CI Introduction to Candlestick Charting

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Introduction to Candlestick Charting By Wayne A. Thorp, CFA

Modern-day technical analysis is typically traced back to Charles Dow around the beginning of the 20th century. However, almost 300 years earlier, the Japanese were using similar techniques focusing on price behavior and patterns to trade rice contracts. Out of this came candlestick charts, which appeared in the second half of the 1800s. After hundreds of years of modification and refinement, candlestick charts are popular among day traders and buy-and-hold investors alike. Like all forms of technical analysis, candlestick charting attempts to forecast the future price movements of a security by examining its past price behavior and the patterns that appear on a historical chart. Here we will offer an overview of candlestick charts and highlight the significance of some different types of candlesticks. To illustrate our examples, we will use a few popular charting Web sites. For more information on Web sites offering candlestick Figure 1. Candlestick Formation

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charts, refer to the “Technical Analysis and Charting Web Sites” Comparison article in the March/April 2007 issue of Computerized Investing (available on-line at AAII.com). Constructing Candlesticks Candlestick charts require four data points—the open, high, low and close values for each period (day, week, month, etc.). It is important to keep this in mind, especially if you are collecting historical price data for use with a technical analysis software program. Some data services may only offer high, low, and close values. Without open prices, it is impossible to create true candlestick charts. Figure 1, taken from the StockCharts.com Chart School (www.stock charts.com) shows two candlesticks. The broadest part of the candlestick, which may be hollow or filled in, is called the “real body” (often referred to as simply the “body”). The real body represents the range between the opening and closing prices for the period. The thin lines drawn out from the ends of the body indicate the high/low range of the price for the period and are called “shadows” or “wicks.” The top of the upper shadow represents the high price for the period, while the bottom of the lower shadow represents the low price. A hollow, or white, candlestick means that the closing price was higher than the opening price (be aware that some services color the body green to indicate that the closing price was

higher than the open instead of showing it hollow). The bottom of the hollow candlestick’s body represents the opening price and the top of the body represents the closing price. Likewise, when the closing price is lower than the opening price, the candlestick body is filled in and the top of the body represents the opening price and the bottom of the body represents the closing price (services such as Yahoo! Finance that color “up” days green typically color the candlestick red for days when the closing price is below the open). Figure 2 shows three-month daily bar and candlestick charts for GameStop Corp. (GME) using BigCharts.com (www.bigcharts.com). Candlesticks are similar to the bars on a bar chart in that both portray the open, high, low, and close value for a given period. However, as you can see, a candlestick offers a much different graphical representation of a period’s price action. Almost immediately you can compare the relationship between the open and close price (whether it was an “up” or “down” day) as well as the high and low. Interpreting Candlesticks Chart analysis and interpretation is not an exact science. Luckily, the work of various technicians—including that of Steve Nisson, widely credited for bringing candlestick charting to the West—has led to the identification of many patterns that you can use to gauge your buying and selling. Long Bodies vs. Short Bodies One reason why many investors prefer candlesticks to bars is the information provided just by the size and color of the real body. Here are a few common rules regarding individual candlesticks: • Long, white (hollow) real bodies indicate strong buying pressure; • Long, black real bodies indicate strong selling pressure; and CI

• Small real bodies (white or black) indicate market indecision and possibly a loss of momentum in the current market trend. The longer the candlestick, the greater the range between the open and the closing prices. For white or hollow candlesticks, the longer the candlestick, the greater the closing price is compared to the open. This is a signal that buyers were aggressive. In general, white long candlesticks are bullish, but you must consider their positioning on the chart. After a

prolonged decline, long white candlesticks may mark a reversal or support level. In contrast, a long white candle after a long advance may indicate an overbought or excessively bullish situation. Long black candlesticks illustrate strong selling pressure. In this case, the longer the black candlestick, the more the price closed below the open. This may indicate aggressive selling. A long black candle after a prolonged upward move may indicate a reversal or a future level of resistance. Alterna-

tively, following a long decline, a long black candlestick could illustrate the market wringing out the last of the selling pressure. Figure 3 is a six-month daily candlestick chart for Ford Motor Company from StockCharts.com. As we mentioned earlier, some services may follow their own methodology when creating candlestick charts, and StockCharts.com is no exception. Following the “traditional” method of deciding when to draw a hollow or filled-in candlestick, StockCharts fills in the

Figure 2. Bar Chart and Candlestick Chart for GameStop Corp.

Source: BigCharts.com.

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Figure 3. Six-Month Daily Candlestick Chart for Ford Motor Company

Source: StockCharts.com.

candlestick if the close is less than the open and leaves the candlestick hollow (white) if the close is higher than the open. However, if you were to go to the StockCharts Web site and create a candlestick chart, you would also see hollow candlesticks that are red and black as well as filled red and filled black candlesticks. This is because StockCharts also follows these additional steps: • If the previous day’s close is less than or equal to the current day’s close, the current day’s candlestick is black; and • If the previous day’s close is greater than or equal to the current day’s close, the current day’s candlestick is red. Note that Figure 3 does not show these nuances because it is not in full color. Therefore, a black candlestick on a StockCharts.com candlestick chart indicates a period when the price opened above the previous period’s close and fell during the period, but still managed to close above the previous period’s close. In addition, a hollow red candle appears when the open price is below the previous period’s close and the price rose dur-

ing the period, but the closing price was still below the previous period’s closing price. Long Shadows vs. Short Shadows While, from an analysis standpoint, the real body of a candlestick provides the most compelling information, the length and position of the shadows/ wicks can offer significant insight as well. A long upper shadow illustrates that the market has tested and rejected higher prices, whereas a long lower shadow signifies a market that has tested and rejected lower prices. Furthermore, candlesticks with long upper shadows and short lower shadows typify a market where the buyers dominated that period, bidding prices higher. However, sellers then forced prices down from their highs and the weak close created the long upper shadow. Conversely, candlesticks with long lower shadows and short upper shadows illustrate markets where sellers dominated and forced prices downward. Later in the session, buyers emerged to drive prices higher and the strong close created a long lower shadow.

The Doji Those familiar with candlestick analysis know that there are a variety of descriptive names given to candlesticks depending on their size, shape, color, and position on the chart. You may have run across terms such as spinning top, hammer, hanging man, and morning star. One important candlestick type is the doji. In candlestick analysis, the doji is a warning that the current trend may be ending. In fact, the Japanese have a saying: “When you see a doji, take notice.” Among the various candlestick patterns used, it is the only one that can be signified by a single candlestick: All of the other significant candlestick patterns consist of multiple candles. However, doji can also exist within a multi-candlestick pattern. The term doji refers to a candlestick where the open and close are virtually equal or the same (Figure 4). The lengths of the upper and lower shadows can vary widely. Likewise, some doji have no upper shadow or no lower shadow. A “textbook” doji exists when the open and closing prices are the same. This can happen if after the opening for the period, the bears push prices down and then subsequently the

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Figure 4. The Doji

bulls manage to bid the price back to the opening price, or vice versa. Since doji form when the open and close prices are basically the same, they typify an indecisive marketplace. In other words, there is a “tug-of-war” between bulls and bears, buyers and sellers. Depending on which side eventually gains control, this could mark the beginning of a turning point. While we said earlier that doji are warnings, by themselves they are neutral patterns—predicting neither upward nor downward price movement. In addition, a series of doji or a doji amidst candlesticks with small real bodies are not important. The significance of the doji is that it is signaling a possible reversal. However, a reversal may never take place and the original trend may continue. The greatest indications of a possible trend reversal are when doji appear with other candlesticks, especially those with long real bodies. However, the relevance of a doji, and whether it indicates future bullish or bearish movement, depends on what happens before and after the doji appears. After a price advance—illustrated by long white candlesticks—a doji may signal that the buying pressure is losing steam. After a series of long black candlesticks, which takes place during a downward trend, a doji may signify that selling pressure is fading. Doji indicate equalization between supply and demand and that a change in trend may be nearing. Further confirmation of a declining trend may come in the form of a gap down (where the opening price

is below the previous period’s close) or a long black candlestick. A gap up (opening price is above the previous close) or a long white candlestick following the doji could be confirmation of a developing bullish situation. There are several types of doji, and each provide unique information. Dragonfly Doji A doji with no upper shadow and a long lower shadow is called a dragonfly doji (Figure 5, left). This candlestick shows that sellers were able to drive prices downward from the open but, eventually, buyers were able to gain control and move the price back to session highs near or at the open price. Like most other candlesticks, whether a dragonfly doji indicates a trend reversal depends on the price action leading up to its appearance. After a long downward price decline, a dragonfly may signal a near-term bottom and a bullish reversal. In this case, buyers appear to be reentering the market, as they were able to lift prices back near or to the open after an initial decline in the period (which creates the long lower shadow). In comparison, a dragonfly after a prolonged upward price move might signal a bearish reversal and a nearterm top. Here, the drop in price creating the long lower shadow points to growing selling pressure that was, at least for that period, neutralized by continued buying. Gravestone Doji The opposite of the dragonfly in appearance is the gravestone doji (Figure 5, right). Here, the open, low, and close prices are very close and the high price for the period creates a long upper shadow. Gravestone doji appear when buyers initially control the action—bidding the prices higher during the period. However, selling pressure eventually overcomes the buyers and the price falls back to the opening level. Again, the future course prices may take following a gravestone doji depends on prior price action.

Figure 5. Doji Formations

After a long upward price move, a gravestone doji points to a possible bearish reversal. Since buyers were not able to sustain the upward momentum—thus, the long upward tail where the close is well below the high—this could indicate the upward trend is nearing its end. However, when gravestones appear after a downtrend, the buying pressure that creates the long upper shadow is the important element and the potential exists for a bullish reversal. Conclusion Most investors are familiar with bar charts but may be new to candlesticks. While they look different from traditional open-high-low-close bar charts, it is reassuring to know that both candlesticks and bars illustrate exactly the same data; they just do it in different ways. By becoming familiar with some of the more popular candlestick patterns, and understanding them within the context of prior price movements, you have a tool that could help you identify trends and possible reversals (knowledge that could prove quite profitable). In future issues, we will discuss candlestick charting further to illuminate other elements of this topic. Wayne A. Thorp, CFA, is editor of Computerized Investing and AAII’s financial analyst.

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