This section discusses only a few of the scores of candle chart patterns. There are many important candle patterns and trading tactics not discussed in this basic introduction. As such, do not trade based on the limited information. The goal here is to illustrate how candles can open new and unique analytical doors, not to provide a trading methodology. For example, there are many times candle signals should be ignored. This is where experience with candle charts comes in.
WHAT ARE CANDLESTICKS?
Candle chart analysis, so called because the lines resemble candles. These charts are now used internationally by traders, investors and premier financial institutions. Candle charts:
- Are easy to understand: Anyone, from the first-time chartist to the seasoned professional can easily harness the power of candle charts. This is because, as will be shown later, the same data required to draw a bar chart (high, low, open and close) is used for a candle chart.
Provide earlier indications of market turns: Candle charts can send out reversal signals in a few sessions, rather than the weeks often needed for a bar chart reversal signal. Thus, market turns with candle charts will frequently be in advance of traditional indicators. This will help you to enter and exit the market with better timing.
Furnish unique market insights: Candle charts not only show the trend of the move, as does a bar chart, but, unlike bar charts, candle charts also show the force underpinning the move.
Enhance Western charting analysis: Any Western technical tool you now use can also be used on a candle chart. Candle charts, however, will give you timing and trading benefits not available with bar charts. This merging of Eastern and Western analysis will give you a jump on those who use only traditional Western charting techniques.
CONSTRUCTING THE CANDLESTICK LINE
The broadest part of the candlestick line is the real body. It represents the range between the session’s open and close.
If the close is lower than the open the real body is black. The real body is white if the close is higher than the open. The real body is white if the close is higher than the open.
The thin lines above and below the real body are called the shadows. The peak of the upper shadow is the high of the session and the bottom of the lower shadow is the low of the session.
The color and length of the real body reveals whether the bulls or the bears are in charge. Note that the candle lines use the same data as a bar chart (the open, high, low and close). Thus, all Western-charting techniques can be integrated with candle chart analysis.
USING INDIVIDUAL CANDLE LINES
A critical and powerful advantage of candle charts is that the size and color of the real body can send out volumes of information. For example:
- a long white real body visually displays the bulls are in charge
- a long black real body signifies the bears are in control.
- a small real body (white or black) indicates a period in which the bulls and bears are in a “tug of war” and warns the market’s trend may be losing momentum.
While the real body is often considered the most important segment of the candle, there is also substantial information from the length and position of the shadows. For instance, a tall upper shadow shows the market rejected higher prices while a long lower shadow typifies a market that has tested and rejected lower prices.
Let’s look at an example of how a candle chart can help you avoid a potentially losing trade.
Picture 1 is a bar chart. In the circled area, the stock looks strong since it is making consecutively higher closes. Based on this aspect, it looks like a stock to buy.
The candle chart, uses the same data as Picture 1. Let’s now look at the circled area on the candle chart in Picture 2. Note the different perspective we get with the candle chart than with the bar chart. On the candle chart, in the same circled area, there are a series of small real bodies which the Japanese nickname spinning tops. Small real bodies hint that the prior trend (i.e. the rally) could be losing its breath.
As such, while the bar chart makes it look attractive to buy, the candle chart proves there is indeed a reason for caution about going long. The small real bodies illustrate the bulls are losing force. Thus, by using the candle chart, a trader or investor would likely not buy in the circled area. The result — avoiding a losing trade.
This is but one example of how candles will help you preserve capital.
When investing his own money, Warren Buffet has two simple rules that he follows:
RULE #1: Don’t lose money
RULE #2: Don’t forget rule #1.
Candles truly shine at helping you preserve capital!
Let’s now look at a specific type of candle line that has a very long lower shadow called a hammer (shown in Picture 3). So called because the Japanese will say the market is trying to hammer out a base. The criteria for the hammer are:
1. The real body is at the upper end of the trading range.
2. The color of the real body can be black or white.
3. A bullish long lower shadow that is at least twice the height of the real body.
4. It should have no, or a very short, upper shadow.
The hammer reflects the visual insights obtained from a candle chart—specifically the hammer’s extended lower shadow shows that the market rejected lower price levels to close at, or near, the highs of the session.
In the intra-day chart shown at Picture 4, I show two hammers at the same area (denoted by the arrow). These areas took on extra significance since there were two hammers at the same level and these dual hammers confirmed a support level shown by the dashed line. This illustrates how easy and powerful it is to combine the insights of candle charts (the hammers) with classic western trading signals (the support line) to signal the likelihood of a market turn.
Most of the candle signals are made with candle patterns in which we have more than one candle line. An example of a candle pattern is a bullish engulfing pattern as shown in Picture 5. The market falls, and a black candle forms. Next session a candle line develops with a white real body that wraps around the prior session’s black body. The name for this pattern is based on the fact the white candle “engulfs” the black candle. As the white real body opens under the prior black real body’s close, and closes above that session’s open, it shows buying pressure has overpowered selling pressure, i.e., the bulls have taken charge! If the market is solid, the lows of the bullish engulfing pattern should be support.
Picture 6 illustrates a classic bullish engulfing pattern in IBM in which the bullish engulfing pattern confirmed a support area set by a hammer.
With candle charts, one can use candle charting techniques, or Western techniques, or a combination of both. This union of Eastern and Western techniques provides trader with uniquely effective tools to help enhance profits and decrease market risk exposure.