In the 1600s, the Japanese developed a method of
technical analysis to analyze the price of rice contracts. This
technique is called candlestick charting. Steven Nison is credited with
popularizing candlestick charting and has become recognized as the
leading expert on their interpretation.
Candlestick charts display the open, high, low, and
closing prices in a format similar to a modern-day bar-chart, but in a
manner that extenuates the relationship between the opening and closing
prices. Candlestick charts are simply a new way of looking at prices,
they don't involve any calculations.
Each candlestick represents one period (e.g., day)
of data. Figure 45 displays the elements of a candle.
Interpretation
I have met investors who are attracted to
candlestick charts by their mystique--maybe they are the "long forgotten
Asian secret" to investment analysis. Other investors are turned-off by
this mystique--they are only charts, right? Regardless of your feelings
about the heritage of candlestick charting, I strongly encourage you to
explore their use. Candlestick charts dramatically illustrate changes in
the underlying supply/demand lines.
Because candlesticks display the relationship
between the open, high, low, and closing prices, they cannot be
displayed on securities that only have closing prices, nor were they
intended to be displayed on securities that lack opening prices. If you
want to display a candlestick chart on a security that does not have
opening prices, I suggest that you use the previous day's closing prices
in place of opening prices. This technique can create candlestick lines
and patterns that are unusual, but valid.
The interpretation of candlestick charts is based
primarily on patterns. The most popular patterns are explained below.
Bullish Patterns
Long white (empty) line. This is a bullish
line. It occurs when prices open near the low and close
significantly higher near the period's high.
Hammer. This is a bullish line if it
occurs after a significant downtrend. If the line occurs after a
significant up-trend, it is called a Hanging Man. A Hammer is
identified by a small real body (i.e., a small range between the
open and closing prices) and a long lower shadow (i.e., the low is
significantly lower than the open, high, and close). The body can be
empty or filled-in.
Piercing line. This is a bullish pattern
and the opposite of a dark cloud cover. The first line is a long
black line and the second line is a long white line. The second line
opens lower than the first line's low, but it closes more than
halfway above the first line's real body.
Bullish engulfing lines. This pattern is
strongly bullish if it occurs after a significant downtrend (i.e.,
it acts as a reversal pattern). It occurs when a small bearish
(filled-in) line is engulfed by a large bullish (empty) line.
Morning star. This is a bullish pattern
signifying a potential bottom. The "star" indicates a possible
reversal and the bullish (empty) line confirms this. The star can be
empty or filled-in.
Bullish doji star. A "star" indicates a
reversal and a doji indicates indecision. Thus, this pattern usually
indicates a reversal following an indecisive period. You should wait
for a confirmation (e.g., as in the morning star, above) before
trading a doji star. The first line can be empty or filled in.
Bearish Patterns
Long black (filled-in) line. This is a
bearish line. It occurs when prices open near the high and close
significantly lower near the period's low.
Hanging Man. These lines are bearish if
they occur after a significant uptrend. If this pattern occurs after
a significant downtrend, it is called a Hammer. They are identified
by small real bodies (i.e., a small range between the open and
closing prices) and a long lower shadow (i.e., the low was
significantly lower than the open, high, and close). The bodies can
be empty or filled-in.
Dark cloud cover. This is a bearish
pattern. The pattern is more significant if the second line's body
is below the center of the previous line's body (as illustrated).
Bearish engulfing lines. This pattern is
strongly bearish if it occurs after a significant up-trend (i.e., it
acts as a reversal pattern). It occurs when a small bullish (empty)
line is engulfed by a large bearish (filled-in) line.
Evening star. This is a bearish pattern
signifying a potential top. The "star" indicates a possible reversal
and the bearish (filled-in) line confirms this. The star can be
empty or filled-in.
Doji star. A star indicates a reversal and
a doji indicates indecision. Thus, this pattern usually indicates a
reversal following an indecisive period. You should wait for a
confirmation (e.g., as in the evening star illustration) before
trading a doji star.
Shooting star. This pattern suggests a
minor reversal when it appears after a rally. The star's body must
appear near the low price and the line should have a long upper
shadow.
Reversal Patterns
Long-legged doji. This line often
signifies a turning point. It occurs when the open and close are the
same, and the range between the high and low is relatively large.
Dragon-fly doji. This line also signifies
a turning point. It occurs when the open and close are the same, and
the low is significantly lower than the open, high, and closing
prices.
Gravestone doji. This line also signifies
a turning point. It occurs when the open, close, and low are the
same, and the high is significantly higher than the open, low, and
closing prices.
Star. Stars indicate reversals. A star is
a line with a small real body that occurs after a line with a much
larger real body, where the real bodies do not overlap. The shadows
may overlap.
Doji star. A star indicates a reversal and
a doji indicates indecision. Thus, this pattern usually indicates a
reversal following an indecisive period. You should wait for a
confirmation (e.g., as in the evening star illustration) before
trading a doji star.
Neutral Patterns
Spinning tops. These are neutral lines.
They occur when the distance between the high and low, and the
distance between the open and close, are relatively small.
Doji. This line implies indecision. The
security opened and closed at the same price. These lines can appear
in several different patterns.
Double doji lines (two adjacent doji lines) imply that a forceful
move will follow a breakout from the current indecision.
Harami ("pregnant" in English). This
pattern indicates a decrease in momentum. It occurs when a line with
a small body falls within the area of a larger body.
In this example, a bullish (empty) line with a long body is followed
by a weak bearish (filled-in) line. This implies a decrease in the
bullish momentum.
Harami cross. This pattern also indicates
a decrease in momentum. The pattern is similar to a harami, except
the second line is a doji (signifying indecision).
Example
The following chart of Corn illustrates several
Japanese candlestick patterns and principles.
You can see that advancing prices are usually
accompanied with empty lines (prices opened low and closed higher) and
that declines are accompanied with filled-in lines (prices opened high
and closed lower).
Bearish engulfing lines occurred at points "A" and
"B" (and prices subsequently moved lower). Bullish white lines occurred
at points "1," "2," and "3" (as prices moved higher).
