Candlesticks

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© Copyright FMRAnalysts, 2007. All rights reserved.

Candlestick Analysis

Candlesticks have become one of the most popular methods for reading stock prices. When evaluating stock, commodity, option, or market values, the Japanese Candlestick not only provides all price data, but it also gives you a visual identification of buyer and seller demand.

This document is a beginners explanation to reading Japanese Candlesticks.

For any trader/investor who wishes to evaluate and make decisions using charts, the Candlestick will become your closest ally.

Contents

Contents................................................................................................................................... 1 Sources for Beginners: ............................................................................................................... 1 History ..................................................................................................................................... 2 Price......................................................................................................................................... 2 Makeup of a Candlestick ............................................................................................................ 3 Candlestick Body .................................................................................................................... 3 Candlestick Shadows............................................................................................................... 4

Resistance Levels....................................................................................................................... 6 Support Levels........................................................................................................................... 7 The Doji.................................................................................................................................... 7 Other Patterns........................................................................................................................... 8 Volume..................................................................................................................................... 8 Case Study.............................................................................................................................. 10 Summary................................................................................................................................ 11 Disclaimer............................................................................................................................... 11

Sources for Beginners:

Japanese Candlestick Charting Techniques by Steve Nison This book is considered the pinnacle of information on Candlesticks. Steve Nison literally brought this technique out of Japan and into the western world.

The Secret of Candlestick Charting by Louise Bedford An Australian author who has simplified the learning of candlesticks. This book suits the beginner and should give sufficient knowledge to begin using this technique.

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History

Needless to say, Japanese Candlesticks originate from Japan. Somewhere around the 1600’s in Fuedal Japan, Rice Traders began plotting the price of rice. At the time, rice was the predominant method of currency, and a Rice Exchange actually formed.

As one can imagine, without the help of computers, plotting prices was quite painstakingly difficult, and so the method of Candlesticks were developed.

To put this into perspective, while the Candlestick was being used to plot the changing prices of rise in Japan, Europe was in the midst of Tulipmania, which subsequently resulted in an economic crash. Whilst both the Japanese and the Dutch were using a crude form of Futures contracts to purchase rice and tulip bulbs respectively, only the Japanese were using a visual aid to analyze and plot the price changes.

Up until the early 1990’s, however, Candlesticks were still not predominant in the western world. Renowned author Steve Nison translated much of the material available in Japan on the subject, producing one of the most widely read books today: Japanese Candlestick Charting.

Westerners had been using a cruder technique of price plotting called Bar Charts. They depict the same information, however, the Candlestick offers far greater benefits as a visual aid. This is due to the depth of its body (see further sections for explanation).

Today, Japanese Candlesticks are one of the most predominant methods for evaluating price, with nearly all software packages providing this technique. For the trader/investor who is able to proficiently read candlesticks, a great insight is provided into the balance between buyers and sellers.

Price

The daily movement of a stock price consists of 5 pieces of data:

• Open price • Close price • High price • Low price • Volume

Candlesticks represent all of this information except Volume (Equivolume candlesticks are not discussed in this paper). Therefore, by using the candlestick as our price evaluation technique, we are able to visualize whether the day was dominated by buyers or sellers, whether there was weakness in buyers or sellers, and the relationship of the days’ movements compared to previous days.

Other methods to evaluate price movement include:

• Line Chart – only one price is represented (typically the closing price), but is a simple method to view price activity.

• Bar Chart – similar to a Candlestick, but does not have a body. • Point and Figure Charting – one of the first methods of analyzing price movement, they evaluate

price movement by marking an X for an upward movement, and an O for a downward movement.

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Analysis of price is the base to where most traders/investors begin. To put it simply, by analyzing the price, we are attempting to determine whether or not that price is “overvalued” or “undervalued”. Other factors will also apply in this determination, but analysis of the price is the starting point in an effort to follow the golden rule:

Buy Low … Sell High

Makeup of a Candlestick

There are two sections to a candlestick:

q The body q The shadow

Candlestick Body

The body represents where the open and closing prices are.

For a candle that has an open body, the opening price is at the bottom of the body and the closing price is at the top of the body

For a candle that is solid, the opening price is at the top of the body and the closing price is at the bottom.

Color is used to determine whether today’s close is higher or lower then the previous days close. For example:

Note: in the above examples, the Green candle is open and the Red candle is solid. This means the Green candle has a closing price at the top of the body. While the Red candle has a close at the bottom of the body.

Open

Close

Close

Open

The close of the 2 nd candle is higher then the first candle. This denotes the 2 nd candle as a Green candle

The close of the 2 nd candle is lower then the first candle. This denotes the 2 nd candle as a Red candle

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A series of Green (open) candles suggests that the share price is rising. Each days’ close is higher then the last, defining an upwards trending movement.

A series of Red (solid) candles, suggests that the share price is falling. Each days’ close is lower then the previous day, defining a downwards trending movement.

With candles grouped, we can identify the difference between trends. A trend is the primary method to evaluate the potential direction of a share price. A series of candles trading in the one direction will help us identify when a trend is forming.

Candlestick Shadows

Shadows represent the high and low price for the day. They are lines moving above and below the body of the candlestick:

For the Green candle, the opening price was at the bottom of the body. We would assume the low price was in the morning session of trading as it is close to the open. During the day the share price has been driven up to the high. Later towards the end of the day there was a little selling activity to force the close down a little off the high. This is a positive day where buyers were predominantly in the market.

High

Low Open

Close

Close

Open

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For the Red candle, the open is at the top of the body. There was a little buying activity early in the day to force the price to the high, but shortly thereafter sellers came to the market and the share price traded down all day to the low. Late in the day, towards the end of trading, there was a little buying pressure that forced the price up off the low. This is a day that is predominantly dominated by sellers – a negative trading day.

Typical price movement during the life of the candle may be represented with the following diagrams:

• Share price opens at bottom of candlestick body • Dips slightly to form a lower point than at the open • Rallies through the day, reaching a high point • Retracing slightly to close just below the high of the day

• Share price opens at top of candlestick body • A slight rise in the share price forms a higher point than the open • Share price retraces throughout the day, reaching a low point • A slight rally and the share price closes just above the low of the day

Shadows can offer signs of possible reversal situations:

In this example, as the price has risen due to buying pressure, the shadow shows us signs of afternoon selling activity that has been a pivot point to the reversal of the price direction.

This candle is called a Shooting Star. It shows buyers dominating the first half of the trading day. At a certain point, sellers see the share price to be overvalued and begin selling. This selling pressure drives the share for the remainder of the day. The reason why this is seen as a direction reversal pattern is because owners of the share see a large fall in the price by the end of the day and many decide to sell the next morning, which drives the share price further down.

Shadow represents reversal point

Afternoon selling pressure pulls the share price down from the high to close near the open. Sellers have dominated the later session of the trading day. This could reflect a continuation of selling activity the next morning.

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Shadows at the bottom of candles that are found at the bottom of a trend can represent buying pressure:

As sellers are forcing this share down in value, the buyers come back to the market following a shadow at the bottom of the movement. This candle has been the Pivot Point in the change of direction.

This candle is called a Hammer. Sellers have started the trading and dominated for the majority of the day. In the later session of trading, the price has reached a level that the buyers then perceive to be of good value. Buyers come to the market in force and push the price up to close near the open. Many traders would see this as being a positive move by the market and would enter the following morning.

Resistance Levels

Shadows can help identify resistance levels:

Here we see sellers in the later sessions of each day selling the share once it meets a certain price (resistance). This means buyers are not willing to push the price up higher then on previous days.

Multiple candles with long shadows on top, finding resistance at similar prices, suggests buyers do not have the demand to push the price higher.

Buyers come to the market later in the day. This can be seen as a possible reversal from a downward trend, with buyers forcing the price up and away from the low of the day.

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Support Levels

Shadows can also help identify support levels:

Here we find buyers entering the market as the share reaches a certain price (support).

The Doji

At times candles can show us that there is indecision in the market. This candle is known as the Doji:

In the above 3 examples, there is equilibrium between buyers and sellers. The open and close prices are the same, and there has been some buying and selling activity during the day, but neither the buyers nor sellers have been predominantly in control.

If these are seen at the tops or bottoms of trends, they could be points of possible reversal.

Trading Tip: Never trade directly after identifying a candlestick pattern. Wait for one day of confirmation that the buyers or sellers are now in the market.

This “Star” Doji has no body. The Open and Close price for the day were at the same level. The price fluctuated between the high and low, but failed to find direction.

This “Dragonfly” Doji has no body. The Open and Close price are at the same level, though there was some selling pressure during the day to form the tail of the candle.

This “Gravestone” Doji has no body. The Open and Close price are at the same level, however, there was some buying pressure during the day to form the wick of the candle.

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Other Patterns

This report does not provide an exhaustive list of the candlestick patterns that are available for use in your charting. Following are brief descriptions of the basic single candle patterns not already mentioned:

Volume

Although not part of the Candlestick, Volume is an extremely important factor when analyzing a chart. Along with analysis of buyer/seller demand from the candle, volume helps confirm strength or weakness in a movement.

Increasing volume suggests more activity. When this is coupled with a directional movement in the price, we can assume there is either buyer or seller strength.

Vice versa when volume is decreasing. If volume is decreasing and there is a directional movement, there is not as much trading activity, and we can assume there is some weakness in either buyers or sellers.

In this example, volume is decreasing while the share price is rising. This suggests there is weakening buyer demand, and could result in the share price stalling, or reversing.

In this example, increasing price with increasing volume suggests increasing Buyer Demand.

There is a higher potential that the share price will continue to rise while there is strength behind the buyers.

Marubozu: long candles with no shadows

Spinning Top: small candles with small shadows either side

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In this example, a decreasing price with increasing volume suggests increasing Selling pressure, or Supply.

There is a higher potential that the share price will continue to fall while there is strength behind the sellers.

In this example, volume is decreasing as the share price falls. This suggests weakening selling pressure, and could result in the share price stabilizing, possibly even reversing.

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Case Study

Chart A

From the above chart, we are viewing the price activity from January 2007, through to the end of June 2007. Each candle represents 1 day of price activity.

An upwards trend begins from lows in March, through to the right hand side of the chart.

Point A – Here we have 2 Doji candlesticks. They represent uncertainty between buyers and sellers, shortly after the market has rallied for 5 days. Subsequently, some mild selling pressure pulls the stock price down.

Point B – A Hammer candlestick represents weakness from sellers. The long shadow at the bottom of the small open green body shows sellers were not able to hold the share price at the lows. Subsequently, buyers lifted the stock, and this triggered an upwards price move the following day.

Point C – A Spinning Top pattern has formed at the top of the trend. It represents weakness, and with a Solid Red candle, with a large shadow on top, the following day, a confirmation that sellers have taken control after a few weeks of buyer dominance.

Point D – This is a Solid Green candlestick. The closing price of this candle is higher then the previous day (denoting green colour), however, the body is solid. This suggests the share price gapped up to open at the top of the body, but retraced through the day to close at the bottom of the body. This close is still higher then the previous day. It is a sign of weakness from the buyers, with similar psychology as a Shooting Star pattern.

A

B

C

D

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Summary

In this article, you have learnt:

• The background of the Japanese Candlestick • The makeup of a Japanese Candlestick • How to read a Japanese Candlestick • The basic single candle patterns • How volume supports strength or weakness in the candlestick movement • That Candlesticks are one of the most effective, and popular, methods to read the balance

between buyers and sellers – Supply and Demand.

If you have any further questions, or if you have a topic you would FMR Analysts to explain, please contact us on [email protected]

Web: www.fmranalysts.com Email: [email protected] Phone: +61 7 55030534 Postal: PO Box 1036, Runaway Bay. QLD 4216

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Candlesticks

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