CANDLESTICK PATTERNS

The candlestick techniques we use today originated in the style of technical charting used by the Japanese for over 100 years before the West developed the bar and point-and-figure analysis systems. In the 1700s, a Japanese man named Homma, a trader in the futures market, discovered that, although there was a link between price and the supply and demand of rice, the markets were strongly influenced by the emotions of traders. He understood that when emotions played into the equation, a vast difference between the value and the price of rice occurred. This difference between the value and the price is as applicable to stocks today as it was to rice in Japan centuries ago. The principles established by Homma are the basis for the candlestick chart analysis, which is used to measure market emotions surrounding a stock.

This charting technique has become very popular among traders. One reason is

that the charts reflect only short-term outlooks, sometimes lasting less than eight

to 10 trading sessions. Candlestick charting is a very complex and sometimes

difficult system to understand. Here we get things started by looking at what a

candlestick pattern is and what it can tell you about a stock.

Candlestick Components

When first looking at a candlestick chart, the student of the more common bar

charts may be confused; however, just like a bar chart, the daily candlestick line

contains the market's open, high, low and close of a specific day. Now this is

where the system takes on a whole new look: the candlestick has a wide part,

which is called the "real body". This real body represents the range between the

open and close of that day's trading. When the real body is filled in or black, it

means the close was lower than the open. If the real body is empty, it means the

opposite: the close was higher than the open.

Figure 1: A candlestick

Just above and below the real body are the "shadows". Chartists have always

thought of these as the wicks of the candle, and it is the shadows that show the

high and low prices of that day's trading. If the upper shadow on the filled-in body

is short, it indicates that the open that day was closer to the high of the day. A

short upper shadow on a white or unfilled body dictates that the close was near

the high. The relationship between the day's open, high, low and close

determines the look of the daily candlestick. Real bodies can be either long or

short and either black or white. Shadows can also be either long or short.

Comparing Candlestick to Bar Charts

A big difference between the bar charts common in North America and the

Japanese candlestick line is the relationship between opening and closing prices.

We place more emphasis on the progression of today's closing price from

yesterday's close. In Japan, chartists are more interested in the relationship

between the closing price and the opening price of the same trading day.

In the two charts below we are showing the exact same daily charts of IBM to

illustrate the difference between the bar chart and the candlestick chart. In both

charts you can see the overall trend of the stock price; however, you can see

how much easier looking at the change in body color of the candlestick chart is

for interpreting the day-to-day sentiment.

Figure 2: Daily bar chart of IBMSource: TradeStation

Figure 3: Daily candlestick chart of IBMSource: TradeStation

Basic Candlestick Patterns

In the chart below of EBAY, you see the "long black body" or "long black line".

The long black line represents a bearish period in the marketplace. During the

trading session, the price of the stock was up and down in a wide range and it

opened near the high and closed near the low of the day.

By representing a bullish period, the "long white body," or "long white line" (in the

EBAY chart below, the white is actually gray because of the white background) is

the exact opposite of the long black line. Prices were all over the map during the

day, but the stock opened near the low of the day and closed near the high.

Spinning tops are very small bodies and can be either black or white. This

pattern shows a very tight trading range between the open and the close, and it

is considered somewhat neutral.

Doji lines illustrate periods in which the opening and closing prices for the period

are very close or exactly the same. You will also notice that, when you start to

look deep into candlestick patterns, the length of the shadows can vary.

Figure 4: Daily chart of EBAY showing Doji lines and spinning topsSource: TradeStation

The Bottom Line

The candlestick charting pattern is one that any experienced trader must know.

As Japanese rice traders discovered centuries ago, investors' emotions

surrounding the trading of an asset have a major impact on that asset's

movement. Candlesticks help traders to gauge the emotions surrounding a stock,

and thus make better predictions about where that stock might be headed.

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Derivatives - Options: Calls and PutsAn option is common form of a derivative. It's a contract, or a provision of a

contract, that gives one party (the option holder) the right, but not the obligation

to perform a specified transaction with another party (the option issuer or option

writer) according to specified terms. Options can be embedded into many kinds

of contracts. For example, a corporation might issue a bond with an option that

will allow the company to buy the bonds back in ten years at a set price.

Standalone options trade on exchanges or OTC. They are linked to a variety of

underlying assets. Most exchange-traded options have stocks as their underlying

asset but OTC-traded options have a huge variety of underlying assets (bonds,

currencies, commodities, swaps, or baskets of assets). 

There are two main types of options: calls and puts:

Call options provide the holder the right (but not the obligation) to purchase

an underlying asset at a specified price (the strike price), for a certain

period of time. If the stock fails to meet the strike price before the

expiration date, the option expires and becomes worthless. Investors buy

calls when they think the share price of the underlying security will rise or

sell a call if they think it will fall. Selling an option is also referred to as

''writing'' an option.

Put options give the holder the right to sell an underlying asset at a

specified price (the strike price). The seller (or writer) of the put option is

obligated to buy the stock at the strike price. Put options can be exercised

at any time before the option expires. Investors buy puts if they think the

share price of the underlying stock will fall, or sell one if they think it will

rise. Put buyers - those who hold a "long" - put are either speculative

buyers looking for leverage or "insurance" buyers who want to protect their

long positions in a stock for the period of time covered by the option. Put

sellers hold a "short" expecting the market to move upward (or at least stay

stable) A worst-case scenario for a put seller is a downward market

turn. The maximum profit is limited to the put premium received and is

achieved when the price of the underlyer is at or above the option's strike

price at expiration. The maximum loss is unlimited for an uncovered put

writer.

To obtain these rights, the buyer must pay an option premium (price). This is the

amount of cash the buyer pays the seller to obtain the right that the option is

granting them. The premium is paid when the contract is initiated.

In Level 1, the candidate is expected to know exactly what role short and long

positions take, how price movements affect those positions and how to calculate

the value of the options for both short and long positions given different market

scenarios. For example:

Q. Which of the following statements about the value of a call option at expiration

is FALSE? 

A. The short position in the same call option can result in a loss if the stock price

exceeds the exercise price.

B. The value of the long position equals zero or the stock price minus the

exercise price, whichever is higher. 

C. The value of the long position equals zero or the exercise price minus the

stock price, whichever is higher. 

D. The short position in the same call option has a zero value for all stock prices

equal to or less than the exercise price.

A. The correct answer is "C". The value of a long position is calculated as

exercise price minus stock price. The maximum loss in a long put is limited to the

price of the premium (the cost of buying the put option). Answer "A" is incorrect

because it describes a gain. Answer "D" is incorrect because the value can be

less than zero (i.e. an uncovered put writer can experience huge losses).

Derivatives - Options: Basic CharacteristicsBoth put and call options have three basic characteristics: exercise price,

expiration date and time to expiration.

The buyer has the right to buy or sell the asset.

To acquire the right of an option, the buyer of the option must pay a price

to the seller. This is called the option price or the premium.

The exercise price is also called the fixed price, strike price or just the

strike and is determined at the beginning of the transaction. It is the fixed

price at which the holder of the call or put can buy or sell the underlying

asset.

Exercising is using this right the option grants you to buy or sell the

underlying asset. The seller may have a potential commitment to buy or

sell the asset if the buyer exercises his right on the option.

The expiration date is the final date that the option holder has to exercise

her right to buy or sell the underlying asset.

Time to expiration is the amount of time from the purchase of the option

until the expiration date. At expiration, the call holder will pay the exercise

price and receive the underlying securities (or an equivalent cash

settlement) if the option expires in the money. (We will discuss the degrees

of moneyness later in this session.) The call seller will deliver the securities

at the exercise price and receive the cash value of those securities or

receive equivalent cash settlement in lieu of delivering the securities.

Defaults on options work the same way as they do with forward contracts.

Defaults on over-the counter option transactions are based on

counterparties, while exchange-traded options use a clearing house.

Example: Call Option

IBM is trading at 100 today. (June 1, 2005)

The call option is as follows: Strike price = 120, Date = August 1, 2005,Premium

on the call = $3

In this case, the buyer of the IBM call today has to pay the seller of the IBM call

$3 for the right to purchase IBM at $125 on or before August 1, 2005. If the buyer

decides to exercise the option on or before August 1, 2005, the seller will have to

deliver IBM shares at a price of $125 to the buyer.

Example: Put Option

IBM is trading at 100 today (June 1, 2005)

Put option is as follows: Strike price = 90, Date = August 1, 2005, Premium on

the put = $3.00

In this case, the buyer of the IBM put has to pay the seller of the IBM call $3 for

the right to sell IBM at $90 on or before August 1, 2005. If the buyer of the put

decides to exercise the option on or before August 1, 2005, the seller will have to

purchase IBM shares at a price of $90.

Example: Interpreting Diagrams

For the exam, you may be asked interpret diagrams such as the following, which

shows the value of a put option at expiration.

A typical question about this diagram might be:

Q: Ignoring transaction costs, which of the following statements about the value

of the put option at expiration is TRUE? 

A. The value of the short position in the put is $4 if the stock price is $76. 

B. The value of the long position in the put is $4 if the stock price is $76. 

C. The long put has value when the stock price is below the $80 exercise price. 

D. The value of the short position in the put is zero for stock prices equaling or

exceeding $76.

The correct answer is "C". A put option has positive monetary value when the

underlying instrument has a current price ($76) below the exercise price ($80).

Swaps