Candlestick charts are on record as being the oldest type of charts developed and used by Japanese traders as far back as the 1700’s for predicting rice prices. In fact, during this era in Japan, Munehisa Homma became a legendary rice trader and gained a huge fortune using candlestick analysis. He is said to have executed over 100 consecutive winning trades!
Japanese traders gave colourful names to the candlesticks themselves and the formations they shape. Western technical analysts have given suitable ‘user-friendly’ English names to most of the candlestick formations but to date, some Japanese names like the doji, harami and marubozu are widely used.
Candle charts display a more detailed and accurate map of the market than do bar charts.
- Candle charts open new avenues of analysis and offer many advantages over bar charts.
- Candle charts often provide clues of imminent reversals in one to three sessions while bar chart often take weeks to give a reversal signal
The first step in using the power of candles is learning how to construct a candle line. Exhibits 1 and 2 show that the candle line consists of a rectangular section and two thin lines above and below this section. The individual lines often look like candles with their wicks. The rectangular part of the candle line is called the real body. It represents the range between the session’s open and close. When the real body is black or shaded, it shows that the close was lower than the open. If the real body is white or empty, it means the close was higher than the open.
The thin lines above and below the real body are called the shadows. The shadows represent the session’s price extremes. The shadow above the real body is called the upper shadow and its peak is the session high. Likewise, the shadow below the real body is called the lower shadow and its trough is the session low.
Candle charts can be used for any time frame. For a daily chart, one would use each day’s open, high, low and close. For a weekly chart, one uses Monday’s open, the week’s high and low and Friday’s close. For an hourly chart, each hour’s open, high, low and close are used.
Long White Real Bodies
- In candlestick charts, even an individual candle has meaning and one of the first clues about the vitality of the market is to look at the size and color of the real body. To the Japanese, the real body is the essence of the price movement. Through the height and color of the real body, candle charts clearly and quickly display the relative power of the bulls and bears. We will now study three types of candles:
- Candles with long white or black real bodies.
- Candles with small real bodies called spinning tops.
- Candles that have no real bodies called doji.
A long white real body is defined as a session that opens at or near the session low and closes at or near the session high. For a long white real body to have significance, some Japanese candlestick traders believe that the real body should be at least three times as long as the previous day’s real body.
Long White Candle at a Low Price Level
A single candle is rarely able to forecast an immediate reversal. However, a long white candle at a low price range may be the first sign of a market bottom because it shows that the ability of the price to rise is virtually unimpeded by the bears. Exhibit 3 shows that dollar/yen fell from 124. 07 on 30th November 1998 to a low of 108.22 on 11th January 1999 before closing in New York at 108.89. The very next day, dollar opened at 108.88 in the Far East and closed at 112.58. This was a long white candle and the dollar rallied to 123.75 by March 4th. Exhibit 4 shows the Euro’s sharp rally from a low of 1.0108 to a high of 1.0825 which commenced with a long white candle on July 19th when it opened in the Far East at 1.0188 and closed in New York at 1.0313.
Long White Candle Confirms Support
A long white candle that bounces off a support such as trendline, moving average, lower bollinger band, retracement level or a previous support gives extra confirmation of that support and underscores the aggressiveness of the bulls. Exhibit 5 shows a long white candle in the dollar/yen chart from the lower bollinger band at 117.91 on 14th June 1999.
Long White Candle Breaks Resistance
Whenever a market breaks an important resistance with a long white candle, it probably confirms a major breakout with the earlier resistance now becoming a good support. Exhibit 6 shows dollar/mark finding good resistance in April 1999 just under the 1998 high of 1.8565. However, on 26th May, the long white candle pierced through this resistance. Thereafter, this level acted as a good support and gave way only in July but only after dollar/mark had reached significant new highs at 1.9339.
Long White Candles as Support
Long white candles often offer good support to both rising and falling markets. Any subsequent reactions usually find support at the middle of the long white real body or the low of the long white candle. This tool is not available with bar charts. After a long white candle, the market may reach a short-term overbought state with prices having risen too fast. Hence, prices may dip to relieve the overbought condition before rallying further. Exhibit 7 shows the long white candle in the Euro chart on July 19th 1999 and the next day’s intraday dip finding support at 1.0280 just over the midpoint of the previous day’s long white real body.
What holds goods for long white candles also holds good for long black candles but in the opposite direction/sense.
Spinning tops are candles with small real bodies. They are warning signs that the market is losing its momentum particularly after a long rise or a fall. A spinning top accompanied with heavy volume after a large fall suggests accumulation. On the other hand, a spinning top with heavy volume after a long rally indicates distribution. Exhibits 8 and 9 show spinning tops.
- A doji is one of the more important candlesticks and is formed when a session’s open and close are the same or almost the same.
- If the market is trading sideways, the doji is neutral.
- However a doji that emerges after a large rally or sell-off has a greater chance of signalling a reversal. At such times, a doji provides a hint of tops and bottoms.
- A doji is not a reversal signal but only points to a market at crossroads or in transition.
- Always safer to wait for a couple of days to get the confirmation of an anticipated trend reversal or continuation.
- Dojis that appear close to supports or resistances will more often than not hint a correction if not reversal. However, dojis appearing ahead of a long weekend or major economic releases may just be a pause in the trend. This will of course not be evident from the chart but will have to be inferred from other available market information or calendar. Exhibits 10 and 11 illustrate dojis.
We shall now see how some of the more common and important candle patterns can provide powerful insights into the market behaviour. The psychology of market participants, the supply and demand equation and the relative strengths of buyers and sellers are all reflected in individual candlesticks and combinations thereof.
Single Candle Lines
In this section, we shall examine the hammer, the hanging man and the shooting star. All these candles have either a long upper shadow or a long lower shadow. Additionally, they have a small real body near the top or bottom of the day’s trading range. Hence, these candles have special significance.
- It is a candle with a small real body near the top of the range and a long lower shadow, appearing after a large decline or in an oversold market.
- The term "hammer" signifies that the market is hammering out a base.
- The hammer is a reversal indicator and as such should have a downtrend to reverse. A hammer that appears after a fall of 2 to 3 days is usually not important.
- Since the hammer is most useful after a significant decline, it should be borne in mind that the first bounce from a hammer may fail and prices may fall to test the hammer low.
- Exhibit 12 shows an illustration of a hammer.
The Hanging Man
The Shooting Star
- A hanging man has a small real body near the top of the day’s range and a long lower shadow.
- This is also a reversal signal but should appear after a major rally.
- Since the underlying sentiment is bullish, the first decline may not sustain with the bulls reappearing to test the hanging man high. Since prices have rallied towards the end of hanging man session, it is preferable to wait for a bearish confirmation in the next session with a close under the hanging man’s real body. In that event, all those who bought at the open or close of the hanging man session are out of the money and may decide to bail themselves out. Exhibit 13 candle chart of the Dow Jones Industrial Average with hanging man on 11th May'99.
- A session with a long upper shadow and a small real body near the bottom end of the trading range is called a shooting star.
- Just as the long lower shadow of a hammer is bullish, so the long upper shadow of a shooting star is bearish. The long upper shadow means that the bears have been able to drag prices back from their highs. A shooting star has significance only if it appears after an uptrend. Exhibit 14 shows a shooting star.
To summarize, always look at the preceding trend to determine if the hammer, hanging man or shooting star should be acted upon. Remember that as reversal signals, they need a prior trend to reverse.
Dual Candle Lines
Dark Cloud Cover
- A dark cloud cover shows that the market has a poor chance of rising.
- The first session of a dark cloud cover is a strong white candle. With buying pressure left over, the market opens higher in the next session but prices decline later and eventually close under the centre of the previous session's white real body. This pattern shows that the upward power of the strong white candle is dissipated by the next session’s weak black candle. In discontinuous markets that have a definite time interval between one day’s close and the next day’s open, the second session should ideally open above the previous day’s high but in any case above the previous day’s close. However, the interbank currency market is a continuous market from Monday morning in Wellington to Friday close in New York. Hence, it may suffice if the second session opens very near the close of the previous session.
- A dark cloud cover often becomes resistance but if the market closes above the dark cloud’s high, it is very likely that the prior trend has resumed. Longer the prior uptrend, greater is the significance of a dark cloud cover. Exhibit 15 is an example of dark cloud cover.
The Piercing Pattern
The Engulfing Patterns
- This is the opposite of the dark cloud cover and should appear after a downtrend to have significance. The piercing pattern is a white body that closes above the midpoint of the previous strong black body. Refer Exhibit 16.
- An engulfing pattern is one where the second real body engulfs an opposite colour real body. A bullish engulfing pattern is formed when after a downtrend, a white body real body wraps around a black real body. On the other hand, a bearish engulfing pattern is completed when after a rally a black real body envelops a white real body. Refer Exhibits 17 & 18.
The importance of an engulfing pattern depends on the relative size of the real bodies, the relationship of the shadows to one another and other factors. For example, the strictest definition of an engulfing pattern would be if the first candle is small and the second candle very large with the second real body wrapping around the entire first candle. The next strictest definition would be if the shadows of the second candle exceeded those of the first candle, that is, a higher high and a lower low on the second day.
In the interbank currency market, the Far East open is almost the same as the previous day’s New York close. This is OK. However, if the two candles are almost of the same size, the market may move sideways.
The window, also known as disjointed candles, is one of the more powerful candlestick patterns. A window is nothing but a gap in the West. That is, for a rising window, the top of yesterday’s upper shadow should be under the low of today’s lower shadow. A falling window means the bottom of yesterday’s lower shadow is above the top of today’s upper shadow. Windows are a good visual clue because they clearly show that sentiment is one-sided.
Windows occur more often in discontinuous markets like the stock markets as compared to the interbank currency market for the major currencies traded round the clock except on weekends. However, Exhibits 19 & 20 show two powerful windows or gaps in the dollar/mark charts that occurred in September 1985 and May 1989. The first window occurred immediately after the well-known Plaza Accord and is yet to be filled while the second took a few months to be filled.