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. There are two colours that you will see when looking at a candlestick chart. Green candles, which indicate that the price of the share is increasing and red candles, which indicate that the price of the share is falling. Each candle represents a specific amount of time and contains important information for traders. When looking at a 1hr chart, each candle represents 1hr of trading information. The same applies to a 5min chart etc.
Skill, strategy and psychology are as important in developing a trading system in the market as they are in battle. Candlesticks and the shapes and formations were given military names by the Japanese traders, owing to the feudal environment during that time. Candlesticks developed names such as “counter attack lines” and the “advancing three soldiers”.
Candlesticks are used primarily to identify turning points in the market. To use candlesticks successfully we need to understand their composition and the patterns they generate
1. The highest price a share or instrument traded in a set period. This will be referred to as the HIGH.
2. The lowest price the share or instrument traded in a set period. This will be referred to as the LOW.
3. The price or point at which the share or instrument opened for the period. This will be referred to as the OPEN.
4. The price or point where the share or instrument closed for the period. This will be referred to as the CLOSE.
The Doji is a candlestick where the opening and closing prices are the same (or almost the same). It can take many forms, as shown here, depending on what the trading activity was in that period.
What’s key with a doji is that neither the bears nor the bulls have gained control, and that the price has ended where it began. It’s a sign of indecision in the market, and could (in conjunction with other indicators) signal a change in market direction.
Applying doji candlesticks: a good trick is to look out for a doji near the edge of a price channel (i.e., if a doji appears at the top of a channel it could indicate a bearish correction.)
The bullish engulfing formation is formed when the instrument or share is in a downtrend or range bound. This formation occurs when body of the second candle (2) engulfs the body of the first candle (1).
The two candles must be different in colour where the first candle is red (bearish or “selling pressure”) and the second is green (bullish or “buying” pressure) in nature. This formation indicates levels of support.
The support area in the example would be the lows of the two candles which make up the bullish engulfing formation.
This shows that before this instrument can continue to move to new lows; it will first have to fall below the low of candle 1.
For a bearish engulfing formation to be recognized, the instrument needs to be in an uptrend. The pattern consists of two candles where the body of the first candle (1) is “engulfed” by the body of the second candle (2). The two candles must be different in colour.
The first candle is green (bullish in nature or “buying” pressure) and the second is red (bearish in nature or “selling” pressure). This formation assists in determining levels of resistance.
The resistance area would be the highs of the two candles that make up the bearish engulfing formation.
This indicates that before this instrument can continue to move to new highs it will first have to overcome the resistance level, being the high of candle 1.
The dark-cloud cover has a dual candle formation which is very similar to the previous formations. The primary difference between the dark-cloud cover formation and bearish engulfing is that the second candle (2) engulfs at least fifty percent of the first candle (1). This type of formation will generally take place in a congestion band where the instrument is range bound. The greater the penetration of the first candle by the second the greater the likelihood that the instrument has reached the top. In the event that a bullish candle precedes the dark-cloud cover formation and surpasses the highs of the formation, this could indicate an imminent rally. When the second candle is accompanied by heavy volume then a buying blow-off may have occurred.
The piercing line formation can be compared to the bullish engulfing. The main difference is that the second candle (2) engulfs at least fifty percent of the first candle (1).
The greater the penetration of the first candle by the second the greater the likelihood that the instrument has reached the bottom of the formation. In the event that a bearish candle precedes the piercing line formation and surpasses the lows of the formation, it could indicate a further fall to come. When the second candle is accompanied by heavy volume then a selling blow-off could have occurred.
The body of the Hammer (1) can be either bullish or bearish. In other words, the success of the Hammer is not dependent on the colour but rather on the length of the shadow.
The following guidelines are used to identify a Hammer formation:
- The body of the candle is at the upper end of trading range for that period
- The formation should have a very short upper shadow or no upper shadow
- The lower shadow should be at least twice the length of the body of the candle
- A Hammer is found after a bear trend and indicates a potential change in trend.
The Hanging Man has a long lower shadow which is viewed as positive. Wait for confirmation before trading off this formation. Confirmation would be an opening below the body of the Hanging Man for the aggressive trader or a close below the shadow of the Hanging Man for the conservative trader.
The following guidelines are used to identify the Hanging Man:
•The body of the candle is at the upper end of trading range
•The candle should have a very short upper shadow or no upper shadow at all
•The lower shadow should be at least twice the length of the body of the candle
•The Hanging Man is found after a rally in the value of the instrument
The Evening Star is a top reversal formation which is produced by three candles.
The formation is made up as follows:
- a long green body found to the left of the reversal candle
- a candle with a small body (colour is irrelevant),the reversal candle
- the third candle must have a long red body.
A disadvantage of using the Evening Star is that the formation takes a while to form. The third candle has to form before the short trade can be made. As a result, the trade is often placed slightly late.
The Morning Star is a bottom reversal formation which is made up of three candles.
The formation is defined as:
- A long red body, found to the left of the reversal candle
- A candle with a small body (colour is irrelevant), the reversal candle
- The third candle must have a long green body.A disadvantage of using the Morning Star is that the formation takes a while to form.
The third candle has to form before the long trade can be made. As a result, the trade is often placed slightly late.
This formation requires that two or more candles have matching highs, or highs that are roughly on the same level (1and 2 above). The candles shadows can be compared to the prongs of a pair of Tweezers and hence the name.
The highs of the shadows represent an area of resistance. When trading this formation, it would be ideal to be short and as close as possible to the highs. Tweezer Tops that are viewed on intraday and daily data do not carry much weight as when they are found on a weekly or monthly chart.
The Tweezer Bottom requires two or more candles to have matching lows, or lows that are roughly on the same level as illustrated in 1 and 2 in the example above. The formation once again represents the prongs of a pair of Tweezers and hence the name.
The lows of the shadows represent an area of support. When trading this formation, it would be ideal to be long as close to the low of the pattern as possible. As with Tweezer Tops, Tweezer Bottoms are far more reliable when viewed on weekly or monthly charts as opposed to intraday or daily charts.
The Three Black Crows pattern is the opposite of the Three Advancing White Soldiers pattern. The Three Black Crows pattern is a bearish reversal pattern that consists of three bearish candlesticks that are ominous and dark in color, hence the name. This is a moderate trend reversal pattern that should only come into consideration when it appears in a rally or an established uptrend. The Three Black Crows usually indicates a weakness in an established uptrend and the potential emergence of a down trend.
Each of the three candlesticks in the Three Black Crows pattern should be relatively long bearish candlesticks with each candlestick closing at or near the low price for the period. Each successive candlestick should mark a steady decline in price and should not have long lower shadows or wicks. Preferably, each of the three candlesticks should open within the real body of the preceding candlestick in the pattern but this is not essential. When this pattern appears in an uptrend, it indicates the potential weakening of the trend and a possible trend reversal. However, if the three candlesticks are over extended and make significant price declines, you may need to be wary of oversold conditions.
The Three Advancing White Soldiers, which is sometimes referred to simply as the Three White Soldiers, the Advance Block and the Stalled Pattern are three similar candlestick patterns thatconsist of three bullish candlesticks. These are three moderate trend reversal patterns. The Three Advancing White Soldiers usually indicates a weakness in an established down trend and the potential emergence of an uptrend. However, the Advance Block and the Slatted Pattern have bearish connotations, and indicate possible weakness in an uptrend.
The Three Advancing White Soldiers pattern is the opposite of the Three Black Crows pattern. It is called the Three Advancing White Soldiers patternbecause it consists of three relatively long bullish (advancing) candlesticks that are light in color. Each of the three candlesticks should close on or near the high price for the period and, with each candlestick making steady advances in price. Each candlestick should not have long upper shadows or wicks and should preferably open within the real body of the preceding candlestick in the pattern, though the latter is not essential. When this pattern appears in a downtrend, it indicates the potential emergence of strength and a possible trend reversal. However, if the three candlesticks are over extended and make significant advances you may need to be wary of overbought conditions.