The Art of Candlestick Charting - Part 1

December 17, 2002 | By Investopedia Staff, (Investopedia.com)

The candlestick techniques we use today originated in the style of technical

charting used by the Japanese for over 100 years before the West developed the
bar and point-and-figure analysis systems. In the 1700s a Japanese man named
Homma, a trader in the futures market,
discovered that, although there was a link
between price and the supply and demand of
rice, the markets were strongly influenced by
the emotions of the traders. He understood
that when emotions played into the equation
a vast difference between the value and the
price of rice occurred. This difference between
the value and the price is as applicable to
stocks today as it was to rice in Japan
centuries ago. The principles established by
Homma are the basis for the candlestick chart
analysis, which is used to measure market
emotions towards a stock.

This charting technique has become very popular among traders. One reason is
that the charts reflect only short-term outlooks--sometimes lasting less than eight
to 10 trading sessions. Candlestick charting is a very complex and sometimes
difficult system to understand, but in this four-part series, we take go inside the
more common ways to construct and read candlestick patterns. (For our other
candlestick charting articles, see our Technical Analysis 101 archives.)

Candlestick Components

When first looking at a candlestick chart, the student of the more common bar
charts may be confused; however, just like a bar chart, the daily candlestick line
contains the market's open, high, low and close of a specific day. Now this is
where the system takes on a whole new look: the candlestick has a wide part,
which is called the "real body". This real body represents the range between the
open and close of that day's trading. When the real body is filled in or black, it
means the close was lower than the open. If the real body is empty, it means the
opposite: the close was higher than the open.

Just above and below the real body are the "shadows". Chartists have always
thought of these as the wicks of the candle, and it is the shadows that show the
high and low prices of that day's trading. If the upper shadow on the filled-in body
is short, it indicates that the open that day was closer to the high of the day. And
a short upper shadow on a white or unfilled body dictates that the close was near
the high. The relationship between the day's open, high, low, and close determine
the look of the daily candlestick. Real bodies can be either long or short and either
black or white. Shadows can also be either long or short.

Comparing Candlestick to Bar Charts

A big difference between the bar charts common in North America and the
Japanese candlestick line is the relationship between opening and closing prices.
We place more emphasis on the progression of today's closing price from
yesterday's close. In Japan, chartists are more interested in the relationship
between the closing price and the opening price of the same trading day.

In the two charts below I am showing the exact same daily charts of IBM to
illustrate the difference between the bar chart and the candlestick chart. In both

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charts you can see the overall trend of the stock price; however, you can see how
much easier looking at the change in body color of the candlestick chart is for
interpreting the day-to-day sentiment.

Chart Created with Tradestation

Chart Created with Tradestation

Basic Candlestick Patterns
In the chart below of EBAY, you see the 'long black body', or 'long black line'. The
long black line represents a bearish period in the marketplace. During the trading
session, the price of the stock was up and down in a wide range and it opened
near the high and closed near the low of the day.

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By representing a bullish period, the 'long white body', or 'long white line'--(in the
EBAY chart below, the white is actually gray because of the white background) is
the exact opposite of the long black line. Prices were all over the map during the
day, but the stock opened near the low of the day and closed near the high.

'Spinning tops' are very small bodies and can be either black or white. This
pattern shows a very tight trading range between the open and the close, and it is
considered somewhat neutral.

'Doji lines' illustrate periods in which the opening and closing prices for the period
are very close or exactly the same. You will also notice that, when you start to
look deep into candlestick patterns, the length of the shadows can vary.

Chart Created with Tradestation

In Part 2 of this series we look closer at pattern analysis; in Part 3 we focus on

continuation patterns; and in Part 4 we conclude by exploring patterns on both
the bullish and bearish sides of the equation.

Remember it's your money - invest it wisely.

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The Art of Candlestick Charting - Part 2

In Part 1 we look at the history and the basics of the art of Japanese candlestick
charting. Here in Part 2 we look deeper into how to analyze candlestick patterns.

Principles behind the Art

Before learning how to analyze them, we need to understand that candle
patterns, for all intents and purposes, are merely reactions of traders at a
particular time in the marketplace. The fact that human beings often react en
masse to situations allows candlestick chart analysis to work.

Many of the investors who rushed to the marketplace in the fall and winter of
1999-2000 had, before that time, never bought a single share in a public
company. The volumes at the top were record breaking and the smart money was
starting to leave the stock market. Hundreds of thousands of new investors,
armed with computers and new online trading accounts, were sitting at their
desks buying and selling the dotcom flavor of the moment. Like lemmings, these
new players took greed to a level never seen before, and, before long, they saw
the market crash around their feet.

Chart Created with Tradestation

Lets have a look at what was a favorite of many investors during that time. This
presentation of JDS Uniphase (JDSU) on the chart above is a lesson in how to
recognize long bullish candles, which formed as the company's stock price moved
from the $25 area in late Aug 1999 to an outstanding $140 plus in Mar 2000. Just
look at the number of long green candles that occurred during a seven-month
ride.

Analyzing Patterns
Traders must remember that a pattern may consist of only one candlestick but
could also contain a number or series of candlesticks over a number of trading
days.

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A reversal candle pattern is a number or series of candlesticks that normally show
a trend reversal in a stock or commodity being analyzed; however, determining
trends can be very difficult. Perhaps this is best explained by Gregory L. Morris in
the chapter her wrote for John J. Murphy's classic "Technical Analysis of the
Financial Markets" (1999):

"One serious consideration that must be used to identify patterns as being either
bullish or bearish is the trend of the market preceding the pattern. You cannot
have a bullish reversal pattern in an uptrend. You can have a series of
candlesticks that resemble the bullish pattern, but if the trend is up it is not a
bullish Japanese candle pattern. Likewise, you cannot have a bearish reversal
candle pattern in a downtrend."
The reader who takes Japanese candlestick charting to the next level will read
that there could be as many as 40 or more patterns that will indicate reversals.
One-day reversals form candlesticks such as 'hammers' and 'hanging men'. A
hammer is an umbrella that appears after a price decline, and, according to
candlestick pros, comes from the action of "hammering" out a bottom. If a stock
or commodity opens down and the price drops throughout the session only to
come back near the opening price at close, the pros call this a hammer.

A hanging man is very important to recognize and understand. It is an umbrella

that develops after a rally. The shadow should be twice as long as the body.
Hanging men that appear after a long rally should be taken notice of and acted
upon. If a trading range for the hanging day is above the entire trading range of
the previous day, a "gap" day may be indicated.

Lets look at two charts, one with a hammer and the other with a hanging man.
The first charts Lucent Technologies and shows a classic hanging man. After three
days of the stock price rising, the hanging man appears, and on the following day,
the stock price drops over 20%. The second chart shows a hammer from a period
in 2001 when Nortel Networks was trading in the $55-$70 range. The hammer
appears after two days of declining prices and effectively stops the slide, marking
the beginning of a nine-day run with the stock price moving up $11.

Chart Created with Tradestation

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 Chart Created with Tradestation

For those of you who would like to explore this area of technical analysis more
deeply, I suggest that you look for books written by Steve Nison. He has written a
number of textbooks that even a novice will understand upon the first reading.

The Art of Candlestick Charting - Part 3

This third article of a four-part series introducing you to candlestick charting

focuses on continuation patterns and how they can confirm or deny trends that
the chartist will recognize over and over again. (In Part 1 we review the
components of a candlestick, and in Part 2 we introduce the techniques of
analyzing patterns.) It is the confirmation or denial of a trend that determines
whether an investor will sit tight today and hold his or her position or decide to
enter or exit an issue that could be long or short the market.

Patterns on the Bullish and Bearish Sides

In the world of Japanese candlesticks, there are a number of bullish and bearish
continuation patterns. With a short list on the bullish side of the market, a chartist
would look for the following patterns: 'mat hold', 'rising three methods',
'separating three lines', 'side-by-side white lines', 'upside gap three methods', and
'upside Tasuki gap'. This article focuses on 'rising three methods', 'mat hold' and
'separating three lines'.

With a short list on the bearish side of the market, one would look for the
following patterns: 'falling three methods', 'in-neck', 'on-neck', 'separating lines',
'side-by-side white lines', and 'black crows'. In this article, we focus on 'falling
three methods', 'separating lines' and 'in-neck'.

(Keep in mind there are many more different patterns on the bullish and bearish
sides of the market. If you'd like to look deeper into this complex art, visit

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Stockcharts.com for their look at Japanese candlesticks and have a look in your
local bookstore for the excellent books on the subject written by Steve Nison.)

Illustrating the Patterns

For each continuation pattern shown below, we describe the pattern and break it
down allowing you to recognize the formation more easily in the future. Starting
with the bulls, let's have a look at rising three methods.

Rising Three Methods

This pattern starts out with what is called a "long white day". Then, on the second,
third and fourth trading sessions small real bodies appear - these small real
bodies form from a fall-off in price, but they still stay within the price range of the
long white day (day one in the pattern). The fifth and last day of the pattern
shows another long white day.

This pattern is, in the world of Japanese candlestick charting, a very bullish chart.
It shows an upward trend on day one with investors taking a few trading sessions
to relax to prepare for the next rise in price that occurs on the fifth day. Even
though the pattern shows us that the prices are falling for three straight days, a
new low is not seen and the bulls prepare for the next leg up.

Bullish Mat Hold

This pattern begins with a long white day and then, on the second day of trading,
the issue gaps up and is a black day. What we see next in this pattern is
somewhat similar to the previous pattern.

The second, third, and fourth days see the issue falling off slightly but not trading
outside the range of the long white day on day one. Finally, the last day in the
pattern is another long white day that closes above the close of the first long
white day.

Separating Lines (Bullish)

In the pattern of bullish separating lines, you can see that the first day is a black
day and the next day is a white day. The key to the second day is that the issue
has the same opening price as day one.

In a bullish market, this pattern is simply viewed as a continuation of the trend

because the second day starts off from where day one left off and continues the

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trading session to close higher still.

Now, on the bearish side of the equation, let's have a look at what the bears are
looking for, starting with separating lines.

Separating Lines (Bearish)

You can see immediately that the bearish separating lines pattern is the exact
opposite of the bullish separating lines pattern, so it does not need any further
explanation.

Falling Three Methods (Bearish)

The pattern known as bearish falling three methods confuse many chartists at
first. It is not until the third or fourth day of the pattern that it becomes clear.

Look close and you can see that a new high is not formed from the high set on the
first day. This is a very bearish signal and short sellers react strongly to this
pattern.

In-Neck (Bearish)
The first day of the in-neck continuation pattern is a long black day and the
second is a white day that shows an opening of trading below the low of the prior
trading session. Then on the close the price is equal to or just above the closing
price of the prior session.

This pattern has the bears looking for the falling trend to continue but it may be
some time before it is confirmed.

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The Art of Candlestick Charting - Part 4

In Part 1 of this four-part series on candlestick charting we review the components

of a candlestick, and in Part 2 we introduce the techniques of analyzing patterns.
In part 3, we start to look at some of the more recognizable or perhaps popular
patterns that regularly appear on candle charts.

This article focuses on continuation patterns and how they could deny or confirm
trends in today's markets, giving the investor a clearer picture of whether or not
to hold his or her position or execute a buy/sell order.

The Patterns
We continue this look at candle charts with some additional patterns on both the
bullish and bearish sides of the equation. On the bullish side of the market, show
you the 'engulfing pattern', 'harami', and the 'harami cross'. Opposite, on the
bearish side, we will have a closer look at the 'engulfing pattern', 'the evening
star' and both the 'harami' and the 'harami cross'.

Engulfing Pattern - Bearish

Engulfing pattern (bearish) develops in an uptrend when the sellers outnumber
the buyers; this action is reflected by a long red real body engulfing a small green
real body.

You can see the opening was higher than the previous day, and, during the
trading session, the issue sold off with volume much greater than the previous
session.
(Please note that the charts in part 3 were black and white. To avoid confusion,
you should know that candle charts in many of today's software programs are
shown in red [instead of black] and green [instead of white]).

Engulfing Pattern - Bullish

Engulfing pattern on the bullish side of the market is the opposite of the previous
pattern and takes place when the buyers outpace the sellers, which is reflected in
the chart by a long green real body engulfing a small red real body.

As you can see, this is a chart of an issue in a downtrend that has now lost
momentum. The buyers may be coming back into this issue, creating a trend
reversal and bottoming out of this downtrend.

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Evening Star - Bearish
Evening star (bearish) is a top reversal pattern that is very easy to identify
because the last candle in the pattern opens below the previous days' small real
body, which can be either red or green and closes deep into the real body of the
trading range of the candle two day's prior.

This pattern shows that investors are perhaps losing confidence in the issue and
it's direction. This thought process will be confirmed if the next day is another
down session.

Harami - Bearish
Harami (bearish) is another very recognizable candlestick pattern that shows a
small real body (red) completely inside the previous day's real body.

Technicians will watch very closely now because the harami bearish indicates that
the current uptrend may be coming to an end, especially if the volume is light.
Students of candlestick charts will also recognize the harami pattern as the first
two days of the three inside pattern.

Harami - Bullish

Harami (bullish) is just the mirror reflection of the harami bearish. As you can see
in the chart above, a downtrend is in play and a small real body (green) is shown
inside the large real body (red) of the previous day. This tells the technician that
the trend is coming to a conclusion. The harami implies that the preceding trend
is about to conclude. A candlestick closing higher the next day would confirm the
trend reversal.

Harami Cross - Bearish

Harami cross (bearish) is a pattern of a harami with a doji instead of a small real

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body following up on the next trading session.The doji is within the range of the
real body of the prior session.

Like the harami, the trend starts out in play, but the market then decides to
reverse intra-day with volume being somewhat non-existent and the pattern
closing at the same price as the issue opened. The uptrend has been reversed.

Harami Cross - Bullish

The harami cross, whether the bullish or bearish version, starts out looking like
the basic harami pattern. The harami cross bullish is the exact opposite of the
harami cross bearish and does not require any further explanation. Again, a trend
has been reversed.

This four-part series barely scratches the surface of Japanese candlestick charts
and the interpretation of the patterns. If you want to gain more in-depth
knowledge be sure to read Steve Nison's excellent books on the subject.

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