- 2000: Volume 9, No. 6 Introduction to Candlesticks

Over 100 years before traditional bar and point and figure analysis originated, the Japanese were using their own style of technical charting that would eventually evolve into the candlestick techniques they currently use today. Many candlestick patterns are similar to those of Western technical analysis but they have several advantages. One advantage is in their descriptive names. For example, the equivalent of a bearish one-day reversal, one where price gaps higher on the open, continues to make new highs but changes course to end up closing lower, is called a "dark-cloud cover." As its name implies, the market is about to get stormy and investors should make preparations (i.e.-sell).

While it is important to view the markets as other participants do, candlestick charting offers other unique advantages. One important advantage comes from the combining of patterns. These often reveal changes in volatility and momentum without the use of oscillators and other derivatives of price. By using oscillators in addition to candlesticks, the analysis becomes very powerful.

READING CANDLESTICKS

Like a bar chart, the daily candlestick line contains the open, high, low, and close for the market for a specific day. However, unlike a bar the candlestick has a wide part which is called the "real body". It represents the range between the open and close. When the real body is black (i.e., filled in) it means the close was lower than the open. If the real body is white (i.e., empty), it means the close was higher than the open. See the candlestick illustrations in Figure 1.

Figure 1:

The thin lines above and below the real body, which resemble the wicks of the candle, are called the "shadows." The shadows represent the high and low of the day. The shorter the upper shadow on a black body, the closer the open was to the high. A short upper shadow on a white body means 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 long or short and black or white. Shadows can be long or short as well.

BASIC CANDLESTICK SHAPES

Long Black Body. This represents a bearish period in the market. Prices experienced a wide range, and the market opened near the high and closed near the low of the period.

Long White Body. This is the opposite of a long black body, and represents a bullish period in the market. Again, prices experienced a wide range, however, the market opened near the low and closed near the high of the trading period.

Spinning Tops. These are small real bodies, and can be either black or white. The small body represents a relatively tight range between the open and close for the period. In a trading range environment, spinning tops are neutral, but they may become important parts of other chart patterns.

Doji Lines. These illustrate periods where the opening and closing prices for the period are the same. The length of the shadows can vary. Doji lines are important in a variety of patterns.

REVERSAL INDICATORS

Just like with Western analysis, candlesticks can forecast changes in market direction. Some have only one candle, usually with a specific shape. Others have two or more candles combining simple candles with more exotic shapes.

The simplest reversal pattern is the Umbrella candlestick. It gets its name from its somewhat remote resemblance to a rain umbrella but can be more objectively recognized by two features: 1) a spinning top real body at the upper end of the entire trading range, with little or no upper shadow, and 2) a lower shadow that is at least twice the length of the real body. The color of the real body is not important.

Umbrellas can be either bullish or bearish depending on where they appear in a trend. If they occur during a downtrend, they are called hammers and are bullish, as in "the market is 'hammering out' a base." If an umbrella appears in an uptrend it is bearish, and is referred to as a hanging man. The latter's ominous name is derived from its look of a hanging man with dangling legs.

The engulfing pattern is a strong reversal signal, especially after a prolonged trend. It is similar to the Western reversal pattern. Only the real body is important in this formation; shadows are virtually ignored.

The bearish engulfing pattern has a black real body that engulfs the prior day's white real body. This pattern is bearish during an uptrend. Conversely, a white body at the bottom of a downtrend that engulfs the prior day's black body is a potentially bullish signal.

The piercing line is a bullish pattern. This combination is composed of a long black body followed by a white body. The white body should open lower and then close above the center of the black body. Here, the market gaps lower on the opening and then retraces to close above the midpoint of the previous period's black body. If the white body does not "pierce" this halfway point, more weakness can be expected in the market.

As mentioned earlier, the dark cloud cover is a bearish pattern. This is the opposite of a piercing line. A strong white body is immediately followed by a black body. A dark cloud cover must have a black body opening above the high of the previous white body as well as closing below the white body's center.

There are various candle combinations called stars (hoshi), so named because they are located significantly above their preceding candles like a star in the sky. All stars are reversal indicators and are more important after prolonged trends or large moves. A star is a small real body or a doji made on a gap that follows a long real body. Even if the shadows overlap, the formation is still considered a star, since only the real bodies are important.

The morning star pattern is a signal of a potential bottom in the market. It is aptly called a morning star because it appears just before the sun rises (in the form of higher prices). After a long black body, we see a downside gap to a small real body. This is followed by a white body that closes above the midpoint of the black body made just before the star. The morning star is similar to a piercing line with a "star" in the middle.

The evening star formation is the reverse of the morning star. Aptly named because it appears just before darkness sets in, the evening star is a bearish signal. Basically, the evening star is similar to a dark cloud cover with a "star" in the middle.

The doji star appears after a prolonged move, and is composed of a gap and a doji line (remember a doji is when the open and the close are the same price). This is often the sign of an impending top or bottom. Doji stars often mark imminent turning points in the market, but more conservative traders should wait for the next day's body to confirm a change in price trend.

The shooting star pattern appears at short-term tops in the market, and is a bearish signal. As its name suggests, the shooting star is a small real body at the lower end of the price range with a long upper shadow.

Harami lines are similar to an inside day in contemporary Western analysis. But while an inside day is usually considered neutral, the harami line is an indication of a waning of momentum. The small body of the harami line is contained within the long body directly preceding it. (Harami appropriately means pregnant in Japanese). If the harami line is also a doji, it is referred to as a harami cross.

These patterns indicate that the market is at a point of indecision and a trend change, or a reversal, is possible. The harami cross pattern is useful in forecasting trend changes - especially after a long white body in an uptrend.

CONTINUATION INDICATORS

Candle patterns can also indicate that the market will continue its current trend. There are many types that occur but for this introduction we'll only briefly cover one, the window (ku).

A window is the same as a gap in contemporary western analysis. With bar charts, we say "filling in the gap," the Japanese expression is "closing the window." Our experience is that gaps often become support or resistance areas. And windows (i.e., gaps) are viewed in the same context as support or resistance. Shadows are also considered in closing the window. Unclosed windows signal continuation of the trend.

DOJIS

Doji lines are important enough to get their own discussion. Basically, dojis reflect indecision which makes sense since the market closed unchanged for the day after trading significantly higher and lower intraday. If you see two or more doji lines within a short time in a market where this normally does not occur, then a sttrong move is possible. Double dojis may foretell an increase in market volatility. Option traders who are confident of price direction could use this signal to buy options (assuming volatility levels are attractive). They could benefit from premium expansion based on increased volatility and a significant price move. For those not confident about the direction of the break, a long straddle or strangle (or similar long volatility plays) may be considered.

Doji days can become support or resistance, usually on a short-term basis. And a series of three doji lines after a prolonged move could signal a rate and important top or bottom.

Variations on doji patterns have interesting names like rickshaw man (very long shadows) and gravestone (no lower shadow and a very long upper shadow). However, their significance remains the same as other dojis.

Trading with Candlesticks

Let's put some of the basic candle formations to work, with other technical indicators, to analyze a real market situation.

Figure 2 shows December Cocoa from April through June 1992. The biggest question a trader would ask during this period is "When will this market stop going down?" There are several patterns on the chart that forecasted times for corrections and finally, the end of the decline. Using Candlesticks with other confirming technical indicators lets you figure out which is which.

Figure 2:

The market was trending lower and at the bottom of the channel, the gap lower (called a "window") could have signaled a continuation of the decline on a bar chart. The candle after the gap had a small real body (the wide part of the candle marking the open and close). This is known as a "star" and signifies uncertainty in the market. The next day the market opened higher and closed within the real body of the candle before the gap. This completed a "morning star" and is a bullish reversal pattern.

But was that the bottom of the decline? The three stars that followed indicated that the market did not really have much buying support so the channel was not broken.

At the channel bottom, the one-day reversal pattern on a bar chart appeared as an "engulfing line" with candlesticks. The white real body "engulfs" the previous black real body.

Here a "doji", which has no bar chart equivalent, signifies that the rally again did not have sufficient buying power. The market opened and closed at the same price after trading in a wide range. Dojis are very good at calling market tops. The next day gapped higher and proceeded to fall until it closed virtually unchanged (the long black body is bearish).

Further confirmation was found with the small candle the next day (uncertainty) and another long black body which failed to break the channel. The small real body completely within the larger real body of the previous day, a reversal indicator, is called a "harami" and gets its name from its shape; the body and the protruding belly of a pregnant woman. (Who says you can't drink saki and trade at the same time?)

Things were starting to look good again until the "star" said otherwise. This pattern was completed the next day with the gap lower to a black body, this time called an "evening star." It is the opposite of the "morning star" and, as its name implies, is bearish. This particular "evening star" was not as perfect as the trader might like because the last candle should really close within the real body of the candle preceding the gap up. (A check of the then-current month, July, shows a better pattern.) Then, at the bottom of the channel, we see another "harami." And, once again at the top of the channel, another "doji."

This "morning star" is much stronger as the final white candle is long and closes well within the first black candle. Add to this the fact that prices did not make it back to the bottom of the channel this time and that the RSI bottomed out at an oversold level at #7, we have confirmation. This is the true bottom.

Finally, a very strong white candle breaks through the channel.

Figure 3 shows the same span but as a bar chart. First, note the RSI divergence as mentioned above. Next, notice that on June 25, the date that the "morning star" completed, there was no bullish indication. The bar chart trader would have waited until the trend break and missed out on about 30 points!

Figure 3:

Michael N. Kahn is a columnist for Barron's Online based out of Florida. He also writes a free technical newsletter. To subscribe to this service, please visit www.midnighttrader.com. The complete collection of Michael Kahn's "Tips on Technicals" is available in Real World Technical Analysis.