Candlestick Trading Explained

History

Back in the 1600's, the Japanese originiated technical analysis with their rice trading. In an effort to smooth the flow of goods and money, the Japanese began to track several things--and their early form of technical analysis was born. There were several guiding principles that pointed the way for the early rice traders:

1. Price action was more important than the reasons.
2. The price reflects all known information
3. The market will change, sometimes rapidly and sometimes slowly.
4. Fear and Greed are the two main movers of the market (PRICE)
5. Price doesn't always accurately reflect true value.

Sometime after 1850, according to Steve Nison, a trader named Homma began to develop candlestick charting. Over time, this form of charting was refined into what is now called Candlestick Charting or Candlestick Trading today.

Candlestick Formations

A candlestick chart is built using the following pieces of data:

1. Open Price
2. High Price
3. Low Price
4. Close Price

The duration or length of the chart can be any size. For instance, the most common form of candlestick charting is a daily chart. In this example, the pieces of information are taken as the daily open, the daily high, the daily low and the daily close. But you can create a candlestick chart on 5 minute increments or yearly increments--whatever works best for your trading objectives.

To actually build the candlestick chart, you plot the open, close, high and low on a chart. The middle, wide part of the formation is called the body. If the open is higher than the close, then the body will be shaded. This shows that the price closed lower than it opened. If the open price is lower than the close price, then the body will be an "empty box". This shows that the price went up for the day (or time period being charted). Then the high and the low are charted with a long thin line right in the middle of the candlestick.

DISCLAIMER

I am not a trading professional. I am not advising any trading decisions. This is merely an informational hub. Any decisions you make as to your trading are yours and yours alone.

There are thousands of different candlestick patterns. There are a few dozen that are incredibly powerful. Watch for these patterns--when they occur, they are right more often than not and an astute trader can cash in by taking advantage.

Candlestick patterns are broken into continuation patterns or reversal patterns. A continuation pattern signals that the current trend should continue. A reversal pattern shows that the current trend is changing direction.

Here are what I consider the top ten candlestick patterns--in no particular order:

1. Doji
2. Dark Cloud Cover
3. Engulfing Pattern
4. The Hammer
5. Hanging Man
6. Evening Star
7. Morning Star
8. Harami
9. Shooting Star
10. Piercing Line

What, Why and How

The following paragraphs will go into more depth on each of the top ten candlestick patterns and explain what they mean, why they happen and how to trade them.

Doji

The doji pattern forms when the opening and the closing prices are exactly (or essentially) the same. The price pattern looks like a plus sign. This pattern shows indecision on the part of the market and frequently represents a turning point in the current pattern. Watch for a reversal in the trend.

Dark Cloud Cover

The Dark Cloud Cover Pattern forms when the current trend is up as shown by the three rising "sticks" in the picture to the right. Then, this two-day formation is created by a long white (rising) body candlestick that is followed the next day (or whatever period you are trading) by a dark candlestick that opens at a new high and then closes below the midpoint of the previous day's pattern. This is a bearish reversal signal and watch for the market to move into a downtrend.

Engulfing Pattern

The engulfing pattern is a two day pattern. The first day's body is smaller than the next day. This is critical. They are also both of opposite colors. If the first day is white, the second is black and vice-versa. This pattern is a reversal pattern. Watch for the market to begin moving in the opposite direction.

Hammer

A Hammer pattern occurs when the trading for the day is significantly below the open but ends up well above the low for the day. It also closes at the high. So the pattern looks like a hammer. When this pattern occurs during a downtrend it is considered a reversal pattern. Watch for the pattern to move higher over the next few days or weeks.

Hanging Man

The opposite of the Hammer, this pattern occurs during an uptrend. The Hanging Man signals a reversal to the downside.

Evening Star

The Evening Star is a three day pattern that occurs when a long white body is followed by a small gap up candlestick and tehn by a down candlestick that closes below the midpoint of the first day. This is a reversal pattern and the stock or commodity being charted will most likely go down after this pattern.

Morning Star

The Morning Star pattern is the opposite of the Evening Star. It is a series of down days that results in a three day pattern of a large down day, a smaller down gap down day and then an up day that pierces the midpoint of the first day. It is a bullish reversal pattern. After this candlestick pattern look for the instrument in question to begin moving up.

Harami

The Harami is a two day candlestick where the second day has a small body that is completely engulfed by the first day. The two candlesticks are always opposite colors. Typically signals an end to a short term trend. It is especially strong when it comes with low trading volume.

Shooting Star

A shooting star is during an uptrend and the distance between the highest price and the opening price must be more than twice as large as the actual body. The distance between the closing price and the day's low is very small or nonexistant. It is typically a reversal of an uptrend. Watch for declining prices.

Piercing Line

A Piercing Line is a two day candletick formation that is a bullish reversal. The first day is a continuation of the prevailing downtrend and normally has a long black body. The second day opens lower than the first day's low but then closes above the midpoint of the previous day's candlestick. This is a powerful indicator. Watch for rising prices.

For those of you who enjoy the details, this section goes into the nitty gritty of the development of Candlestick Trading.

The concept of Candlestick Trading is based on an ancient Japanese trading system that was developed during the 1600's in a highly militaristic period. Because of this, many of the terms used in Candlestick trading have military connotations. According the Candlestick trading theory, trading is all about strategy, tactics, and solid planning as well as requiring the ability to make strategic or tactical withdrawals depending on changes in the trading environment (the battlefield).

During this time of war, Osaka came to be regarded as the capital of Japan. Because it was located near the sea, and because sea travel was less costly and less dangerous, it became a centralized depot for many of the supplies that the growing nation needed. Osaka became Japan's largest city of finance and commerce during this period. Many warehouses and storage facilities were built here and it soon became the biggest profit center for Japan. In doing this, many ancient social standards were changed. Previous to this, a man who hunted for profits was often scorned and despised. In the 1700's, because of the growth of Osaka and the growth of the merchant class, the merchants finally achieved a social breakthrough to respectability. In Osaka today, one of the most common greeting is "Mokarimakka" which translates to "are you making a profit?"

During this period, a man named Yodoya Keian became an extremely succesful merchant. Some have called him a war merchant. His reputation grew to such a point that after a time his front yard became the very first rice exchange. His wealth was later taken from him by the government (run by the Shogun) under the charge that he was living life beyond his social rank.

The Dojimi Rice Exchange, the institutionalized rice market that developed from Yodoya's front yard, gave merchants the ability to grade the rice as well as negotiate a market price. After the year 1710, rice trading expanded so far as to issue and negotiate rice warehouse receipts that later became known as rice coupons. These rice coupons were the first form of futures. The Osaka based rice brokerage became the driving engine for wealth in the city and after a time, over 1300 rice dealers worked in teh exchange. It allowed a person in need of money to sell his excess rice to Osaka in return for a rice receipt. This rice coupon could then be sold for cash or traded for other goods. The exchange reduced cash flow problems for many farmers and other producers of goods. After a time, future years of rice crops were mortgaged in order to take care of current expenses. Hence the growth of "futures".

Because a holder of a rice coupon did not actually hold physical rice, they were sometimes referred to as "empty rice" coupons. In 1749, over 1110,0000 bales of rice were traded even though there were only about 30,000 bales of physical rice in all of Japan. During this time, the method of Candlestick Trading grew into existence.

A man named Munehisa Homna, who later became known as the "God of the Markets", first inherited his family's business because of his trading savvy even though he wasn't the oldest son. He moved the trading firm from his city of Sakata to Edo (later known as Tokyo). His research into historic price moves of the rice and the interrelationship of this with the weather conditions of the trade dates allowed him to create a set of rules, known as "Sakata Rules" that became the basis for Candlestick Trading. His set of rules included open and close prices as well as the high and low prices of each specific period (day, week, month, or year) that was being studied. His method was so successful that many claim he had over one hundred winning trades in a row.

Recently, the concept of Japanese Candlestick analysis and trading made its way into the US trading community. The first books on this technique started hitting the market in the last 40 years or so. The advent of computers allowed the analysis and visual strength of Candlestick analysis to grow exponentially here in the US. As US traders became more proficient and savvy in regards to Candlestick analysis, many fell in love with the visual simplicity and the sheer volume of information that can be assessed rather quickly with the method of Candlestick Charting.

In 1991 Steve Nison published his first edition of "Japanese Candlestick Charting Techniques". This book still stands as one of the best on the market for someone wanting to learn Candlestick analysis and trading.