The Art of Candlestick Charting - Part 1



The Art of Candlestick Charting - Part 1

The candlestick techniques we use today originated in the style of technical charting used by the Japanese for over 100 years before the West developed the bar and point-and-figure analysis systems. In the 1700s a Japanese man named Homma, a trader in the futures market, discovered that, although there was a link between price and the supply and demand of rice, the markets were strongly influenced by the emotions of the traders. He understood that when emotions played into the equation a vast difference between the value and the price of rice occurred. This difference between the value and the price is as applicable to stocks today as it was to rice in Japan centuries ago. The principles established by Homma are the basis for the candlestick chart analysis, which is used to measure market emotions towards a stock.

This charting technique has become very popular among traders. One reason is that the charts reflect only short-term outlooks--sometimes lasting less than eight to 10 trading sessions. Candlestick charting is a very complex and sometimes difficult system to understand, but in this four-part series, we take go inside the more common ways to construct and read candlestick patterns. (For our other candlestick charting articles, see our Technical Analysis 101 archives.)

Candlestick Components

When first looking at a candlestick chart, the student of the more common bar charts may be confused; however, just like a bar chart, the daily candlestick line contains the market's open, high, low and close of a specific day. Now this is where the system takes on a whole new look: the candlestick has a wide part, which is called the "real body". This real body represents the range between the open and close of that day's trading. When the real body is filled in or black, it means the close was lower than the open. If the real body is empty, it means the opposite: the close was higher than the open.

Just above and below the real body are the "shadows". Chartists have always thought of these as the wicks of the candle, and it is the shadows that show the high and low prices of that day's trading. If the upper shadow on the filled-in body is short, it indicates that the open that day was closer to the high of the day. And a short upper shadow on a white or unfilled body dictates that the close was near the high. The relationship between the day's open, high, low, and close determine the look of the daily candlestick. Real bodies can be either long or short and either black or white. Shadows can also be either long or short. 

Comparing Candlestick to Bar Charts

A big difference between the bar charts common in North America and the Japanese candlestick line is the relationship between opening and closing prices. We place more emphasis on the progression of today's closing price from yesterday's close. In Japan, chartists are more interested in the relationship between the closing price and the opening price of the same trading day.

In the two charts below I am showing the exact same daily charts of IBM to illustrate the difference between the bar chart and the candlestick chart. In both charts you can see the overall trend of the stock price; however, you can see how much easier looking at the change in body color of the candlestick chart is for interpreting the day-to-day sentiment.

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|Chart Created with Tradestation |

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|Chart Created with Tradestation |

Basic Candlestick Patterns

In the chart below of EBAY, you see the 'long black body', or 'long black line'. The long black line represents a bearish period in the marketplace. During the trading session, the price of the stock was up and down in a wide range and it opened near the high and closed near the low of the day.

By representing a bullish period, the 'long white body', or 'long white line'--(in the EBAY chart below, the white is actually gray because of the white background) is the exact opposite of the long black line. Prices were all over the map during the day, but the stock opened near the low of the day and closed near the high.

'Spinning tops' are very small bodies and can be either black or white. This pattern shows a very tight trading range between the open and the close, and it is considered somewhat neutral.

'Doji lines' illustrate periods in which the opening and closing prices for the period are very close or exactly the same. You will also notice that, when you start to look deep into candlestick patterns, the length of the shadows can vary. 

 

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|Chart Created with Tradestation |

In Part 2 of this series we look closer at pattern analysis; in Part 3 we focus on continuation patterns; and in Part 4 we conclude by exploring patterns on both the bullish and bearish sides of the equation.

The Art of Candlestick Charting - Part 2

In Part 1 we look at the history and the basics of the art of Japanese candlestick charting. Here in Part 2 we look deeper into how to analyze candlestick patterns.

Principles behind the Art

Before learning how to analyze them, we need to understand that candle patterns, for all intents and purposes, are merely reactions of traders at a particular time in the marketplace. The fact that human beings often react en masse to situations allows candlestick chart analysis to work. 

Many of the investors who rushed to the marketplace in the fall and winter of 1999-2000 had, before that time, never bought a single share in a public company. The volumes at the top were record breaking and the smart money was starting to leave the stock market. Hundreds of thousands of new investors, armed with computers and new online trading accounts, were sitting at their desks buying and selling the dotcom flavor of the moment. Like lemmings, these new players took greed to a level never seen before, and, before long, they saw the market crash around their feet.

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|Chart Created with Tradestation |

Lets have a look at what was a favorite of many investors during that time. This presentation of JDS Uniphase (JDSU) on the chart above is a lesson in how to recognize long bullish candles, which formed as the company's stock price moved from the $25 area in late Aug 1999 to an outstanding $140 plus in Mar 2000. Just look at the number of long green candles that occurred during a seven-month ride.

Analyzing Patterns

Traders must remember that a pattern may consist of only one candlestick but could also contain a number or series of candlesticks over a number of trading days.

A reversal candle pattern is a number or series of candlesticks that normally show a trend reversal in a stock or commodity being analyzed; however, determining trends can be very difficult. Perhaps John J. Murphy explains it best in this short piece, which discusses reversal patterns, from his classic "Technical Analysis of the Financial Markets":

"One serious consideration that must be used to identify patterns as being either bullish or bearish is the trend of the market preceding the pattern. You cannot have a bullish reversal pattern in an uptrend. You can have a series of candlesticks that resemble the bullish pattern, but if the trend is up it is not a bullish Japanese candle pattern. Likewise, you cannot have a bearish reversal candle pattern in a downtrend."

The reader who takes Japanese candlestick charting to the next level will read that there could be as many as 40 or more patterns that will indicate reversals. One-day reversals form candlesticks such as 'hammers' and 'hanging men'. A hammer is an umbrella that appears after a price decline, and, according to candlestick pros, comes from the action of "hammering" out a bottom. If a stock or commodity opens down and the price drops throughout the session only to come back near the opening price at close, the pros call this a hammer.

A hanging man is very important to recognize and understand. It is an umbrella that develops after a rally. The shadow should be twice as long as the body. Hanging men that appear after a long rally should be taken notice of and acted upon. If a trading range for the hanging day is above the entire trading range of the previous day, a "gap" day may be indicated.

Lets look at two charts, one with a hammer and the other with a hanging man. The first charts Lucent Technologies and shows a classic hanging man. After three days of the stock price rising, the hanging man appears, and on the following day, the stock price drops over 20%. The second chart shows a hammer from a period in 2001 when Nortel Networks was trading in the $55-$70 range. The hammer appears after two days of declining prices and effectively stops the slide, marking the beginning of a nine-day run with the stock price moving up $11.

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|Chart Created with Tradestation |

|[pic] |

|Chart Created with Tradestation |

For those of you who would like to explore this area of technical analysis more deeply, I suggest that you look for books written by Steve Nison. He has written a number of textbooks that even a novice will understand upon the first reading.

In Part 3 we focus on continuation patterns; and in Part 4 we conclude by exploring patterns on both the bullish and bearish sides of the equation.

The Art of Candlestick Charting - Part 3

This third article of a four-part series introducing you to candlestick charting focuses on continuation patterns and how they can confirm or deny trends that the chartist will recognize over and over again. (In Part 1 we review the components of a candlestick, and in Part 2 we introduce the techniques of analyzing patterns.) It is the confirmation or denial of a trend that determines whether an investor will sit tight today and hold his or her position or decide to enter or exit an issue that could be long or short the market.

Patterns on the Bullish and Bearish Sides

In the world of Japanese candlesticks, there are a number of bullish and bearish continuation patterns. With a short list on the bullish side of the market, a chartist would look for the following patterns: 'mat hold', 'rising three methods', 'separating three lines', 'side-by-side white lines', 'upside gap three methods', and 'upside Tasuki gap'. This article focuses on 'rising three methods', 'mat hold' and 'separating three lines'.

With a short list on the bearish side of the market, one would look for the following patterns: 'falling three methods', 'in-neck', 'on-neck', 'separating lines', 'side-by-side white lines', and 'black crows'. In this article, we focus on 'falling three methods', 'separating lines' and 'in-neck'.

(Keep in mind there are many more different patterns on the bullish and bearish sides of the market. If you'd like to look deeper into this complex art, visit for their look at Japanese candlesticks and have a look in your local bookstore for the excellent books on the subject written by Steve Nison.)

Illustrating the Patterns

For each continuation pattern shown below, we describe the pattern and break it down allowing you to recognize the formation more easily in the future. Starting with the bulls, let's have a look at rising three methods.

Rising Three Methods

This pattern starts out with what is called a "long white day". Then, on the second, third and fourth trading sessions small real bodies appear - these small real bodies form from a fall-off in price, but they still stay within the price range of the long white day (day one in the pattern). The fifth and last day of the pattern shows another long white day.

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This pattern is, in the world of Japanese candlestick charting, a very bullish chart. It shows an upward trend on day one with investors taking a few trading sessions to relax to prepare for the next rise in price that occurs on the fifth day. Even though the pattern shows us that the prices are falling for three straight days, a new low is not seen and the bulls prepare for the next leg up.

Bullish Mat Hold

This pattern begins with a long white day and then, on the second day of trading, the issue gaps up and is a black day. What we see next in this pattern is somewhat similar to the previous pattern.

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The second, third, and fourth days see the issue falling off slightly but not trading outside the range of the long white day on day one. Finally, the last day in the pattern is another long white day that closes above the close of the first long white day.

Separating Lines (Bullish)

In the pattern of bullish separating lines, you can see that the first day is a black day and the next day is a white day. The key to the second day is that the issue has the same opening price as day one.

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 In a bullish market, this pattern is simply viewed as a continuation of the trend because the second day starts off from where day one left off and continues the trading session to close higher still.

Now, on the bearish side of the equation, let's have a look at what the bears are looking for, starting with separating lines.

Separating Lines (Bearish)

You can see immediately that the bearish separating lines pattern is the exact opposite of the bullish separating lines pattern, so it does not need any further explanation.

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Falling Three Methods (Bearish)

The pattern known as bearish falling three methods confuse many chartists at first. It is not until the third or fourth day of the pattern that it becomes clear.

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Look close and you can see that a new high is not formed from the high set on the first day. This is a very bearish signal and short sellers react strongly to this pattern.

In-Neck (Bearish)

The first day of the in-neck continuation pattern is a long black day and the second is a white day that shows an opening of trading below the low of the prior trading session. Then on the close the price is equal to or just above the closing price of the prior session.

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This pattern has the bears looking for the falling trend to continue but it may be some time before it is confirmed.

In Part 4 we conclude by continuing our look at patterns on both the bullish and bearish sides of the market.

The Art of Candlestick Charting - Part 4

In Part 1 of this four-part series on candlestick charting we review the components of a candlestick, and in Part 2 we introduce the techniques of analyzing patterns. In part 3, we start to look at some of the more recognizable or perhaps popular patterns that regularly appear on candle charts.

This article focuses on continuation patterns and how they could deny or confirm trends in today's markets, giving the investor a clearer picture of whether or not to hold his or her position or execute a buy/sell order.

The Patterns 

We continue this look at candle charts with some additional patterns on both the bullish and bearish sides of the equation. On the bullish side of the market, show you the 'engulfing pattern', 'harami', and the 'harami cross'. Opposite, on the bearish side, we will have a closer look at the 'engulfing pattern', 'the evening star' and both the 'harami' and the 'harami cross'.

Engulfing Pattern - Bearish

Engulfing pattern (bearish) develops in an uptrend when the sellers outnumber the buyers; this action is reflected by a long red real body engulfing a small green real body.

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You can see the opening was higher than the previous day, and, during the trading session, the issue sold off with volume much greater than the previous session.

(Please note that the charts in part 3 were black and white. To avoid confusion, you should know that candle charts in many of today's software programs are shown in red [instead of black] and green [instead of white]).

Engulfing Pattern - Bullish

Engulfing pattern on the bullish side of the market is the opposite of the previous pattern and takes place when the buyers outpace the sellers, which is reflected in the chart by a long green real body engulfing a small red real body.

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As you can see, this is a chart of an issue in a downtrend that has now lost momentum. The buyers may be coming back into this issue, creating a trend reversal and bottoming out of this downtrend.

Evening Star - Bearish

Evening star (bearish) is a top reversal pattern that is very easy to identify because the last candle in the pattern opens below the previous days' small real body, which can be either red or green and closes deep into the real body of the trading range of the candle two day's prior.

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This pattern shows that investors are perhaps losing confidence in the issue and it's direction. This thought process will be confirmed if the next day is another down session.

Harami - Bearish

Harami (bearish) is another very recognizable candlestick pattern that shows a small real body (red) completely inside the previous day's real body.

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Technicians will watch very closely now because the harami bearish indicates that the current uptrend may be coming to an end, especially if the volume is light. Students of candlestick charts will also recognize the harami pattern as the first two days of the three inside pattern.

Harami - Bullish

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Harami (bullish) is just the mirror reflection of the harami bearish. As you can see in the chart above, a downtrend is in play and a small real body (green) is shown inside the large real body (red) of the previous day. This tells the technician that the trend is coming to a conclusion. The harami implies that the preceding trend is about to conclude. A candlestick closing higher the next day would confirm the trend reversal.

Harami Cross - Bearish

Harami cross (bearish) is a pattern of a harami with a doji instead of a small real body following up on the next trading session.The doji is within the range of the real body of the prior session.

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Like the harami, the trend starts out in play, but the market then decides to reverse intra-day with volume being somewhat non-existent and the pattern closing at the same price as the issue opened. The uptrend has been reversed.

Harami Cross - Bullish

The harami cross, whether the bullish or bearish version, starts out looking like the basic harami pattern. The harami cross bullish is the exact opposite of the harami cross bearish and does not require any further explanation. Again, a trend has been reversed.

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This four-part series barely scratches the surface of Japanese candlestick charts and the interpretation of the patterns. If you want to gain more in-depth knowledge be sure to read Steve Nison's excellent books on the subject.

Until next time, remember it's your money - invest it wisely.

By Investopedia Staff, ()

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