We have seen the traditional charting patterns so far where in we
have used the normal high-low bar or a close only type (line) chart.
Japanese Candlestick charting, added an exciting dimension to Technical
Analysis, and candle pattern analysis using the basic data of Open,
High, Close and Low determines the insight in to the recent trading
psychology. Japanese Candlesticks offers a clear picture of the
psychology of short-term trading.
Since it does this by using
the same data points, it has, very rapidly, become the most popular way
of looking at stocks. Most traders as well as market advisors use this
form of stock charting as it is visually more appealing and is able to
convey at the very first impression, seemingly, more information than
the other forms of charting.
Candlestick charting was
originally used by rice traders in Japan back in the 11th century and
therefore can be said to be the earliest form of technical analysis! It
was brought to the notice of the Western world through the efforts of
Steve Nison who has authored two very successful books on the subject
entitled, Japanese Candle Stick Charting and Beyond Candlesticks. The
popularity of this form of charting proved to be so high that today we
have several more books on the subject by different authors and there
are also a number of software’s available which draw the charts in this
particular method.
Drawing the Candlestick Charts
As
stated earlier, the candlestick chart uses the same data points as the
other charts i.e. the Open, High, Low and Close. A traditional Japanese
chart consists of a real body, representing the open and close, and
upper and lower shadows, representing the high and low of the day.
Pictorially, it would look as follows :
It
can be seen in the picture above that two candles are shown, both with
different colours. It can be noticed that all the four data points –
O,H,L,C – are featured on the chart. The major difference is in the
fact that the area between the open and the close has been broadened a
bit which makes the picture resemble that of a Candle. The small
vertical line above the mid thick portion – which is the body – are the
“shadows” or the wick of the candle. Since the entire picture looks
like a candle, this form of charting also came to be known as
“candlestick” charts.
It is also seen in the picture above that
there are two colored candles shown. The one to the left is shown in
green and if one observes closely, it will be found that the Open is
shown to be lower than the close. Exactly vice versa is the case in the
example on the right. Here the close is shown to be higher than the
open.
This is the major differentiating factor between the
candles of different colors and that is what gives them a greater
visual impressionability. It is to be noted that the body of the candle
is what is colored and not the shadows. By color- coding the body, an
immediate idea of the close vis-à-vis the open is understood by the
analyst.
The importance of the open and the close
The
reason why the candlestick pattern lays so much emphasis on
differentiating between the open and the close – and to a large extent,
disregarding the importance of the highs and lows – lies in the fact
that these two are the most important valuation areas of the price for
the day. The open is the sum total of all the facts/news known up to
that moment and the view formed on these. Then the market trades during
the day to establish the high and low for the day. Finally, the
overnight news and views along with the input from the day’s trading
pattern gets distilled to form the view near the close. Hence maximum
valuation goes into computation of the open and close.
If the
open is higher than the close, then it would mean that the day’s
trading pattern was such that people ended the day more bearish than
where they began. Likewise, if the close is higher than the open, it
would mean that the view at the close was more bullish than when the
market began. This has a bearing on the market for the next day.
Therefore,
by depicting this more visually, by color- coding the candle body – a
different color for bullish and bearish set ups – the candlestick gives
a more immediate make of the market. Though in the example above, the
colors are shown to be green and red, the general convention has been
to show the bearish candle (i.e. close below open) as black and the
bullish candle (i.e. close above open) as white. Hence by common usage,
you have the black candle referring to bearish close and white candle
referring to bullish close.
The body size
The next consideration
in the candlestick chart part is the size of the body. Those who have
by now followed the concept of the construction would immediately
realize the value of the size of the body. Since the body is made up of
the distance between the open and the close, it is natural to note that
its length will depend upon how far away from the open the market or
the stock closed. If the open and close were wide apart we would have a
very long bodied candle while if the close came back to near or at
where the market opened, we would have a very small bodied candle. In
common usage, one would also be frequently hearing of “long” and
“small” bodied candles and these are then combined with the color of
the body and are called “long white” or “long black”.
One usually does not refer to the color of the small body candle. The
reasons for the same will become clear as the discussion on
candlesticks unfolds.
It should be pretty clear that when the
close ends a good distance away from the open, the stock has had some
clear directional movement. To put it in a different way, after the
market opens, if the stock begins moving away from the opening price in
one direction and closes far away from it, some particular reasoning
must have prevailed in the market on that day top ensure such a
movement. Directional movement in prices can only occur when there is a
conviction about the direction. Hence a long body candle represents the
predominance of a view. Depending upon the color, the view would be
either bullish or bearish. Sentiment wise, long body represents
decisive action by market participants.
In exactly a similar
way, the small-bodied candle represents the opposite of the above –
that is, the close of the day ends quite near the open. This would mean
that the stock, after opening at a price, went up and down to establish
the high and low of the day (i.e. the range for the day) and then
decided to move back to near where it opened. Such a movement depicts
the non-directionality of the price move. Looked at from the mental
perspective, it suggests that the players are unsure of the day’s
movements and the news and therefore returned to the valuation that
they placed on the stock near the open. Therefore, small body
represents indecision by market participants. Since indecision
prevails, it matters only marginally whether the candle is black or
white.
There are some situations where the market will close
at the level of the open. In such a case, there is no body and a
horizontal line depicting the open and the close – just like in the
normal hi-low chart- represents the candlestick. This special condition
will be dealt with under patterns of candlesticks in future tutorials.
An example of candle charts can be seen in the following graph. It shows the different types of candle areas. |