TraderPlanet s Quick Guide to

Transcription

1 TRADERPLANET SPECIAL REPORT By Darrell Jobman

2 TraderPlanet s Quick Guide to CANDLESTICKS Candlestick charting traces its roots to Japanese rice traders in the 17th and 18th centuries as trading in physical rice moved to the first futures exchange, the Dojima Rice Exchange of Osaka. Munehisa Homma ( ), also referred to as Sokyu Homma or Sokyu Honma, was a wealthy rice merchant and trader who is widely credited with being a pioneer in technical analysis and the father of Japanese candlestick charting. In 1755, he wrote The Fountain of Gold - The Three Monkey Record of Money, a text focused on market psychology. The person generally credited with bringing candlesticks to the attention of the Western world is Steve Nison, an analyst at Merrill Lynch who introduced candlestick techniques in an article in the December 1989 issue of Futures magazine and in his first book, Japanese Candlestick Charting Techniques: A Contemporary Guide to the Ancient Investment Techniques of the Far East, published in 1991, followed by another book a few years later, Beyond Candlesticks: More Japanese Charting Techniques Revealed. Since Nison s introduction, candlesticks have become the charting method of choice for many traders, and numerous other books and articles have been written about candlestick concepts. What are candlesticks? Candlestick charts provide the same information as the traditional bar chart open, high, low and close prices but do so in a way that is a more visual depiction of price action during a single time period or series of time periods. Western bar chart

3 Candlestick chart using same price data One candlestick itself can provide important information about the strength or weakness of the market during a given day or other time period, visually portraying where the close is relative to the open. A white or clear real body indicates prices moved higher from the open to the close for the period and is a bullish sign. A black or solid color real body indicates prices moved lower from the open to the close for the period and is a bearish sign. Although the color of the real body generally sets the bullish or bearish tone of a trading session, the wicks are also important, showing how far traders were willing to push prices during the period before coming back to close in the real body.

4 One candle alone can be significant but, depending upon its location on a chart, a candlestick pattern usually takes several candlesticks to produce chart formations that give the best signals. Candlesticks may look identical but have an entirely different meaning after an uptrend than they do after a downtrend. Candlestick analysts have added a little mystique to candlestick charts by giving various patterns clever names and providing more descriptive characteristics for these patterns than is the case in typical bar chart analysis. Both types of charts have their double tops, inside days, gaps and other formations. But candlestick analysis ascribes more meaning to the candlestick bodies price action between the open and close and to the shadows or tails or wicks price action that takes place outside of the open-close range for a period. The length of the candle body and the length of the wick are both significant. This brief guide to candlesticks covers some of the major patterns. The color combination used for the bodies of the candles is white or clear candles to indicate the close is higher than the open and black or solid candles to indicate the close is lower than the open. Some traders prefer to use red to indicate bearish candles and green or black to indicate bullish candles. Whatever combination you use, candlesticks will provide a quick visual representation of trading activity that occurred during the period covered by the candle. Indecision patterns Individual candlesticks or candlestick patterns tend to be most useful in helping to spot market reversal tops or bottoms, but they can also provide information as a trend is unfolding. Some candlesticks suggest that bullish and bearish traders may have achieved some kind of balance and the market can t decide which way to go next. This candlestick pattern may just be setting up to continue the trend that is already in place, or the indecisive sign may be a turning point if the market has been trending. Dojis Perhaps the best-known candlesticks reflecting an indecisive market are a group of individual candlesticks known as doji. A doji has no real body that is, the open and the close price are equal or nearly so. A doji indicates no net price movement from the first price to the last price recorded during the predefined time interval that formed the candlestick. A doji indicates a lack of progress, a standoff, and an equal balance between the forces of supply and demand. A doji also implies uncertainty about the trend.

5 Bullish doji Bearish doji Dragonfly doji has a long lower shadow and no upper shadow. Following an uptrend, it indicates a bearish trend reversal. Dragonfly doji Gravestone doji has a long upper shadow and no lower shadow that is, the open and close are at the low of the period. Following an uptrend, the longer the upper shadow, the more bearish the indication. Following a downtrend, the gravestone doji can indicate an upside reversal, but that requires a bullish confirmation in the following period. Gravestone doji Four price doji has only one price for the period that is, the open, high, low and close prices are all the same. It indicates an unusually quiet market. The same type of candle might also indicate a limit up or limit down price move so this candle s location must be taken into account along with its appearance.

6 Other doji names include long-legged doji, which has very long upper and lower shadows and indicates a trend reversal, and rickshaw man, a specific type of longlegged doji where the open and close are in the middle of the price range. Spinning Top A spinning top is similar to a doji, but it has a real body that is, the open and close are not the same and shadows that are longer than its real body. The shade (white or black) of the real body is unimportant. Spinning tops indicate indecision, a standoff of bullish and bearish forces. Several spinning tops together often mark a point of price trend change. Spinning top Reversal patterns Stars Stars are reversal patterns and come in several different forms. The pattern consists of three candles, the first usually a large candle at the end of an extended trend followed by a smaller candle that leaves a gap or window and then another large body candle in the direction of the new trend. Large volume would help to confirm the reversal signal. The shooting star has a long upper shadow, a small real body at the lower end of the price range and little or no lower shadow. It looks like the hammer but appears at the top of a trend rather than the bottom. After an upward move in previous sessions, a strong rally from the open occurs, but the market rejects the high prices and prices collapse back down to close near the open. This means that, after early buying enthusiasm on the open, the rally attempt proved unsustainable, an obvious failure of demand. It is more significant if the current open gaps up from the previous real body. More significant is the more complex evening star, which comprises three candlesticks: First, a long white candle; second, a gap-higher open and a small real body (black or white), which should be completely above but not touching the real body of the first candle; and third, a black real body that closes well into the white body of the first candlestick. The longer this third black real body, the more meaningful it is. A volume surge on this third black real body would add power to the reversal signal.

7 Evening star If the middle candle is a doji, the pattern is called an evening doji star, which is more significant than an ordinary evening star. If the middle doji s shadows are completely above and do not touch the shadows of the first and third candlesticks, the pattern is called an abandoned baby top and is even more significant. The morning star is a major bottom reversal signal following a decline. It is comprised of three candlesticks: (1) a long black candle; (2) a gap-lower open and a small real body (black or white) that should be entirely below and not touching the real body of the first candlestick, and (3) a large white real body that closes well into the long black body of the first candlestick. The longer this third white real body, the more meaningful it is. Also, a volume surge on this white real body would add power to the reversal signal. Morning star If the middle candle is a doji, the pattern is called a morning doji star and is said to be more meaningful than an ordinary morning star. If the middle doji s shadows are completely below without touching the shadows of the first and third candlesticks, the pattern is called an abandoned baby bottom and is considered to be even more significant. Abandoned baby bottom Tri-Star This rare but significant reversal pattern is formed by three dojis, the middle one a doji star that gaps away from the previous period s doji. Tri-Star often follows a trend of long duration that has run its course. The three dojis clearly indicate a loss of momentum and an exhaustion of the existing trend.

8 Tri-Star dojis Engulfing patterns Prices open below the previous close (bullish) or above the previous close (bearish) and then stage a strong turnaround, producing a candle body that totally engulfs the previous candle and suggesting a change in trend direction. A bearish engulfing pattern suggests supply overwhelms demand; the bulls are immobilized. Bullish engulfing pattern Bearish engulfing pattern Harami The harami is a reversal pattern following a trend. Rather than engulfing the previous candle, price action for the current candle is entirely within the range of the previous candle body. For example, the bearish harami is a reversal pattern following an uptrend, formed by a long white real body during the previous period and a short black body during the current period. Both the open and close are contained completely within the previous period s long white real body. This pattern requires immediate follow-through for confirmation. Bullish harami

9 Bearish harami A bearish harami cross is a major reversal pattern. In an uptrend, a long white real body is followed by a doji (open and close at the same price, giving a cross-like appearance), and that doji is contained within the previous large white body. A bullish harami cross occurs in a downtrend when a long black real body is followed by a doji that is contained within the large black body. Piercing line, dark cloud cover These reversal patterns are mirror images of one another and are close relatives of the engulfing patterns except that the current candle s body does not engulf the previous candle. Instead, the market has a gap opening, then moves sharply in the opposite direction and closes more than halfway through the previous candle s body. For the dark cloud cover, the weaker the second black candlestick s close, the more meaningful and bearish it is. For example, a close near the low of the current black candlestick and below the midpoint (or lower) of the previous white real body would be significant. This candlestick indicates bulls led a charge up the mountain to new price highs but could not hold the ground. Now the bears are pushing them back down the mountain. Piercing line Dark cloud cover Hammer, hanging man These two reversal patterns look very much alike, but their name and impact on prices depend on whether they occur at the end of a downtrend or an uptrend. The signal candlestick has a small real body, little or no upper shadow and a long lower shadow, suggesting the previous trend is losing momentum. This pattern also requires confirmation by the next candle. Although the color of the real body is not critical, black

10 is more bearish than white for the hanging man and white is more bullish than black for the hammer. The next period s action would confirm the bearish implications of the hanging man if there is a downward window (gap) or a long black candle. For the hammer, the next period s action would confirm the bullish implications if there is an upward window or a long white candle. The hammer occurs within an established downtrend and has a small real body (white or black) at or near the high of the candle thus, little or no upper shadow. It has a long lower shadow, which implies that extreme low prices were rejected by the market. The hammer's small real body implies the previous downtrend is losing momentum. The market can be said to be hammering out a base. Another name applied to a candlestick (white or black) with no upper shadow is shaven head. Hammer The hanging man is a bearish reversal pattern occurring within an established uptrend. It has a small real body (white or black) at or near the high; therefore, it has little or no upper shadow and a long lower shadow, like legs dangling down from the body. The hanging man's small real body implies the previous uptrend is losing momentum. The next period s action would confirm the bearish implications of the hanging man if there is a downward window (gap) or a long black candlestick. Hanging man Inverted hammer or shaven bottom The inverted hammer is a bullish reversal pattern that follows a downtrend. It has a small real body (white or black), long upper shadow (longer than the body) and little or no lower shadow. This pattern is confirmed the next day by a strong upside gap on the open followed by further substantial upside movement to form a large white real body. Another name applied to a candlestick (white or black) with no lower shadow is shaven bottom.

11 Inverted hammer Tweezers Tweezers are minor reversal signals that are more important if they are part of a larger pattern. A tweezer bottom has two or more candles with matching bottoms; a tweezer top has two or more candles with matching tops. They do not have to be consecutive candles. They do require follow-through for confirmation. Tweezer bottom Tweezer top Two crows Two crows reverse an existing uptrend. First, there appears a relatively small black candlestick that signals a loss of upside momentum. That small black candlestick is immediately followed by a much more substantial black candlestick, which confirms a bearish change in momentum. Two crows Three black crows

12 Three black crows more decisively reverse an existing uptrend. Look for three relatively large, consecutive black candlesticks that close near or at their lows of the period. If the three candlesticks are identical, the pattern is called identical three black crows. Three black crows Three white soldiers Three white soldiers reverse an existing downtrend. Look for three relatively large, consecutive white candles that close near or at their highs of the period. Three white soldiers Belt hold In an uptrend, belt hold forms when prices open much higher on a large window (gap) but close substantially lower, giving up most of the early gain. Belt hold

13 Belt hold Bearish counterattack line In an uptrending market, a large white candlestick is following by a large black candlestick that opens on a big gap higher and then slumps back during the period to close at the same price as the previous close. The bearish black candlestick needs followup action to the downside to confirm the turn to a downtrend. Bearish counterattack line Bullish counterattack line In a downtrending market, a large black candlestick is following by a large white candlestick that opens on a big gap lower and then rallies during the period to close at the same price as the previous close. The bullish white candlestick needs followup action to the upside to confirm the turn to an uptrend. Bullish counterattack line Three Inside Down Three inside down is composed of three candles. Following a prevailing uptrend, a large white candlestick is followed by a short black candlestick, which is entirely contained within the real body of the previous big white candlestick. This suggests some loss of upward price momentum. The third candlestick is a large black candlestick that closes below the lows of the previous two candlesticks, thus confirming a bearish change in trend direction. Three Outside Down Three outside down is also composed of three candlesticks. Following a prevailing uptrend, a white candlestick is followed by a larger black candlestick, which is an

14 engulfing line that is, its real body contains the entire previous period s price range. This alone suggests a change in upward price momentum. The third candlestick is a large black candlestick that closes below the lows of the previous two candlesticks, thus confirming a bearish change in trend direction. Kicking Kicking can also be a two-day bull trap. Following a decisive day of buying where prices open on their lows and close on their highs, thus forming a substantial white candle with no shadows, the very next day prices totally reverse on the open, forming a falling window on a large downside opening price gap. Prices close that day on their lows, forming a substantial black candle with no shadows. The bulls can t help but suffer big losses, and they are likely to be punished by further price weakness in the days ahead, with the market showing no mercy. The bulls suffer a severe kicking. Deliberation Deliberation occurs in an uptrend with a three white candlestick pattern where the first two are substantial but the third is small. This indicates a loss of upward momentum, as if the market is preparing for a trend change from up to down. Advance block Advance block occurs in an uptrend when there are three consecutive white candlesticks with the second and the third both exhibiting a smaller price range and real body than the previous one, thus indicating diminishing upward price momentum. Ladder top A ladder top reverses a bullish uptrend. After three consecutive and decisive buying sessions forming three substantial white candlesticks, there may be a noticeable slowing of upward momentum in the fourth period. The trend change from bull to bear is confirmed in the fifth period by a relatively large black candlestick that closes on its low and at a new low relative to the most recent past three periods. Three Buddha top Three Buddha top is a longer-term pattern similar to a Western head-and-shoulders top. A sell signal is confirmed when the price falls below the intervening two minor pullback lows, preferably on a large black candlestick or a falling window (breakaway gap) and a rise in trading volume to indicate serious selling. Three mountains top Three mountains top is a longer-term pattern similar to a Western triple top. A sell signal is confirmed when the price falls below the intervening two minor pullback lows,

15 preferably on a large black candlestick or a falling window (breakaway gap) and a rise in trading volume to indicate serious selling. Dumping Top A dumping top is a longer-term pattern similar to a Western rounding top, where a sell signal is validated by a falling window (breakaway gap) to indicate overwhelming supply. Rounding top Eight new price lines Eight new price lines is a chart pattern consisting of eight new price highs. This implies an overbought market where profit-taking would be appropriate. Continuation Patterns A continuation pattern suggests that the trend in place should stay in place or resume. Flag formations and triangles in Western analysis are pauses or consolidation areas where the market seems to take a little breather to let prices adjust to conditions. Candlestick charts also feature similar patterns. Rising three methods The rising three methods pattern occurs in an uptrend and is composed of five candlesticks. The first is a long white candle. The next three periods produce three small real bodies, two of which are dark and all of which are contained within the range of the first long white body. The fifth candlestick is another long white candlestick that closes at a new high and confirms resumption of the uptrend. Rising three methods Falling three methods The falling three methods pattern occurs in a downtrend and is composed of five candlesticks. The first is a long black candle. The next three periods produce three small

16 real bodies, two of which are white, and all of which are contained within the range of the first long black body. The fifth candlestick is another long black candlestick that closes at a new low and confirms resumption of the downtrend. Falling three methods Windows The window, known as a gap in the West, occurs anytime when the current price range does not overlap the previous period s price range. Windows are usually continuation patterns indicating the existing trend before the window is likely to continue after the window. For the trend to continue, the window should function as a support in an uptrend or as resistance in a downtrend. The window should not be closed, or filled in, on a closing price basis. If the window is closed on a closing price basis, the trend is over. Windows are very powerful and important indications of demand and supply. Windows following congestion patterns validate the new trend direction, giving the same signal as Western breakaway gaps. For a rising window, the current period s low is higher than the previous period s high, leaving an upside gap on the chart. A downward reaction or correction against the uptrend is likely to find support within the window that is, the previous period s high should offer support to any downward reaction against the uptrend. For a falling window, the current period s high is lower than the previous period s low, leaving a downside gap on the chart. An upward reaction or correction against the downtrend is likely to find resistance within the window that is, the previous period s low should offer resistance to any upward reaction against the downtrend. Three windows often signal the end of a move. The first window is the breakaway gap that initiates a move. The second window is a continuation gap or measuring gap that often occurs halfway into a move. The third window is an exhaustion gap that occurs at the end of a move. Three falling windows are three downside gaps followed by a bullish white candlestick to indicate selling pressure is exhausted. Three rising windows are three upside gaps followed by a bearish black candlestick to indicate buying pressure is exhausted.

17 Tasuki Gap Tasuki gap is the name of a brief, contratrend retracement that may enter the area of a recent window but does not close the window on a closing price basis. Tasuki gap bottom Tasuki gap top Meeting line Meeting line is defined by a window (gap) in the direction of the prevailing trend on the open, but the close reverses to meet the previous period s close. This should not happen if the trend is to continue, so the trend is likely to reverse.

18 Fry pan bottom Fry pan bottom is a Western rounding bottom, where a buy signal is validated by a rising window (breakaway gap) to indicate strong buying. Fry pan bottom Lighting the way Like any other aspect of trading, using candlestick charts won t guarantee profits or instant trading success. You will still have to do your analytical work when you use candlesticks, you will still have to make tough trading decisions, you will still have to manage your trades and your account carefully to avoid risks or exposure beyond your capability to control it. But, using the same open, high, low, close price data available to all traders using all kinds of charts and methods, candlesticks will provide you with a better visual picture of what is happening in a market during a specific period of time. With a clearer view of the dynamics of market movement within that period, you can interpret traders reactions to various price levels and make decisions about how you might respond to what the charts are telling you. Candlesticks are a relatively new approach to Western traders, but the speed at which they have become perhaps the most popular way to look at markets and charts today attests to the value traders have found in them. For many traders who have become familiar with the various candlestick patterns and the nuances of each of them, there will be no going back to the traditional old bar charts any time soon.

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