market.

“I looked at the gamut. I looked at candlestick charts, I looked at market profile, point and figure, you name it,” says Michael J. Zarembski, a futures analyst at XpressTrade LLC. “I am a very visual learner, so what I liked about the candlesticks especially was how the patterns appeared clear to me.... In conjunction with using moving averages and oscillators, they helped me get the bigger picture of how the market was progressing and get a broader picture of the market.”

Bodies and shadows

Candlesticks present the same information that you would expect to see on a regular western-style bar chart: the open and closing price and the high and the low, but the information is presented in a highly graphical way that emphasizes the relationship between the opening and closing prices of a single period. This is a crucial difference between candlesticks and western style bar charts, which track the closing price relative to the previous day’s closing price. Candlesticks can be used to display the price action of any interval, but daily charts are utilized most.

“The power of the candles is that they are easy to construct but very revealing,” says Nison. The top and bottom of the candlestick’s wider section, called the real body, represents the open and closing price. When the candlestick body is empty, prices have closed higher than the opening price. When the body is shaded in, it means that prices have closed lower than the opening prices. Some software programs will have the higher close in green and the lower close in red.

The candle’s wick, actually called the shadow, represents the high of the period selected, while the bottom shadow represents the low.

With just these four pieces of information, even a rookie trader can discern several important things about price action:

If the real body is long and white, it shows that buyers are dominating, pushing prices up beyond the previous day’s close. If the real body is long and black, it shows that sellers are dominating, pushing prices down beyond the previous day’s close.

If the real body is short, it shows the struggle between buyers and sellers. If the real body is white, buyers have the upper hand, if the sellers have the upper hand, it will be black. These look like, and are called spinning tops.

Doji, baby

“Dojis look like crosses,” Nison says. “We are seeing equilibrium between the bulls and the bears.” Dojis can indicate the probability of a change in the trend, but they are frequently misread, Nison says. “People think they mean that the market is going from up to down; it doesn’t. It means that it’s going from up to neutral,” a very important distinction.

Again, don’t get hung up on the names; rather, consider who has had control, buyers or sellers, and whether the trend is likely to continue based on price action.

REVERSE

Individual candlesticks such as the hanging man and hammer formations display a wealth of information and can indicate the probability of a one-day reversal, but there is also the possibility that they could simply be outliers, so patterns made of multiple candlesticks can offer confirmation that the reversal is real.

“Unless you wait for confirmation though, you’re really just taking a shot,” Zarembski says. “For more risk adverse traders, you may want to wait for the confirmation to appear.”

And that confirmation can come very quickly. “Candlesticks really shine for getting reversals in just two or three sessions,” Nison says. For important insights into a trend and the probability of a reversal, candlestick analysts look for engulfing patterns, where the real body of a candlestick is larger than and engulfs the previous day’s (or period’s) open and closing prices. Engulfing patterns can be bullish or bearish and indicate that the trend is running out of steam and that there is an increased probability of a reversal (see “Spotting reversals,” page 51).

Both Nison and Zarembski encourage traders to use candlesticks in conjunction with other indicators, such as Bollinger bands, the RSI index and moving averages.

“The thing about candles is that they are not a stand alone feature,” Zarembski says, adding that they are best used as one part of a whole arsenal. “I like to get my confirmation from several different factors.

One indicator in itself may be reliable or maybe not, but if there is more than one thing going in your direction that puts the probabilities in your favor,” Zarembski says, adding that a good trading system and good risk management are more important that chart patterns or indicators.

“Nothing is black and white; it is definitely an art form. But what it does is put the probabilities in your favor,” Zarembski says.

Nison agrees. “The best way to get burnt is on a candlestick,” he says, adding that he encourages traders to incorporate them into what he calls a trading triad success system that uses candlestick charts to identify reversal signals and avoid bad trades, western style indicators and analysis tools and aggressive and conscientious money management. “The easiest way to make money is to not lose it.”

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