Last week in Part 3, we looked at line charts and bar charts. This week, we take charting a step further by looking at a concept introduced by the Japanese: Candlestick charts.
A Brief History
It is debatable who developed the candlestick concept. Many attribute Munehisa Homma, a Japanese rice trader, as the inventor of the candlestick charting approach. Others say it was more probable that candlestick charts arose from general trading activity and practices in the early part of the Meiji period in Japan (in the late 1800’s) and the need to disseminate information. What can’t be argued though, is that during this period, it was discovered that there was a relationship between price, traders’ emotions and the supply and demand of rice. Adding in emotions to the equation added a whole new dimension to the analysis of the rice market. Traders, like Homma, appreciated that raw supply and demand factors weren’t the only driving force behind the price of an asset and that human interaction had a big influence on the shape of the rice market at any given time.
Candlestick charting methods only really hit the Western world in the mid to late 20th century. As technology and computers also developed, it allowed this style of charting to spread more easily and become more widely understood. Candlestick charting is now globally used as a highly effective approach to analysing financial price data, for both the trader and investor in the short and longer term.
What is it?
A candlestick chart is simply a different style of chart used to interpret price movements of a given instrument. Each “candlestick” represents a period of time; whether that be 1 minute, 1 hour, 1 day or 1 week etc.
They are very similar to the bar chart, as each candle represents all four important pieces of information for that period: the open, the close, the high and the low. However, the way they are presented adds far more ‘colour’ around what is going on than the bar chart does, and because of this, I feel they can be interpreted much more easily.
The candlestick chart has two real goals:
- Display price data in a more visual format to tell a story.
- Identify candlesticks in combinations to confirm price trends and determine continuation or reversal.
The Candlestick versus the Bar Chart – how are they different?
The things that make candlesticks more useful than the bar chart are the ‘body’ and clear identification of the ‘wicks’ of the candle, that allow the user to tell a better story of trading events.
What could an up or down day look like?
The following FTSE 100 chart shows a typical range of candlestick daily prices:
Interpreting the candlestick:
Different body / shadow combinations can have different meanings. They are very good for recognising price continuation points and reversals. Hopefully you can see that each candle can now give a ‘psychological’ profile of what is occurring in the market. There are five main features to determine the character of any particular day:
1.Colour of the body – shows the most significant event of the day
2.Range of the day (High to Low) – shows change in price volatility
3.Range of the body (Open to Close) – shows strength of the day’s move
4.Range of the upper shadow – shows range of price & strength of rejection
5.Range of the lower shadow– shows range of price & strength of rejection
There are countless patterns. Some with some great names like the hanging man, the hammer or the abandoned baby! They are categorised as either Continuations or Reversals. Candlestick combinations can include one candle, up to a maximum of seven (normally five). The more candles in the pattern, the more likely the price confirmation. I look at 2 to 5 candlestick combinations for the best patterns.
In future articles we will look into more of the detail around the many patterns available. In practice, I use no more than a dozen. The following are some of my favourites:
Dojis – Great for determining ‘indecision’ points in the market:
The Evening and Morning Star patterns – great for reversal points:
Tasuki Gaps – great for price continuations:
Candlestick reliability improves if teamed up with other forms of technical analysis such as oscillators – stochastics, CCI, RSI etc.
An example showing daily candlesticks for Fitbit Inc overlaid with a moving average, volume and RSI:
The stages to follow when making a candlestick assessment:
- Must identify the trend.
- Use pre-signal oscillators to give a trend signal (filtering e.g. a moving average)
- Confirm with a candlestick pattern
- Further confirmation can be done through looking at volume
- Oscillators are good for aligning with candlestick reversal patterns
Pros and Cons of Candlestick Charting:
I hope you can now see how candlestick charts can add some colour around your trading and investing. They can be used as a stand alone system or to enhance a particular strategy or set up you may have and, as a visual tool, can seriously aid your trading and investing. Once combined with oscillators and other technical analysis tools, they make a powerful instrument that will take your analysis to the next level. In a later article, we will look at a derivative of the candlestick chart known as Heikin Ashi which, if you have twitchy buying / selling fingers or you struggle with the psychology of trade entry and exit, could enhance your analysis further again.
Next time: Technical Analysis (Part 5): Point & Figure charts