free download links about online stock trading, forex, futures, stock investing, market, trading systems
Candlestick FOREX Charting
Back to contents page

The first recorded futures transactions occurred in the 1700s in the Japanese rice markets, where Munehisa Homma amassed a fortune trading the market. His system included the study of price action, the psychology of the market, and the seasonality of the weather. Candlestick charts evolved from Homma's system and are the subject of this chapter. This section covers the fundamentals of candlestick charting and explains how to utilize candle charts to analyze, enter, and exit trades.

The main advantage that candlestick charting provides over bar chart ing is that the candlestick provides immediate visual recognition of the open, the high, the low, and the close. Many traders who employ candle stick charting techniques set their charting software so that the candle sticks are one color for a lower close than the open (such as red or black as shown in Figure 3.1) and another color for a higher close than the open (such as green or white as shown in Figure 3.2). For the purpose of this book, a candle with a higher close than the open will be referred to as a white candle. A candle with a lower close than the open will be referred to as a black candle. A single candle does not tell you if the close is higher or lower than in the previous time period. The single candle only shows whether the close is higher or lower than the open for each candle.

Each candle has different characteristics that provide insight into price movement by the distance between the open, the high, the low, and the close. The candlesticks formed for each time session also indicate if the price movement shows a level of increasing or decreasing pressure by the size of the candle, or its “real body.” Each candle pictured has a differ

ent characteristic that represents the difference or the distance between the open, the high, the low, and the close. Candlestick charting techniques can be used from data for whatever time period you are looking at from as little as one minute to one hour, one day, one week, or one month. The candle still allows for use of traditional Western philosophy of technical analy sis of pattern recognition, trend-line support and resistance, and other helpful tools as we will go into in detail in Chapter 5

COMPONENTS OF A CANDLESTICK

The components of a candlestick are derived from the open, the high, the low, and the close. The main components that we need to identify are:

• Relationship between open and close (the candle bodies).

• Real-body colors.

• Shadows and correlations to the candle body.

• Size of shadows.

• Range or length of the candle.

In uptrends or bullish market conditions, buying comes in on the open; and the market should settle closer to the highs and should close above the open. That is why in bullish market conditions, we see hollow or white candles.

And I assign a higher close than the open. This helps me to identify that buyers are supporting prices. I can tell if the bulls are dominating the market by the distance between the open and the close. If the market opens on the low and has a large range where it closes at the high of the session, that

signifies that the bulls are firmly in control. However, if we have a wide range session and the market price closes back near where it opened, let's say in the middle of the range, that is not a good sign that bulls dominate the market for that particular time period.

In a bearish market condition or in a strong downtrend, we would see black or red real-body candles as shown in the accompanying CD. This represents sellers entering the market on the open and dominating the session right into the close of that time period. If the market opens on the high and prices decline where the close is at or near the low, this shows that the bears are firmly in control. This is why I assign these candles a negative (-) reading. The distance factor between the open and the close is illustrated in a much more defined way in candle charts than in bar charts due to the shape and color coordinates.

Shadows and Correlations to Candle Body

The shadows or wicks are what are made from the distance of a low and/or a high in relationship to the real body as created by the open and the close. They can really illustrate the market's denial of a support or resistance level. Long shadows or tails or wicks that form after a long downtrend in dicate a potential that the trend has exhausted itself and that demand is in creasing or supply is dwindling. Shadows formed at the tops of real bodies, especially after a long price advance, indicate that demand is drying up and supply is increasing. The overall size of shadows is important to watch in relationship to a real body and they can be easily identified.

Size or Length of the Overall Candle

A long real-body candle is hard to miss using the color-coded method of candle charts. An extraordinarily long-ranged candle that opens at the bot tom and closes at the high would be an abnormal occurrence and has sig nificant meaning. After a long downtrend, seeing this formation indicates that a major trend reversal is taking place. After a long uptrend, seeing an unusually long candle that closes above the open or a positive value would indicate that an exhaustion, or a blow-off-top condition, may exist. The re verse is true in downtrends; after a long price decline, a tall red or dark can dle represents the market closing below the open or a negative assigned value and may indicate that a capitulation or exhaustion bottom has formed. After a long uptrend or price advance, if that same candle was formed, it might indicate that a major trend reversal is occurring.

The candle development will give us immediate identification of the current market's environment and the market participants' acceptance or rejection of a support or resistance level in a clearly visual manner. Pay

special attention to the shadows and closes of ranges in relationship to past highs or lows and to where the market closes.

The Doji

The secret weapon of candlestick charting is the doji. Dojis indicate inde cision; the market close ends where it began, on the opening of the time session. Figure 3.3 shows a full-range high and low with the cross mark across the line, representing that the market has no real body as prices closed exactly where they opened. This goes to show that confidence is lost from buyers or sellers on the open because the market made a lot of intra day noise as the range was established. In a bullish or bearish trending mar ket, indecision is the last thing you want to see.

Strong rejection or failure from the high and/or the low is a significant telltale sign that changes are coming. In a strong uptrending market, usu ally the prices will close near a high since larger capitalized traders will hold positions overnight. If the large money traders are not confident that the market will move higher in price, then usually the market closes back near the open.

Traders use the phrasing of Newton 's law in the markets an awful lot because it really applies to market moves. “A body in motion tends to stay in motion until a force or obstacle stops or changes that motion.” I believe and teach that the doji represents that force; it generally stops or changes the motion or momentum due to the uncertainty or indecision that is cre ated at peak and troughs.

Doji formations help confirm reversals. There are different names and nuances associated with certain dojis, such as the gravestone shown in Figure 3.4, the dragonfly shown in Figure 3.5, and the long-legged or rick shaw doji shown in Figure 3.6. All have the same qualities—they close where the session began. After a major trend has occurred, when one of these candles forms, it signals that the trend is near an end or that there is a change in market conditions. What distinguishes the doji from all other

candle formations is that the close of this candle is nearly exactly at the same price as the open. I am generally a little more lenient with this for mation. If after a long-range trading session the close is less than 8 percent of the overall high and low, I consider it a doji. In spot forex markets, if, for example, the British pound had a 150-point range and the market closed within 12 points of the open, I would consider that a doji formation.

Candle patterns can be subjective, and there are many variations to each pattern. The key element to this system is identifying where a market closes in relationship to the prior highs or lows. Certain candles have significant meaning besides the doji. Bearish reversal patterns include dark clouds; engulfing, harami, and harami doji crosses; falling three methods; and evening doji stars. These are all indeed powerful setup chart patterns. The reverse of these are the bullish bottom pattern formations, such as bullish piercing, bullish harami, morning doji star, and even the hammer candle. The candle hammer is what I call the “stop,” or “seek and destroy” action. The bearish version is a shooting star candle.

The Hammer

The hammer shown in Figure 3.7 indicates that a reversal or a bottom is near in a downtrend. When this pattern appears at the top of an uptrend, the name becomes hanging man, and it indicates that a top is near. You

need to know that there are three main characteristics necessary in order for a candle to qualify as a hammer:

1. The real body is at the upper end of the trading range; the color (white or black) is not important.

2. The lower part or the “shadow” should be at least twice the length of the real body.

3. It should have little or no upper shadow, otherwise known as a shaved head candle.

The Shooting Star

One of the single most important bearish candle formations that I wish to share with you is the star, sometimes referred to as the shooting star can dle. It is the inverted formation of the hammer and forms at tops.

The shooting star in Figure 3.8 is the reverse of the hammer, but it forms at the top of an uptrend. It usually signals a major reversal. Here again, the color does not matter, but the body should be at the lower end of the trading range with a long shadow. Its significance is that it shows the market opening near the low of the day, followed by an explosive rally that failed and then closed back down near the low of the day.

Usually there is little or no lower shadow, like a shaven bottom. When it is at the bottom of a downtrend, it is known as an inverted hammer.

The Morning Doji Star

The morning doji star is a major bottom reversal pattern that is a threecandle formation. The first candle has a long black real body; the second candle has a small real body or doji, as shown in Figure 3.9, and gaps lower than the first candle's body. The third candle's body sometimes gaps higher than the second one, but this does not happen often. It is important that it is a white candle and closes well above the midpoint of the first candle's real body.

The Evening Doji Star

The evening doji star shown in Figure 3.10 is the exact opposite of the morning doji star. This is the second-most-bearish top pattern next to the abandoned baby or island top formation.

The Harami

The harami is a small real body within the body of the prior body's candle. This is known as a reversal pattern or a warning of a trend change, espe cially at tops of markets. It is not important that the colors be opposite, but I notice that the more reliable signals are generated when they are. After a long uptrend, if there is a tall white candle, it can indicate an exhaustion especially followed by a small-real-body candle, as shown in Figure 3.11.

Bearish Harami Doji Cross

The bearish harami doji cross shown in Figure 3.12 is a formation that ap pears when a long white candle occurs, signifying that the market has closed above the open with little or no shadows at both ends of the candle; this candle is then followed in the next time period by a doji within the middle of the white candle's real body. This tells me bulls no longer dominate.

Bullish Harami Doji Cross

The bullish harami doji cross in Figure 3.13 is the opposite of the bearish harami. This pattern will form in a downtrending market. The first candle is usually a long dark candle, signifying that the market has closed below the open with little or no real shadows at both ends; a doji then forms during the next trading session.

The Dark Cloud Cover

The dark cloud cover is a bearish reversal signal. Usually it appears after an uptrend. The first white candle is followed by a black candle. The important features here are that the dark candle should open higher than the white candle's high and that the close should pierce well below the midpoint of the white candle's real body, as shown in Figure 3.14.

The Bullish Piercing Pattern

The bullish piercing pattern is the opposite of the dark cloud cover, as you can see in Figure 3.15. It requires that the first candle be a long dark candle and that the second candle gap open lower than the first candle. The other important characteristic is that it closes well above the midpoint of the long dark first candle. Look for 50 percent penetration of the long dark candle.

The Bullish Engulfing Pattern

The bullish engulfing pattern is a powerful setup. Study the pattern as shown in Figure 3.16. It forms when a white candle's real body completely covers the previous black candle's real body. It is also relevant to note that the more “wraps,” or past candles, that are engulfed, the stronger the signal.

The Bearish Engulfing Pattern

The bearish engulfing pattern shown in Figure 3.17 is the opposite of the bullish engulfing pattern. When a black candle's real body completely cov ers the previous white candle's real body and even closes below the prior candle's low, it is a more potent signal. It is also relevant to note that the more “wraps,” or past candles, that are engulfed, the stronger the signal.

Falling Three Methods

The bearish falling three methods is a continuation pattern often used like a bear flag formation. The three little candles usually remain within the range of the first black candle that includes both the real body and the shadow. Some argue that it works with from two up to five candles in the middle. The last dark candle closes below the first candle's close, as Figure 3.18 shows.

Rising Three Methods

Rising three methods is a bullish continuation pattern with the same char acteristics as in the bearish falling three methods but just the opposite. During the beginning stages of an advancing price trend, an unusually long white candle is preceded by three smaller dark or black candles. The three bullish methods pattern needs to stay within the range of the first long white candle. Again, it can have from two up to five candles; but the text book version is three smaller candles, as Figure 3.19 shows. The last white candle shows a powerful advancing white candle that should open above the previous session's close and should close above the first long white candle's close.

Tweezers Tops and Bottoms

The tweezer is a double-top or double-bottom formation that can be dis guised by a few variations. The tweezer top forms after an uptrend followed by two consecutive time periods making an equal high. This signals that there is strong resistance and a short-term top is in place. One variation is that the first day usually consists of a long body candle with a higher close than open (+).

The second day is usually an equal-and-opposite-color real-body candle that has a high equal to the prior day's high. A strong signal exists that a re versal is forming when the second candle's color is the opposite of the first candle's color. A tweezer bottom would be the exact opposite of this formation.

Other variations are called equal-and-opposite or chopstick patterns. In Chinese, it would be called the yin (black or negative close candle) and the yang (white or hollow positive close candle). At times, these real bodies are not perfectly opposite in size, but they should be close.

In Figure 3.20 the tweezer bottom looks more like a pair of thin chop sticks. In Figure 3.21, the tweezer top resembles a pair of fat chopsticks; but notice that the dark candle engulfs the first candle's real body. That is evidence that a top or a peak price has been established. The equal-and opposite formations occur with false breakouts and key reversals; they are powerful signals that should be respected.

Smarter trading The art of day trading Trading Chaos Sane Investing In An Insane World
Beat The Odds In Forex Trading Robert Kiyosaki - Rich Dad, Poor Dad
The Five Rules For Successful Stock Investing Joe DiNapoli - Trading with DiNapoli Levels
Alexander Elder - Trading for a living