Japanese Candlestick Charting

An Introduction to Japanese Candlestick Charting

By Erik Gebhard

Introduction…a New Way to Look at Prices

Would you like to learn about a type of commodity futures price chart that is more effective than the type
you are probably using now? If so, keep reading. If you are brand new to the art/science of chart reading,
don’t worry, this stuff is really quite simple to learn.

Technical Analysis…a Brief Background

Technical analysis is simply the study of prices as reflected on price charts. Technical analysis assumes that
current prices should represent all known information about the markets. Prices not only reflect intrinsic
facts, they also represent human emotion and the pervasive mass psychology and mood of the moment.
Prices are, in the end, a function of supply and demand. However, on a moment to moment basis, human
emotions…fear, greed, panic, hysteria, elation, etc. also dramatically effect prices. Markets may move based
upon people’s expectations, not necessarily facts. A market "technician" attempts to disregard the emotional
component of trading by making his decisions based upon chart formations, assuming that prices reflect
both facts and emotion.

Standard bar charts are commonly used to convey price activity into an easily readable chart. Usually four
elements make up a bar chart, the Open, High, Low, and Close for the trading session/time period. A price
bar can represent any time frame the user wishes, from 1 minute to 1 month. The total vertical
length/height of the bar represents the entire trading range for the period. The top of the bar represents the
highest price of the period, and the bottom of the bar represents the lowest price of the period. The Open is
represented by a small dash to the left of the bar, and the Close for the session is a small dash to the right
of the bar. Below is a standard bar chart example.
Candlestick Charts Explained

You may be asking yourself, "If I can already use bar charts to view prices, then why do I need another type
of chart?"

The answer to this question may not seem obvious, but after going through the following candlestick chart
explanations and examples, you will surely see value in the different perspective candlesticks bring to the
table. In my opinion, they are much more visually appealing, and convey the price information in a quicker,
easier manner.

What is the History of Candlestick Charts?

Candlestick charts are on record as being the oldest type of charts used for price prediction. They date back
to the 1700's, when they were used for predicting rice prices. In fact, during this era in Japan, Munehisa
Homma become a legendary rice trader and gained a huge fortune using candlestick analysis. He is said to
have executed over 100 consecutive winning trades!

The candlesticks themselves and the formations they shape were give colorful names by the Japanese
traders. Due in part to the military environment of the Japanese feudal system during this era, candlestick
formations developed names such as "counter attack lines" and the "advancing three soldiers". Just as skill,
strategy, and psychology are important in battle, so too are they important elements when in the midst of
trading battle.

What do Candlesticks Look Like?

Candlestick charts are much more visually appealing than a standard two-dimensional bar chart. As in a
standard bar chart, there are four elements necessary to construct a candlestick chart, the OPEN, HIGH,
LOW and CLOSING price for a given time period. Below are examples of candlesticks and a definition for
each candlestick component:
  The body of the candlestick is called the real body, and represents the range between the
open and closing prices.

 A black or filled-in body represents that the close during that time period was lower than
the open, (normally considered bearish) and when the body is open or white, that means
the close was higher than the open (normally bullish).

 The thin vertical line above and/or below the real body is called the upper/lower shadow,
representing the high/low price extremes for the period.

Bar Compared to Candlestick Charts

Below is an example of the same price data conveyed in a standard bar chart and a candlestick chart. Notice
how the candlestick chart appears 3-dimensional, as price data almost jumps out at you.
 ( 3a )

( 3b )

The long, dark, filled-in real bodies represent a weak (bearish) close ( 3a ), while a long open, light-colored
real body represents a strong (bullish) close ( 3b ). It is important to note that Japanese candlestick
analysts traditionally view the open and closing prices as the most critical of the day. At a glance, notice
how much easier it is with candlesticks to determine if the closing price was higher or lower than the
opening price.

Common Candlestick Terminology

The following is a list of some individual candlestick terms. It is important to realize that many formations
occur within the context of prior candlesticks. What follows is merely a definition of terms, not formations.

 The Black Candlestick -- when the close is lower than the open.
 The White Candlestick -- when the close is higher than the open.

 The Shaven Head -- a candlestick with no upper shadow.

 The Shaven Bottom -- a candlestick with no lower shadow.

 Doji Lines -- have no real body, but instead have a horizontal line. This represents when the
Open and Close are the same or very close. The length of the shadow can vary.
Candlestick Reversal Patterns

Just as many traders look to bar charts for double tops and bottoms, head-and-shoulders, and technical
indicators for reversal signals, so too can candlestick formations be looked upon for the same purpose. A
reversal does not always mean that the current uptrend/downtrend will reverse direction, but merely that
the current direction may end. The market may then decide to drift sideways. Candlestick reversal patterns
must be viewed within the context of prior activity to be effective. In fact, identical candlesticks may have
different meanings depending on where they occur within the context of prior trends and formations.

 Hammer -- a candlestick with a long lower shadow and small real body. The shadow should
be at least twice the length of the real body, and there should be no or very little upper
shadow. The body may be either black or white, but the key is that this candlestick must
occur within the context of a downtrend to be considered a hammer. The market may be
"hammering" out a bottom.

 Hanging Man -- identical in appearance to the hammer, but appears within the context of
an uptrend.
 Engulfing Patterns -- Bullish -- when a white, real body totally covers, "engulfs" the prior
day's real body. The market should be in a definable trend, not chopping around sideways.
The shadows of the prior candlestick do not need to be engulfed.

 Bearish -- when a black, real body totally covers, "engulfs" the prior day's real body. The
market should be in a definable trend, not chopping around sideways. The shadows of the
prior candlestick do not need to be engulfed.
 Dark-Cloud Cover(bearish) -- a top reversal formation where the first day of the pattern
consists of a strong white, real body. The second day's price opens above the top of the
upper shadow of the prior candlestick, but the close is at or near the low of the day, and
well into the prior white, real body.

 Piercing Pattern (bullish) -- opposite of the dark-cloud cover. Occurs within a downtrend.
The first candlestick having a black, real body, and the second has a long, white, real body.
The white day opens sharply lower, under the low of the prior black day. Then, prices close
above the 50% point of the prior day's black real body.
Stars

These candlestick formations consist of a small real body that gaps away from the real body preceding it.
The real body of the star should not overlap the prior real body. The color of the star is not too important,
and they can occur at either tops or bottoms. Stars are the equivalent of gaps on standard bar charts.
Stars make up part of four separate reversal patterns:

Morning Star

Evening Star

Doji Star

Shooting Star (Inverted Hammer)

 Morning Star -- this is a bullish bottom reversal pattern. The formation is comprised of 3
candlesticks. The first candlestick is a tall black real body followed by the second, a small real body,
which gaps (opens), lower (a star pattern). The third candlestick is a white real body that moves
well into the first period's black real body. This is similar to an island pattern on standard bar
charts.
 Evening Star -- a bearish top reversal pattern and counterpart to the Morning Star. Three
candlesticks compose the evening star, the first being long and white. The second forms a star,
followed by the third, which has a black real body that moves sharply into the first white
candlestick.

 Doji Stars -- When a doji gaps above a real body in an uptrend, or gaps under a real body in a
falling market, that particular doji is called a doji star. Two popular doji stars are the evening star
and the morning star.
 Evening Doji Star -- a doji star in an uptrend followed by a long, black real body that closed well
into the prior white real body. If the candlestick after the doji star is white and gapped higher, the
bearishness of the doji is invalidated.

 Morning Doji Star -- a doji star in a downtrend followed by a long, white real body that closes well
into the prior black real body. If the candlestick after the doji star is black and gapped lower, the
bullishness of the doji is invalidated.
 Shooting Star -- a small real body near the lower end of the trading range, with a long upper
shadow. The color of the body is not critical. Not usually considered a major reversal sign, only a
warning.

 Inverted Hammer-- not really a star, but does look like a shooting star. When occurring within a
downtrend, may be a turning signal. Body color is not critical.
Final Thoughts and Credits

It is important to realize that this introduction is just that, an introduction to candlestick analysis. After
having read this, you will have merely scratched the surface of the many patterns and variables that can go
into candlestick analysis. No attempt was made to provide a thorough analysis of each and every pattern. In
fact, many formations were left out as they cross the border into more complicated analysis. For a more
complete overview of candlestick analysis, it is highly recommended that you read the book that is referred
to below.

A large portion of the material in this introduction is taken from an excellent book called Japanese
Candlestick Charting Techniques: A Contemporary Guide to the Ancient Investment Techniques of the Far
East. In some cases, sentences were taken almost verbatim, as there was no better way to say what Mr.
Steve Nison, the author, already said. In his book, Mr. Nison, completely explains candlesticks and their
formations, but more importantly explains how to combine candlestick analysis with traditional technical
analysis. It is highly recommended that you consider purchasing this book.

As traders, we need as many trading tools in our arsenal, and a basic knowledge of candlesticks provides a
trader much needed ammunition. Also remember that no matter what the trading tool, no matter how
advanced or ancient, it is only effective when put into practice properly. This is, of course, your job as the
trader.