Candle Charting Basics

Editor's Note:
For this week's guest commentary I am pleased to present Steve Nison, CMT, of Candlecharts.com.
Brice

Candle Charting Basics

“A good beginning is the most important of things.”
--Japanese proverb

This article discusses only a few of the scores of candle chart patterns. There are many important candle patterns and trading tactics not discussed in this basic introduction. As such, do not trade based on the limited information. The goal of this section is to illustrate how candles can open new and unique analytical doors, not to provide a trading methodology. For example, there are many times candle signals should be ignored. This is where experience with candle charts comes in.


What Are Candlesticks?

Japanese candle chart analysis, so called because the lines resemble candles, have been refined by generations of use in the Far East. These charts are now used internationally by traders, investors and premier financial institutions. Candle charts:

• Are easy to understand: Anyone, from the first-time chartist to the seasoned professional can easily harness the power of candle charts. This is because, as will be shown later, the same data required to draw a bar chart (high, low, open and close) is used for a candle chart.

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• Provide earlier indications of market turns: Candle charts can send out reversal signals in a few sessions, rather than the weeks often needed for a bar chart reversal signal. Thus, market turns with candle charts will frequently be in advance of traditional indicators. This will help you to enter and exit the market with better timing.

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• Furnish unique market insights: Candle charts not only show the trend of the move, as does a bar chart, but, unlike bar charts, candle charts also show the force underpinning the move.

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• Enhance Western charting analysis: Any Western technical tool you now use can also be used on a candle chart. Candle charts, however, will give you timing and trading benefits not available with bar charts. This merging of Eastern and Western analysis will give you a jump on those who use only traditional Western charting techniques.
  

Constructing The Candlestick Line

The broadest part of the candlestick line is the real body. It represents the range between the session's open and close. If the close is lower than the open the real body is black. The real body is white if the close is higher than the open. The real body is white if the close is higher than the open. The thin lines above and below the real body are called the shadows. The peak of the upper shadow is the high of the session and the bottom of the lower shadow is the low of the session. The color and length of the real body reveals whether the bulls or the bears are in charge. Note that the candle lines use the same data as a bar chart (the open, high, low and close). Thus, all Western-charting techniques can be integrated with candle chart analysis. At Candlecharts.com, we have found the candles are most potent when merged with Western technical analysis. Accordingly, we harness the best charting techniques of the East and West to provide you with uniquely effective trading tools.

Using Individual Candle Lines

A critical and powerful advantage of candle charts is that the size and color of the real body can send out volumes of information.

For example:

• a long white real body visually displays the bulls are in charge
• a long black real body signifies the bears are in control.
• a small real body (white or black) indicates a period in which the bulls and bears are in a "tug of war" and warns the market's trend may be losing momentum.

While the real body is often considered the most important segment of the candle, there is also substantial information from the length and position of the shadows. For instance, a tall upper shadow shows the market rejected higher prices while a long lower shadow typifies a market that has tested and rejected lower prices.

The slogan of our firm is "Helping Clients Spot Market Turns Before the Competition." This is based on the powerful fact that candle charts will often provide reversal signals earlier, or not even available with traditional bar charting techniques.

Even more valuably, candle charts are an excellent method to help you preserve your trading capital. This benefit alone is incredibly important in today's volatile environment.

Let's look at an example of how a candle chart can help you avoid a potentially losing trade.

Exhibit 1 (below) is a bar chart. In the circled area of Exhibit 1, the stock looks strong since it is making consecutively higher closes. Based on this aspect, it looks like a stock to buy.



Exhibit 1

The candle chart, uses the same data as Exhibit 1 (above), (remember, a candle chart uses the same data as a bar chart; open, high, low and close.) Let's now look at the circled area on the candle chart in Exhibit 2 (below). Note the different perspective we get with the candle chart than with the bar chart. On the candle chart, in the same circled area, there are a series of small real bodies which the Japanese nickname spinning tops. Small real bodies hint that the prior trend (i.e. the rally) could be losing its breath.




Exhibit 2

As such, while the bar chart makes it look attractive to buy, the candle chart proves there is indeed a reason for caution about going long. The small real bodies illustrate the bulls are losing force. Thus, by using the candle chart, a trader or investor would likely not buy in the circled area. The result -- avoiding a losing trade.

This is but one example of how candles will help you preserve capital.

When investing his own money, Warren Buffet has two simple rules that he follows:

Candles truly shine at helping you preserve capital!

Let’s now look at a specific type of candle line that has a very long lower shadow called a hammer (shown in Exhibit 3 below). So called because the Japanese will say the market is trying to hammer out a base. The criteria for the hammer are:

1. The real body is at the upper end of the trading range.
2. The color of the real body can be black or white.
3. A bullish long lower shadow that is at least twice the height of the real body.
4. It should have no, or a very short, upper shadow.

Exhibit 3

The hammer reflects the visual insights obtained from a candle chart—specifically the hammer’s extended lower shadow shows that the market rejected lower price levels to close at, or near, the highs of the session.

In the intra-day chart shown at Exhibit 4 (below), I show two hammers at the same area (denoted by the arrow). These areas took on extra significance since there were two hammers at the same level and these dual hammers confirmed a support level shown by the dashed line. This illustrates how easy and powerful it is to combine the insights of candle charts (the hammers) with classic western trading signals (the support line) to signal the likelihood of a market turn.

Exhibit 4

Most of the candle signals are made with candle patterns in which we have more than one candle line. An example of a candle pattern is a bullish engulfing pattern as shown in Exhibit 5 (below). The market falls, and a black candle forms. Next session a candle line develops with a white real body that wraps around the prior session's black body. The name for this pattern is based on the fact the white candle “engulfs” the black candle. As the white real body opens under the prior black real body’s close, and closes above that session’s open, it shows buying pressure has overpowered selling pressure, i.e., the bulls have taken charge! If the market is solid, the lows of the bullish engulfing pattern should be support.

Exhibit 5


Exhibit 6 (below) illustrates a classic bullish engulfing pattern in IBM in which the bullish engulfing pattern confirmed a support area set by a hammer.



Exhibit 6

Concluding Comments

With candle charts, one can use candle charting techniques, or Western techniques, or a combination of both. This union of Eastern and Western techniques provides our clients with uniquely effective tools to help enhance profits and decrease market risk exposure.

A Japanese proverb says, "His potential is that of the fully drawn bow- - - his timing the release of the trigger." The timing of the "release of the trigger" depends on many factors not addressed in this pamphlet. However, while this pamphlet provides only a basic introduction to candle charts we hope you have discovered how candle-charting techniques open new and unique doors of analysis.

As a final note, there have recently been books, articles, and seminars from so-called "candlestick experts" who make no reference to where they found their information about candlesticks. Even more worrying for you as a trader is that they are making up their own candlestick signals without any historical basis.

Conversely, all of the candlestick patterns and signals I've revealed have been confirmed by more than one Japanese source (Japanese traders, Japanese books, etc.). From my vast array of candlestick resources, there is absolutely no mention of many of these "new" patterns I see tossed around by other writers and speakers.

This is not to say some of other authors ideas may not be useful. But you must be careful about the information they give – especially when they teach "home-made" candlestick patterns. True candlestick patterns have been refined by generations of use, and not by someone who has only been using candlesticks for a few years and decided to "invent" a candlestick signal.

As the Japanese proverb says, "If you wish to know the road, inquire of those who have traveled it."

Steve Nison
www.candlecharts.com