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Candlestick Chart Basics
Japanese traders had been using candlestick charts and categorizing various candlestick chart patterns for centuries before the concept began to draw a lot of attention in the West after several books were published in the English language on candlesticks in the early 1990s.
Steve Nison published the first book, Japanese Candlestick Charting Techniques: A Contemporary Guide to the Ancient Investment Techniques of the Far East, in 1991 and added another book a few years later, Beyond Candlesticks: More Japanese Charting Techniques Revealed. Greg Morris’ book, Candlestick Charting Explained, in 1992 thoroughly described and quantitatively tested candlestick patterns, reporting that many were highly reliable. Since then, a number of other authors have written books on candlestick chart analysis.
Early Japanese rice producers and traders became wealthy using candlestick charts, applying some of the rules that are familiar to traders today: trade with the trend, prices that go up require more force to maintain an uptrend than falling prices, when in doubt about a trend, stay out . . .
East Meets West
The quick acceptance of candlestick charts in the West, once they were introduced, is due their similarity with bar charts that traders in the West had been using for years. Any Western techniques that traders used to identify chart patterns could also be applied directly to candlestick charts. Today most computer programs can construct candlestick charts as easily as bar charts.
Candlestick advocates contend that candlestick charts can provide trading signals ahead of traditional Western bar charts. When you look at a series of candlesticks, the trends stand out more clearly on a candlestick chart, and the turns are usually more evident with fewer time periods than bar charts, giving candlestick analysis an edge in timing.
Of course, one candlestick or one candlestick pattern is not a perfect indicator of future price action, and the major trend is more important than short-term price action, no matter what type of chart you are using. Successful trading still requires a combination of sound money management, trading discipline, technical analysis skills to identify trends and patterns, ability to interpret chart patterns and optimal position sizing.
Both Japanese and Western analysts look at three as an important number. R.N. Elliott spelled out the significance of three impulse waves in his Elliott Wave theory, and many of the most reliable candlestick chart patterns require three candlesticks to reveal what is happening with price action. Prices often unfold in three phases reflecting the psychological attitude of the trading masses – the unbelieving or skeptic phase, then a realization and acceptance of the developing trend, then a period of jumping on the bandwagon of the trend move before it all starts to unravel, first with doubts about a trend change as the original trend loses momentum, then with fear about missing or not being onboard the new trending move and then with giving in to the reality of the trend change. The cycle repeats itself over and over, as analysts from both the East and West have recognized with their different styles of charts. There is something in this type of price action that seems to be universal and basic to human behavior in any chart language.
Constructing Candlestick Charts
Japanese candlestick charts can be drawn for any time period. The most popular time interval to plot is one day, with its obvious and readily available open, close, high and low prices. Short-term traders may choose to plot time intervals measured in minutes. For example, a 30-minute candlestick chart could divide the 6.5 hours of the New York Stock Exchange trading day into 13 intervals, using the first price in each half-hour interval as the open and the last price in each half-hour interval as the close.
Longer-term investors consult weekly candlestick charts, using Monday's open and Friday's close to define a weekly candlestick chart’s real body. Monthly candlestick charts are constructed using the first trading day of the month’s open and the last trading day of the month’s close to define the monthly real body.
Japanese candlestick charts are fully compatible with Western charting techniques because they are nearly the same as Western bar charts, except that the range between the opening and closing prices is highlighted and given special emphasis in candlestick chart interpretation. The high and the low price for a period are represented exactly the same way in both Western bar charts and candlestick charts.
The real body is the price range between the period's open and close. This is drawn as the widest part of the candlestick chart. The real body is either white or black, signifying buying or selling dominance after the open. (Of course, with some of today’s analytical software, you can choose any colors you wish.) The contrasting shading (white or black) helps traders perceive changes in the balance of market forces between buying (white) or selling (black) dominance.
White candlestick: If the close is higher than the open, the real body is white. A white candlestick indicates buying dominance after the open.
Black candlestick: If the close is lower than the open, the real body is filled in black. A blackcandlestick indicates selling dominance after the open.
The real body is the most important part of each candlestick. The shade (white or black) and length of the real body reveals whether the bulls or bears are dominant during the main period of trading. A long white real body implies that the bulls are in charge. A long black real body implies that the bears are in charge. Candlesticks with very small real bodies, where the difference between the open and close are relatively tiny compared to normal trading ranges, imply that neither side is currently in charge and, furthermore, that the previous trend may be worn out.
Shadows are the part of the price range that lies outside the real body’s open-to-close price range. Shadows are represented as thin lines extending from the real body to the extreme high and low prices for the period, above and below the real body. The peak of the “upper shadow” is the high of the period, while the bottom of the “lower shadow“ is the low of the period.
The length and position of the shadows are meaningful. A tall upper shadow implies that the market rejected higher prices and is heading lower. A long lower shadow implies that the market rejected lower prices and is heading higher. Very long shadows, both upper and lower, indicate that the market has lost its sense of direction. Putting several of these together points to a trend reversal.
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Candlestick Chart Basics
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Indecision and Continuation
Candlesticks
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Candlestick Reversal Bottoms
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Candlestick Reversal Tops
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Quick Guide to Main Patterns
Main Trading
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