Candlestick Charting

Candlestick
Charting
The first recorded futures transactions occurred in the 1700s in the
Japanese rice markets, where Munehisa Homma amassed a fortune
trading the market. His system included the study of price action, the
psychology of the market, and the seasonality of the weather. Candlestick
charts evolved from Homma’s system and are the subject of this chapter.
This section covers the fundamentals of candlestick charting and explains
how to utilize candle charts to analyze, enter, and exit trades.
The main advantage that candlestick charting provides over bar charting
is that the candlestick provides immediate visual recognition of the
open, the high, the low, and the close. Many traders who employ candlestick
charting techniques set their charting software so that the candlesticks
are one color for a lower close than the open (such as red or black as
shown in Figure 3.1) and another color for a higher close than the open
(such as green or white as shown in Figure 3.2). For the purpose of this
book, a candle with a higher close than the open will be referred to as a
white candle. A candle with a lower close than the open will be referred to
as a black candle. A single candle does not tell you if the close is higher or
lower than in the previous time period. The single candle only shows
whether the close is higher or lower than the open for each candle.
Each candle has different characteristics that provide insight into price
movement by the distance between the open, the high, the low, and the
close. The candlesticks formed for each time session also indicate if the
price movement shows a level of increasing or decreasing pressure by
the size of the candle, or its “real body.” Each candle pictured has a differc03.
ent characteristic that represents the difference or the distance between
the open, the high, the low, and the close. Candlestick charting techniques
can be used from data for whatever time period you are looking at from as
little as one minute to one hour, one day, one week, or one month. The candle
still allows for use of traditional Western philosophy of technical analysis
of pattern recognition, trend-line support and resistance, and other
helpful tools as we will go into in detail in Chapter 5.
COMPONENTS OF A CANDLESTICK
The components of a candlestick are derived from the open, the high, the
low, and the close. The main components that we need to identify are:
• Relationship between open and close (the candle bodies).
• Real-body colors.
• Shadows and correlations to the candle body.
• Size of shadows.
• Range or length of the candle.
In uptrends or bullish market conditions, buying comes in on the open;
and the market should settle closer to the highs and should close above
the open. That is why in bullish market conditions, we see hollow or white
candles.
And I assign a higher close than the open. This helps me to identify that
buyers are supporting prices. I can tell if the bulls are dominating the market
by the distance between the open and the close. If the market opens on
the low and has a large range where it closes at the high of the session, that
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FIGURE 3.1 Selling, or Short FIGURE 3.2 Buying, or Long
signifies that the bulls are firmly in control. However, if we have a widerange
session and the market price closes back near where it opened, let’s
say in the middle of the range, that is not a good sign that bulls dominate
the market for that particular time period.
In a bearish market condition or in a strong downtrend, we would see
black or red real-body candles as shown in the accompanying CD. This
represents sellers entering the market on the open and dominating the session
right into the close of that time period. If the market opens on the high
and prices decline where the close is at or near the low, this shows that the
bears are firmly in control. This is why I assign these candles a negative (–)
reading. The distance factor between the open and the close is illustrated
in a much more defined way in candle charts than in bar charts due to the
shape and color coordinates.
Shadows and Correlations to Candle Body
The shadows or wicks are what are made from the distance of a low and/or
a high in relationship to the real body as created by the open and the close.
They can really illustrate the market’s denial of a support or resistance
level. Long shadows or tails or wicks that form after a long downtrend indicate
a potential that the trend has exhausted itself and that demand is increasing
or supply is dwindling. Shadows formed at the tops of real bodies,
especially after a long price advance, indicate that demand is drying up and
supply is increasing. The overall size of shadows is important to watch in
relationship to a real body and they can be easily identified.
Size or Length of the Overall Candle
A long real-body candle is hard to miss using the color-coded method of
candle charts. An extraordinarily long-ranged candle that opens at the bottom
and closes at the high would be an abnormal occurrence and has significant
meaning. After a long downtrend, seeing this formation indicates
that a major trend reversal is taking place. After a long uptrend, seeing an
unusually long candle that closes above the open or a positive value would
indicate that an exhaustion, or a blow-off-top condition, may exist. The reverse
is true in downtrends; after a long price decline, a tall red or dark candle
represents the market closing below the open or a negative assigned
value and may indicate that a capitulation or exhaustion bottom has
formed. After a long uptrend or price advance, if that same candle was
formed, it might indicate that a major trend reversal is occurring.
The candle development will give us immediate identification of the
current market’s environment and the market participants’ acceptance or
rejection of a support or resistance level in a clearly visual manner. Pay
Candlestick Charting 109
special attention to the shadows and closes of ranges in relationship to
past highs or lows and to where the market closes.
The Doji
The secret weapon of candlestick charting is the doji. Dojis indicate indecision;
the market close ends where it began, on the opening of the time
session. Figure 3.3 shows a full-range high and low with the cross mark
across the line, representing that the market has no real body as prices
closed exactly where they opened. This goes to show that confidence is lost
from buyers or sellers on the open because the market made a lot of intraday
noise as the range was established. In a bullish or bearish trending market,
indecision is the last thing you want to see.
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FIGURE 3.3 Doji
Strong rejection or failure from the high and/or the low is a significant
telltale sign that changes are coming. In a strong uptrending market, usually
the prices will close near a high since larger capitalized traders will
hold positions overnight. If the large money traders are not confident that
the market will move higher in price, then usually the market closes back
near the open.
Traders use the phrasing of Newton’s law in the markets an awful lot
because it really applies to market moves. “A body in motion tends to stay
in motion until a force or obstacle stops or changes that motion.” I believe
and teach that the doji represents that force; it generally stops or changes
the motion or momentum due to the uncertainty or indecision that is created
at peak and troughs.
Doji formations help confirm reversals. There are different names and
nuances associated with certain dojis, such as the gravestone shown in
Figure 3.4, the dragonfly shown in Figure 3.5, and the long-legged or rickshaw
doji shown in Figure 3.6. All have the same qualities—they close
where the session began. After a major trend has occurred, when one of
these candles forms, it signals that the trend is near an end or that there is
a change in market conditions. What distinguishes the doji from all other
candle formations is that the close of this candle is nearly exactly at the
same price as the open. I am generally a little more lenient with this formation.
If after a long-range trading session the close is less than 8 percent
of the overall high and low, I consider it a doji. In spot forex markets, if, for
example, the British pound had a 150-point range and the market closed
within 12 points of the open, I would consider that a doji formation.
Candle patterns can be subjective, and there are many variations to
each pattern. The key element to this system is identifying where a market
closes in relationship to the prior highs or lows. Certain candles have significant
meaning besides the doji. Bearish reversal patterns include dark
clouds; engulfing, harami, and harami doji crosses; falling three methods;
and evening doji stars. These are all indeed powerful setup chart patterns.
The reverse of these are the bullish bottom pattern formations, such as
bullish piercing, bullish harami, morning doji star, and even the hammer
candle. The candle hammer is what I call the “stop,” or “seek and destroy”
action. The bearish version is a shooting star candle.
The Hammer
The hammer shown in Figure 3.7 indicates that a reversal or a bottom is
near in a downtrend. When this pattern appears at the top of an uptrend,
the name becomes hanging man, and it indicates that a top is near. You
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FIGURE 3.4 Gravestone FIGURE 3.5 Dragonfly
FIGURE 3.6 Long-Legged (Rickshaw) Doji
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FIGURE 3.8 Shooting Star
FIGURE 3.7 Hammer
need to know that there are three main characteristics necessary in order
for a candle to qualify as a hammer:
1. The real body is at the upper end of the trading range; the color (white
or black) is not important.
2. The lower part or the “shadow” should be at least twice the length of
the real body.
3. It should have little or no upper shadow, otherwise known as a shaved
head candle.
The Shooting Star
One of the single most important bearish candle formations that I wish to
share with you is the star, sometimes referred to as the shooting star candle.
It is the inverted formation of the hammer and forms at tops.
The shooting star in Figure 3.8 is the reverse of the hammer, but it
forms at the top of an uptrend. It usually signals a major reversal. Here
again, the color does not matter, but the body should be at the lower end of
the trading range with a long shadow. Its significance is that it shows the
market opening near the low of the day, followed by an explosive rally that
failed and then closed back down near the low of the day.
Usually there is little or no lower shadow, like a shaven bottom. When
it is at the bottom of a downtrend, it is known as an inverted hammer.
The Morning Doji Star
The morning doji star is a major bottom reversal pattern that is a threecandle
formation. The first candle has a long black real body; the second
candle has a small real body or doji, as shown in Figure 3.9, and gaps lower
than the first candle’s body. The third candle’s body sometimes gaps higher
than the second one, but this does not happen often. It is important that it
is a white candle and closes well above the midpoint of the first candle’s
real body.
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FIGURE 3.10 Evening Doji Star
FIGURE 3.9 Morning Doji Star
The Evening Doji Star
The evening doji star shown in Figure 3.10 is the exact opposite of the
morning doji star. This is the second-most-bearish top pattern next to the
abandoned baby or island top formation.
HOT TIP
Gaps are not too prevalent in forex trading. Therefore, it is very rare to see a
textbook morning or evening doji star formation. In candlestick terminology, a
gap is called a “window.” It is said, generally speaking, that if a gap forms or a
window opens, the market will most times trade back to fill the gap or close the
window. The trick is knowing when gaps are sometimes “filled” right away and
when prices do not return to fill the gap or close the window for quite a while.
Gap levels can and do act as support and resistance. So pay attention to the
price behavior at these loctions.
The Harami
The harami is a small real body within the body of the prior body’s candle.
This is known as a reversal pattern or a warning of a trend change, especially
at tops of markets. It is not important that the colors be opposite, but
I notice that the more reliable signals are generated when they are. After a
long uptrend, if there is a tall white candle, it can indicate an exhaustion especially
followed by a small-real-body candle, as shown in Figure 3.11.
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FIGURE 3.11 Harami
FIGURE 3.12 Bearish Harami Doji Cross
Bearish Harami Doji Cross
The bearish harami doji cross shown in Figure 3.12 is a formation that appears
when a long white candle occurs, signifying that the market has
closed above the open with little or no shadows at both ends of the candle;
this candle is then followed in the next time period by a doji within the middle
of the white candle’s real body. This tells me bulls no longer dominate.
Bullish Harami Doji Cross
The bullish harami doji cross in Figure 3.13 is the opposite of the bearish
harami. This pattern will form in a downtrending market. The first candle is
usually a long dark candle, signifying that the market has closed below the
open with little or no real shadows at both ends; a doji then forms during
the next trading session.
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FIGURE 3.14 Dark Cloud Cover
FIGURE 3.13 Bullish Harami Doji Cross
The Dark Cloud Cover
The dark cloud cover is a bearish reversal signal. Usually it appears after an
uptrend. The first white candle is followed by a black candle. The important
features here are that the dark candle should open higher than the white
candle’s high and that the close should pierce well below the midpoint of
the white candle’s real body, as shown in Figure 3.14.
The Bullish Piercing Pattern
The bullish piercing pattern is the opposite of the dark cloud cover, as you
can see in Figure 3.15. It requires that the first candle be a long dark candle
and that the second candle gap open lower than the first candle. The other
important characteristic is that it closes well above the midpoint of the
long dark first candle. Look for 50 percent penetration of the long dark
candle.
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FIGURE 3.15 Bullish Piercing Pattern
The Bullish Engulfing Pattern
The bullish engulfing pattern is a powerful setup. Study the pattern as
shown in Figure 3.16. It forms when a white candle’s real body completely
covers the previous black candle’s real body. It is also relevant to note that
the more “wraps,” or past candles, that are engulfed, the stronger the signal.
FIGURE 3.16 Bullish Engulfing Pattern
The Bearish Engulfing Pattern
The bearish engulfing pattern shown in Figure 3.17 is the opposite of the
bullish engulfing pattern. When a black candle’s real body completely covers
the previous white candle’s real body and even closes below the prior
candle’s low, it is a more potent signal. It is also relevant to note that the
more “wraps,” or past candles, that are engulfed, the stronger the signal.
Falling Three Methods
The bearish falling three methods is a continuation pattern often used like
a bear flag formation. The three little candles usually remain within the
range of the first black candle that includes both the real body and the
shadow. Some argue that it works with from two up to five candles in
the middle. The last dark candle closes below the first candle’s close, as
Figure 3.18 shows.
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FIGURE 3.18 Bearish Falling Three Methods
Rising Three Methods
Rising three methods is a bullish continuation pattern with the same characteristics
as in the bearish falling three methods but just the opposite.
During the beginning stages of an advancing price trend, an unusually long
white candle is preceded by three smaller dark or black candles. The three
bullish methods pattern needs to stay within the range of the first long
white candle. Again, it can have from two up to five candles; but the textbook
version is three smaller candles, as Figure 3.19 shows. The last white
candle shows a powerful advancing white candle that should open above
the previous session’s close and should close above the first long white
candle’s close.
FIGURE 3.17 Bearish Engulfing Pattern
Tweezers Tops and Bottoms
The tweezer is a double-top or double-bottom formation that can be disguised
by a few variations. The tweezer top forms after an uptrend followed
by two consecutive time periods making an equal high. This signals that
there is strong resistance and a short-term top is in place. One variation is
that the first day usually consists of a long body candle with a higher close
than open (+).
The second day is usually an equal-and-opposite-color real-body candle
that has a high equal to the prior day’s high. A strong signal exists that a reversal
is forming when the second candle’s color is the opposite of the first
candle’s color. A tweezer bottom would be the exact opposite of this formation.
Other variations are called equal-and-opposite or chopstick patterns. In
Chinese, it would be called the yin (black or negative close candle) and the
yang (white or hollow positive close candle). At times, these real bodies are
not perfectly opposite in size, but they should be close.
In Figure 3.20 the tweezer bottom looks more like a pair of thin chopsticks.
In Figure 3.21, the tweezer top resembles a pair of fat chopsticks;
but notice that the dark candle engulfs the first candle’s real body. That is
evidence that a top or a peak price has been established. The equal-andopposite
formations occur with false breakouts and key reversals; they are
powerful signals that should be respected.
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FIGURE 3.19 Bullish Rising Three Methods
FIGURE 3.20 Tweezer Bottom FIGURE 3.21 Tweezer Top
YIN AND YANG: THE EQUAL-AND-OPPOSITE
TRADE STRATEGY
Forex traders take note: These equal-and-opposite patterns show up frequently
in the currency pairs as well as in cross-currency markets. We see
periods of low volatility between the European and the U.S. sessions; and,
as a result, sideways channels form, otherwise known as a longer-term intraday
consolidation period.
Oftentimes, we see false breakdowns and breakouts that create the
equal-and-opposite (yin and yang) formations. We, therefore, have a trigger
to enter a position if the market price is near an important pivot point support
level. We would buy on the close of the second candle’s time period or
the immediate opening of the next time frame. Place a stop at least 10 PIPs
(percentage in points) beneath the lowest low point. You should see immediate
results as the markets move higher. Adjust your stop accordingly.
Figure 3.22 is a 60-minute chart on the euro currency versus the U.S.
dollar on July 19, 2006. The exact low occurred at 9:00 A.M. (EST) and was
not prompted by any special report. That morning the German Producer
Price Index (PPI) came out, but at 2:00 A.M. (EST). Two U.S. economic
numbers—housing starts and real earnings—were released; but those re-
Candlestick Charting 119
FIGURE 3.22 Equal-and-Opposite Candle Revelations
Used with permission of GenesisFT.com.
ports were released at 8:30 A.M. (EST), one and a half hours earlier. The dollar
got pummeled as U.S. traders started to digest the news. It seems to happen
at times that there is a delayed reaction to the economic reports. But
looking at the false breakdown of the low of the range that was created in
the prior 22 hours of trading shows that an equal-and-opposite candle
formed, and it was at that time that the buy programs kicked in as a very
powerful reversal took place. In fact, the majority of the move on this 60-
minute chart took place in 10 minutes. The market ruthlessly exploded and
increased in value over 90 PIPs in just 10 minutes. The 60-minute chart
showed an equal-and-opposite pattern.
Basically the market went hunting for stops as it broke the low, and
shorts covered as the market reversed like a rocket. You need to look for
these opportunities because the price action in the forex market behaves
like this on a frequent basis. This is a classic failed-pattern breakdown.
Traders saw the market making newer lows as prices broke below the low;
and when there was absolutely no follow-through, it had a slingshot effect
in the opposite direction. This was an ironclad bear trap. By following the
rules on equal-and-opposite patterns, especially when a setup fails to materialize,
such as a breakdown of support, this is a powerful signal to take
a long position. We exercise prudent risk-management techniques placing
a stop 10 PIPs below the lowest low point; and as the trade progresses, you
can adjust your stop or look to exit if the market gives you a windfall profit
that is equal to or exceeds the normal daily range.
MULTIPLE TIME-FRAME CONFIRMATION TACTICS
Using multiple time-frame analysis will help you confirm a great trading opportunity.
Through various time dimensions, if a buy signal is evident, you
should see confirming patterns throughout these various time periods. If
the 60-minute chart is showing a high-probability bullish reversal pattern,
such as the equal-and-opposite candle, then if we break it down to a smaller
time frame, we should see signs or bullish patterns as well. Look at Figure
3.23; this is a five-minute chart detailing how the low was formed. We are
going to cover the high close doji pattern in the very next section; but for
now, I want you to see the magnitude of this strong breakout and the fact
that the lower time frame confirmed the higher time frame’s bullish signal.
To summarize, there are many candle patterns that indicate reversals.
Some are more potent than others, and some work better in various time
frames. But many traders have trouble adapting; they get stuck in a rut
looking for the same results and fail to exploit highly recognizable pattern
failures, such as false breakouts. If you learn to understand the sequence
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and the value of the open close relationship, then you will have a betterthan-
average chance of making serious money. The best trades usually
come in the form of blindsiding traders who are heavily positioned the
wrong way or who have overstayed their welcome in a position. It is
this rush for traders to get to the exit door in a panic that accelerates market
moves. The equal-and-opposite pattern is a major sign of a false breakout.
Think about this: If a market does not do what is expected, such as
when it breaks a long-term support and there is no follow-through, who
wants to hold a short position in the hole? Not many people. Watch for
the yin and the yang, especially at extenuated trend extremes or at congestion
points