Candlestick charts are familiar territory to many traders, so it is surprising to realize that they have been used in the Western world for less than 20 years. They were introduced from Japan by Steve Nison and have replaced the Western-style bar chart for many users. They contain no more information than the bar chart, which is sometimes called the OHLC chart for the prices it represents – open/high/low/close – yet their interpretation is much easier, and they are noted for providing clarity in evaluating the mood of the markets. They are especially powerful in alerting you to
potential reversals.
It often has been said that to learn about the market, you have to ask the market. Simply, there is no room for “coulda, woulda, and shoulda” when talking about price action. The trader’s task is simply to see what the market is telling him or her and act accordingly. There is no better visual gauge of the psychology behind price movements than the candlestick. While some traders may use them just to get an indication of price level, they have many more secrets to reveal to the enthusiast. Market prices are driven both by rational events and emotions, and the emotional side is revealed by candlesticks. It is people who drive the market, and people do not change, so candlestick patterns that were discovered centuries ago by the Japanese are just as valid today.
“The basics” (above) shows the construction of a candlestick. There are three distinct parts to a candlestick, arranged vertically. In the middle is a rectangle, which in candlestick parlance is the “real body.” This tells the viewer about the opening and closing prices for the trading session. A line extends upwards from the real body, up to the highest price attained during the session, and a similar line extends downwards to the level of the lowest session price. These lines are termed “shadows.” The real body may be white or green, which means the opening price was at the bottom of the rectangle and the close at the top, a bullish day; or it may be black or red, with the opening price at the top and the close at the bottom, a bearish day. For such a simple construction, candlesticks have been shown to be amazingly powerful. They are applicable to any time frame, whether each session is one minute long or one month long. A frequently used timeframe is one candlestick for each day, and this is often the default value when opening
charting software.
Perhaps the most important shape of candlestick is known as the Doji. This occurs when the opening and closing prices are identical, which means that the real body has no height, and the candlestick looks like a cross:
Note that the correct plural of Doji is Doji. The position on the candlestick of the line representing the real body is also significant.
When you study candlesticks, it helps if you first realize that the size and color of the real body is a graphic representation of whether the bears or the bulls are in charge, and how much energy and momentum there is to the price. If the real body is long, this shows strength. When the body is white, the bulls are in control, but if the body is black, the bears are clearly winning. Candlesticks that have a short real body are called spinning tops and show a more balanced position between the factions:
You can think of the price as being in a tug-of-war, with the bulls and the bears wrestling for control. The special case of the Doji shows real indecision, and a balanced position that may go either way in the future.
A WORD OF WARNING
Candlesticks should never be used alone to make a trading decision. They don’t show enough about the rest of the price activity, and their interpretation often depends on the trend they are in. You should determine the overall market position using conventional technical indicators. Candlesticks work best at indicating reversal points when the price is overbought or oversold, in which case they can help with the timing of your entry. In this situation, a Doji candle indicates that no one is in charge, neither bulls nor bears, so the trend is in neutral. This often becomes a turning point or reversal.
A stronger indication of a reversal is given by the gravestone Doji candle, which is a Doji with the open, low and close at the same price:
When this occurs in an uptrend, it is a definite bearish signal. Consider what it means — the bulls have been trying to push the price higher, but they were not strong enough to sustain the price to the end of the trading session. Similarly, the candlestick pattern called a shooting star, which is a short real body with a long upper shadow is likely to mark a reversal when it occurs in a rally:
The real body can be white or black in this pattern. Patterns are often valid in a reverse situation, and the equivalent pattern to the shooting star in a bear run is called a hammer, and is thought of as “hammering out” the bottom of the run.
By extension, when the upper shadows of several candlesticks are long, that means the bulls are not managing to overcome the bears to the extent they want. We can observe the market, which is telling us that it is rejecting the higher levels repeatedly. Such a signal, if it occurs at the end of a rally, can herald a down swing. In a more general sense, if you see high wave candles, which are candles that have a short real body and long upper and lower shadows, it shows real uncertainty in the market, with neither the bulls nor the bears managing to make any lasting impression. The market is telling us that it is unsure where the price should be, and it would not be a good time to initiate any new positions.
Note that for the candles that show indecision to be tradable, they really need to come in a trend. To take a change of market sympathy as a reversal, there has to be a trend to be reversed.
Many different patterns have been catalogued, and another of the popular ones is the bearish engulfing pattern:
This occurs in a bull market and indicates a reversal that should be confirmed with another indicator indicating the market is overbought. The bearish engulfing is a two candlestick pattern, with a short white bullish candle followed by a longer black bearish candlestick, which opens above the white candle and closes below it. It engulfs the prices of the previous session. The size of the shadows does not matter. The implication is clear; when the engulfing day opens above the previous close, the traders rush to sell off their holdings, which causes the price to go down. Plainly the market sympathy is that the price will not continue upwards. You usually will see a high volume on the engulfing day.
When using candlestick patterns to help with trading decisions, it is important to remember the basics. A candlestick pattern does not give any information for a price target. This is best determined by Western technical analysis with whichever tool you prefer, whether from previous support and resistance levels, trendlines, or Fibonacci retracements. You must always determine in advance at what level you will know you were wrong and exit the losing trade. This helps give you the discipline to pull the plug if necessary, and is also important information for you to calculate the potential risk/reward of the trade to see if it is worthwhile.
Some examples of the candlestick patterns can be seen in “Putting it all together,” above). At first sight, there are many short candlesticks in the daily December oats chart, which with limited knowledge you may interpret as meaning indecision and a possible reversal. This just demonstrates how candlesticks cannot be relied upon in isolation to provide your trading signal. Once you start to look at the relative strength indicator (RSI) below, then you will see how it all makes sense. For instance, in the middle of August there were many spinning tops (circled) but the market was going sideways. Notice that the RSI was in the middle of its range so you would not be looking for a trade. Towards the end of August the RSI crossed the 75% line, and a shooting star was born with a high level of volume, indicating that the bulls had tried hard and still failed to sustain a higher price. You would then expect and anticipate the resulting bear run from $2.30 per bu. to $2.05, which was in keeping with the signals and stopped at a previous support level.
The run finished in the first quarter of September, with the RSI under 25%. Two consecutive hammer candlesticks hammered out the support level, and the price rose. In both cases the candlesticks provided an indication and confirmation of the move to come, which was suggested by the conventional indicator.
There are hundreds of named candlestick patterns, but many traders choose a few that seem to work best for them in the markets they trade. The successful interpretation of them all comes back to the basic ideas expressed above.
Alan Northcott is a financial writer and his second book “The Complete Guide to Using Candlestick Charting” has just been published. He may be contacted at alannorthcott@msn.com.