Examples of Candlestick Analysis

The broad part of the candlestick line in Exhibit 1 is called the real body. The real body represents the range between the session's open and close. If the close of the session is above the open then the real body is white. If the real body is black the close of the session is lower than the open.

The thin lines above and below the real body are the shadows. These are the session's price extremes. The shadow above the real body is called the upper shadow and the peak of the upper shadow is the high of the session. The shadow under the real body is the lower shadow and the bottom of the lower shadow is the session's low.

Candle lines can be drawn for all time frames, from intra-day to monthly charts. For example, a 60-minute candle line uses the open, high, low and close of that 60-minute period; for a daily chart it would be the open, high, low and close for the day. On a weekly chart the candle would be based on Monday's open, the high and low of the week and Friday's close.

Notice that the candles to the right have no real bodies. These are examples of doji (pronounced doe-gee). A doji is a candle in which the opening and close are the same. Doji represent a market that is in balance between the forces of supply and demand.

While the candlestick line uses the same data as a bar chart, the colour of the candlestick's real body and the length of the candle lines real body and shadows convey an instant x-ray into whose winning the battle between the bulls and the bears.

For instance, when the real body is black, that means the stock closed below its opening price. This gives you an instant picture of a positive or negative close. Those of us who stare at charts for hours at a time find candlesticks are not only easy on the eyes, they convey strong visual signals sometimes missed on bar charts.

The logo of our firm, which is a spinning top, is " Helping Clients Spot Market Turns Before the Competition ". This is because one of the most powerful aspects of candle charts is that they will often provide reversal signals not available with traditional bar charting techniques. Let's take a look at this aspect with a "spinning top."

As mentioned previously, one of more powerful aspects of candle charts is the quick visual information they relay about the market's heath. For example, a small real body (white or black) indicates a period in which the bulls and bears are more in a tug of war. The Japanese have a nickname for small real bodies-"spinning tops" because of their resemblance to the tops we had as children. Such small real bodies give a warning that the market's trend may be losing momentum. As the Japanese phrase it, the "market is losing its breath."

Let's look at an example of how candle charts will often help you preserve capital, a benefit so important in today's volatile environment. In this scenario I will illustrate how a candle chart can help you avoid a potentially losing trade from the long side.

I have two charts below. The top chart is a bar chart . On this chart the stock looks strong since it is making consecutively higher closes. It looks like a stock to buy.

Using the same data as on the bar chart, we now make a candle chart.

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 call "Spinning Tops". Small real bodies hint that the prior trend (i.e. the rally) could be losing its breath.

As such, while the bar chart makes it look attractive to buy, the candle chart shows 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 would likely not buy in the circled area and thus help avoid a losing trade.

This is but one example of how candles shines at helping you preserve capital.

Warren Buffet has two rules:

Rule 1- Don't lose money.
Rule 2- Don't forget rule 1.

Candles shine at helping you preserve capital.

The Doji is one of the most famous Candlestick patterns.

As the real body shrinks we ultimately wind up with a doji. This was shown in the first example. A doji is when the open and close are the same.

The doji indicates a market in complete balance between supply and demand. Since a doji session represents a market at a juncture of indecision, they can often be an early warning that a preceding rally could be losing steam. Indeed, with a doji the Japanese would say, that "the market is tired". (Keep in mind a close over the doji would "refresh" the market).

Properly used, candle charts may not only help improve profits, but will assist in preserving capital. They can do this by helping you avoid a potential losing trade or exiting a profitable trade early. The chart to the left shows an example of this.

This is a chart of the SOX, also known as the Philadelphia Semiconductor Index, which list the biggest computer memory producers in the world, such as Intel, Texas Instruments and Motorola.

The horizontal line in this chart shows a resistance area near 135. A tall white candle pierces this resistance in early March. But observe what unfolded the next session-the doji. This doji line hinted the bulls had lost full of the market (note: it does not mean that the bears has taken control).

This is a classic example of the power of candle charting techniques. Specifically, within one session we were able to see a visual clue via the doji that while the market was maintaining its highs, the doji shouted that the bulls were not in complete control. So while the market looked healthy from the outside, the internals (as shown by the doji) were relaying the fact that this stock was not as healthy as one would think.

We now look at a specific type of candle line that has a very long lower shadow called a hammer. It is so called because the market is trying to hammer out a base.

The criteria for the hammer are:

The real body is at the upper end of the trading range.

The colour 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.

The hammer reflects the market 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. From my experience, most times when there is a hammer the market may not immediately move up, but may rally slightly, or trade laterally, and then, after expanding on a base, then rally. If the market closes under the lows of the hammer longs should be reconsidered.

Candle charts can be used in all time frames- from intra-day day to weekly.

In the intra-day chart, there are two back-to-back hammers (denoted by the arrow). These dual hammers took on extra significance since they confirmed a support level shown by the dashed line.

This is a classic example of the power and the ease with which one can combine the insights of candle charts (the hammers) with classic western trading signals (the support line) to increase the likelihood of a market turn. This synergy of candle charts and western technical tools should provide a powerful weapon in your trading arsenal.

An engulfing pattern is a two-candle pattern.

A bearish engulfing pattern, shown on the left-hand side of the chart, is formed when, during a rally a black real body wraps around a white real body. A bullish engulfing pattern, shown on the right-hand side of the chart, is completed when, during a descent, a white real body envelops the prior black real body.

The engulfing pattern is illustrative of how the candles can help provide greater understanding into the behaviour of the markets. For example, a bullish engulfing pattern reflects how the bulls have wrested control of the market from the bears. A bearish engulfing pattern shows how a superior force of supply has overwhelmed the bulls. The Japanese will say, for instance, that with a bearish engulfing pattern that "the bulls are immobilized".

The chart to the left shows how a bullish engulfing pattern in early October called a reversal at IBM's lows.

This bullish engulfing pattern was especially potent because it reinforced a support area set by a hammer.

CANDLES AND THE OVERALL TECHNICAL PICTURE

You must remember a basic principle about the use of candles: candle-charting techniques are a tool and not a system. Effective candle charting techniques requires not only an understanding of the candle patterns, but also a policy of using sound, coherent trading strategies and tactics. These include using stops, determining the risk and reward aspect of a potential trade, observing where a candle pattern is in relation to the overall trend, and monitoring the market's action after a trade is placed. By understanding, and using, these trading principles, you will be in a position to most fully enhance the power of the candles.

This is only a basic introduction to candle charts. There are many more patterns, concepts and trading techniques that must first be considered. But even with these basic concepts, you can see how the candles open new and unique doors of analysis.

May the candles light your path to profits!