CANDLE CHARTS
Learning objectives
After studying this chapter the student should be able to understand:
• Types of charts
• The candlestick analysis
• Pattern Psychology – investors’ psychology behind formation of candlestick pattern
2.1 The charts
What is a chart?
Charts are the working tools of technical analysts. They use charts to plot the price movements of a stock over specific time frames. It’s a graphical method of showing where stock prices have been in the past.A chart gives us a complete picture of a stock’s price history over a period of an hour, day, week, month or many years. It has an x-axis (horizontal) and a y-axis (vertical). Typically, the x-axis represents time; the y-axis represents price. By plotting a stock’s price over a period of time, we end up with a pictorial representation of any stock’s trading history.A chart can also depict the history of the volume of trading in a stock. That is, a chart can illustrate the number of shares that change hands over a certain time period.
Types of price charts:
1. Line charts
“Line charts” are formed by connecting the closing prices of a specific stock or market over a given period of time. Line chart is particularly useful for providing a clear visual illustration of the trend of a stock’s price or a market’s movement. It is an extremely valuable analytical tool which has been used by traders for past many years.
2. Bar chart
Bar chart is the most popular method traders use to see price action in a stock over a given period of time. Such visual representation of price activity helps in spotting trends and patterns.Although daily bar charts are best known, bar charts can be created for any time period -weekly and monthly, for example. A bar shows the high price for the period at the top and the lowest price at the bottom of the bar. Small lines on either side of the vertical bar serve to mark the opening and closing prices. The opening price is marked by a small tick to the left of the bar; the closing price is shown by a similar tick to the right of the bar. Many investors work with bar charts created over a matter of minutes during a day’s trading.
NIFTY (Daily) Bar Chart
3. Candlesticks
Formation
Candlestick charts provide visual insight to current market psychology. A candlestick displays the open, high, low, and closing prices in a format similar to a modern-day bar-chart, but in a manner that extenuates the relationship between the opening and closing prices. Candlesticks don’t involve any calculations. Each candlestick represents one period (e.g., day) of data. The figure given below displays the elements of a candle.
A candlestick chart can be created using the data of high, low, open and closing prices for each time period that you want to display. The hollow or fi lled portion of the candlestick is called “the body” (also referred to as “the real body”). The long thin lines above and below the body represent the high/low range and are called “shadows” (also referred to as “wicks” and “tails”). The high is marked by the top of the upper shadow and the low by the bottom of the lower shadow. If the stock closes higher than its opening price, a hollow candlestick is drawn with the bottom of the body representing the opening price and the top of the body representing the closing price. If the stock closes lower than its opening price, a fi lled candlestick is drawn with the top of the body representing the opening price and the bottom of the body representing the closing price.Each candlestick provides an easy-to-decipher picture of price action. Immediately a trader can see and compare the relationship between the open and close as well as the high and low. The relationship between the open and close is considered vital information and forms the essence of candlesticks. Hollow candlesticks, where the close is greater than the open, indicate buying pressure. Filled candlesticks, where the close is less than the open, indicate selling pressure. Thus, compared to traditional bar charts, many traders consider candlestick charts more visually appealing and easier to interpret.
NIFTY (Daily) Candlestick Chart
Why candlestick charts?
What does candlestick charting offer that typical Western high-low bar charts do not? Instead of vertical line having horizontal ticks to identify open and close, candlesticks represent two dimensional bodies to depict open to close range and shadows to mark day’s high and low.For several years, the Japanese traders have been using candlestick charts to track market activity. Eastern analysts have identifi ed a number of patterns to determine the continuation and reversal of trend.These patterns are the basis for Japanese candlestick chart analysis. This places candlesticks rightly as a part of technical analysis. Japanese candlesticks offer a quick picture into the psychology of short term trading, studying the effect, not the cause. Applying candlesticks means that for short-term, an investor can make confi dent decisions about buying, selling, or holding an investment.
2.2 Candlestick analysis
One cannot ignore that investor’s psychologically driven forces of fear; greed and hope greatly influence the stock prices. The overall market psychology can be tracked through candlestick analysis. More than just a method of pattern recognition, candlestick analysis shows the interaction between buyers and sellers. A white candlestick indicates opening price of the session being below the closing price; and a black candlestick shows opening price of the session being above the closing price. The shadow at top and bottom indicates the high and low for the session.Japanese candlesticks offer a quick picture into the psychology of short term trading, studying the effect, not the cause. Therefore if you combine candlestick analysis with other technical analysis tools, candlestick pattern analysis can be a very useful way to select entry and exit points.
2.2.1 One candle patterns
In the terminology of Japanese candlesticks, one candle patterns are known as “Umbrella lines”. There are two types of umbrella lines - the hanging man and the hammer. They have long lower shadows and small real bodies that are at top of the trading range for the session. They are the simplest lines because they do not necessarily have to be spotted in combination with other candles to have some validity.
2.2.1.1 Hammer
Hammer is a one candle pattern that occurs in a downtrend when bulls make a start to step into the rally. It is so named because it hammers out the bottom. The lower shadow of hammer is minimum of twice the length of body. Although, the color of the body is not of much signifi cance but a white candle shows slightly more bullish implications than the black body. A positive day i.e. a white candle is required the next day to confirm this signal.
Criteria
1. The lower shadow should be at least two times the length of the body.
2. There should be no upper shadow or a very small upper shadow.
3. The real body is at the upper end of the trading range. The color of the body is not important although a white body should have slightly more bullish implications.
4. The following day needs to confi rm the Hammer signal with a strong bullish day.
Signal enhancements.
1.The longer the lower shadow, the higher the potential of a reversal occurring.
2. Large volume on the Hammer day increases the chances that a blow off day has occurred.
3. A gap down from the previous day’s close sets up for a stronger reversal move provided the day after the Hammer signal opens higher.
Pattern psychology
The market has been in a downtrend, so there is an air of bearishness. The price opens and starts to trade lower. However the sell-off is abated and market returns to high for the day as the bulls have stepped in. They start bringing the price back up towards the top of the trading range. This creates a small body with a large lower shadow. This represents that the bears could not maintain control. The long lower shadow now has the bears questioning whether the decline is still intact. Confi rmation would be a higher open with yet a still higher close on the next trading day.
2.2.1.2 Hanging man
The hanging man appears during an uptrend, and its real body can be either black or white. While it signifi es a potential top reversal, it requires confirmation during the next trading session. The hanging man usually has little or no upper shadow.
Soybean Oil-December, 1990, Daily (Hanging Man and Hammer)
Dow Jones Industrials-1990, Daily (Hanging Man and Hammer)
2.2.1.3 Shooting star and inverted hammer
Other candles similar to the hanging man and hammer are the “shooting star,” and the “inverted hammer.” Both have small real bodies and can be either black or white but they both have long upper shadows, and have very little or no lower shadows. Inverted Hammer
Description
Inverted hammer is one candle pattern with a shadow at least two times greater than the body. This pattern is identifi ed by the small body. They are found at the bottom of the decline 23which is evidence that bulls are stepping in but still selling is going on. The color of the small body is not important but the white body has more bullish indications than a black body. A positive day is required the following day to confi rm this signal.
Signal enhancements
1. The longer the upper shadow, the higher the potential of a reversal occurring.
2. A gap down from the previous day’s close sets up for a stronger reversal move.
3. Large volume on the day of the inverted hammer signal increases the chances that a blow off day has occurred
4. The day after the inverted hammer signal opens higher.
Pattern psychology
After a downtrend has been in effect, the atmosphere is bearish. The price opens and starts to trade higher. The Bulls have stepped in, but they cannot maintain the strength. The existing sellers knock the price back down to the lower end of the trading range. The Bears are still in control. But the next day, the Bulls step in and take the price back up without major resistance from the Bears. If the price maintains strong after the Inverted Hammer day, the signal is confirmed.
STARS
A small real body that gaps away from the large real body preceding it is known as star. It’s still a star as long as the small real body does not overlap the preceding real body. The color of the star is not important. Stars can occur at tops or bottoms.
Shooting star
Description
The Shooting Star is a single line pattern that indicates an end to the uptrend. It is easily identifi ed by the presence of a small body with a shadow at least two times greater than the body. It is found at the top of an uptrend. The Japanese named this pattern because it looks like a shooting star falling from the sky with the tail trailing it.
Criteria
1. The upper shadow should be at least two times the length of the body.
2. Prices gap open after an uptrend.
3. A small real body is formed near the lower part of the price range. The color of the body is not important although a black body should have slightly more bearish implications.
4. The lower shadow is virtually non-existent.
5. The following day needs to confi rm the Shooting Star signal with a black candle or better yet, a gap down with a lower close.
Signal enhancements
1. The longer the upper shadow, the higher the potential of a reversal occurring.
2. A gap up from the previous day’s close sets up for a stronger reversal move provided.
3. The day after the Shooting Star signal opens lower.
4. Large volume on the Shooting Star day increases the chances that a blow-off day has occurred although it is not a necessity.
Pattern psychology
During an uptrend, the market gaps open and rallies to a new high. The price opens and trades higher. The bulls are in control. But before the close of the day, the bears step in and take the price back down to the lower end of the trading range, creating a small body for the day. This could indicate that the bulls still have control if analyzing a Western bar chart. However, the long upper shadow represents that sellers had started stepping in at these levels. Even though the bulls may have been able to keep the price positive by the end of the day, the evidence of the selling was apparent. A lower open or a black candle the next day reinforces the fact that selling is going on.
2.2.2 Two candles pattern
2.2.2.1 Bullish engulfing
A “bullish engulfing pattern” consists of a large white real body that engulfs a small black real body during a downtrend. It signifi es that the buyers are overwhelming the sellers
Engulfing
Bullish engulfing
Description The Engulfing pattern is a major reversal pattern comprised of two opposite colored bodies. This Bullish Pattern is formed after a downtrend. It is formed when a small black candlestick is followed by a large white candlestick that completely eclipses the previous day candlestick. It opens lower that the previous day’s close and closes higher than the previous day’s open.
Criteria
1. The candlestick body of the previous day is completely overshadowed by the next day’s candlestick.
2. Prices have been declining defi nitely, even if it has been in short term.
3. The color of the fi rst candle is similar to that of the previous one and the body of the second candle is opposite in color to that fi rst candle. The only exception being an engulfed body which is a doji.
Signal enhancements
1. A small body being covered by the larger one. The previous day shows the trend was running out of steam. The large body shows that the new direction has started with good force.
2. Large volume on the engulfi ng day increases the chances that a blow off day has occurred.
3. The engulfi ng body engulfs absorbs the body and the shadows of the previous day; the reversal has a greater probability of working.
4. The probability of a strong reversal increases as the open gaps between the previous and the current day increases.
Pattern psychology
After a decline has taken place, the price opens at a lower level than its previous day closing price. Before the close of the day, the buyers have taken over and have led to an increase in the price above the opening price of the previous day. The emotional psychology of the trend has now been altered.When investors are learning the stock market they should utilize information that has worked with high probability in the past.Bullish Engulfing signal if used after proper training and at proper locations, can lead to highly profi table trades and consistent results. This pattern allows an investor to improve their probabilities of been in a correct trade. The common sense elements conveyed in candlestick signals makes for a clear and concise trading technique for beginning investors as well as experienced traders.
272.2.2.2 Bearish engulfing
A “bearish engulfing pattern,” on the other hand, occurs when the sellers are overwhelming the buyers. This pattern consists of a small white candlestick with short shadows or tails followed by a large black candlestick that eclipses or “engulfs” the small white one.
2.2.2.3 Piercing
The bullish counterpart to the dark cloud cover is the “piercing pattern.” The first thing to look for is to spot the piercing pattern in an existing downtrend, which consists of a long black candlestick followed by a gap lower open during the next session, but which closes at least halfway into the prior black candlestick’s real body.
Description
The Piercing Pattern is composed of a two-candle formation in a down trending market. With daily candles, the piercing pattern will often end a minor downtrend (a downtrend that lasts between six and fifteen trading days). The day before the piercing candle appears, the daily candle should have a fairly large dark real body, signifying a strong down day.
Criteria.
1. The downtrend has been evident for a good period.
2. The body of the fi rst candle is black; the body of the second candle is white.
3. A long black candle occurs at the end of the trend.
4. The white candle closes more than halfway up the black candle.
5. The second day opens lower than the trading of the prior day.
Signal enhancements
1. The reversal will be more pronounced, if the gap down the previous day close is more.
2. The longer the black candle and the white candle, the more forceful the reversal.
3. The higher the white candle closes into the black candle, the stronger the reversal.
4. Large volume during these two trading days is a signifi cant confi rmation.
Pattern psychology
The atmosphere becomes bearish once a strong downtrend has been in effect. The price goes down. Bears may move the price even further but before the day ends the bulls enters and bring a dramatic change in price in the opposite direction. They fi nish near the high of the day. The move has almost negated the price decline of the previous day. This now has the bears concerned. More buying the next day will confi rm the move. Being able to utilize information that has been used successfully in the past is a much more viable investment strategy than taking shots in the dark. Keep in mind, when you are given privileged information about stock market tips, where you are in the food chain. Are you one of those privileged few that get top-notch pertinent information on a timely manner, or are you one of the masses that feed into a frenzy and allow the smart money to make the profits?
2.2.2.4 Bearish Harami
In up trends, the harami consists of a large white candle followed by a small white or black candle (usually black) that is within the previous session’s large real body.
Description
Bearish Harami is a two candlestick pattern composed of small black real body contained within a prior relatively long white real body. The body of the fi rst candle is the same color as that of the current trend. The open and the close occur inside the open and the close of the previous day. Its presence indicates that the trend is over.
Criteria
1. The fi rst candle is white in color; the body of the second candle is black.
2. The second day opens lower than the close of the previous day and closes higher than the open of the prior day.
3. For a reversal signal, confirmation is needed. The next day should show weakness.
4. The uptrend has been apparent. A long white candle occurs at the end of the trend.
Signal enhancements
1. The reversal will be more forceful, if the white and the black candle are longer.
2. The lower the black candle closes down on the white candle, the more convincing that a reversal has occurred, despite the size of the black candle.
Pattern psychology
The bears open the price lower than the previous close, after a strong uptrend has been in effect and after a long white candle day. The longs get concerned and start profi t taking. The price for the day ends at a lower level. The bulls are now concerned as the price closes lower. It is becoming evident that the trend has been violated. A weak day after that would convince everybody that the trend was reversing. Volume increases due to the profi t taking and the addition of short sales.
2.2.2.5 Bullish Harami
A candlestick chart pattern in which a large candlestick is followed by a smaller candlestick whose body is located within the vertical range of the larger body. In downtrends, the harami consists of a large black candle followed by a small white or black candle (usually white) that is within the previous session’s large real body. This pattern signifi es that the immediately preceding trend may be concluding, and that the bulls and bears have called a truce.
Description
The Harami is a commonly observed phenomenon. The pattern is composed of a two candle formation in a down-trending market. The color fi rst candle is the same as that of current trend. The fi rst body in the pattern is longer than the second one. The open and the close occur inside the open and the close of the previous day. Its presence indicates that the trend is over. The Harami (meaning “pregnant” in Japanese) Candlestick Pattern is a reversal pattern. The pattern consists of two Candlesticks. The fi rst candle is black in color and a continuation of 33the existing trend. The second candle, the little belly sticking out, is usually white in color but that is not always the case. Magnitude of the reversal is affected by the location and size of the candles.
Criteria
1. The fi rst candle is black in body; the body of the second candle is white.
2. The downtrend has been evident for a good period. A long black candle occurs at the end of the trend.
3. The second day opens higher than the close of the previous day and closes lower than the open of the prior day.
4. Unlike the Western “Inside Day”, just the body needs to remain in the previous day’s body, where as the “Inside Day” requires both the body and the shadows to remain inside the previous day’s body.
5. For a reversal signal, further confirmation is required to indicate that the trend is now moving up.
Signal enhancements
1. The reversal will be more forceful if the black candle and the white candle are longer.
2. If the white candle closes up on the black candle then the reversal has occurred in a convincing manner despite the size of the white candle.
Pattern psychology
After a strong down-trend has been in effect and after a selling day, the bulls open at a price higher than the previous close. The short’s get concerned and start covering. The price for the day fi nishes at a higher level. This gives enough notice to the short sellers that trend has been violated. A strong day i.e. the next day would convince everybody that the trend was reversing. Usually the volume is above the recent norm due to the unwinding of short positions.When the second candle is a doji, which is a candle with an almost non-existent real body, these patterns are called “harami crosses.” They are however less reliable as reversal patterns as more indecision is indicated.
2.2.3 Three candle pattern
2.2.3.1 Evening star
The Evening Star is a top reversal pattern that occurs at the top of an uptrend. It is formed by a tall white body candle, a second candle with a small real body that gaps above the fi rst real body to form a “star” and a third black candle that closes well into the fi rst session’s white real body.
Description
The Evening Star pattern is a bearish reversal signal. Like the planet Venus, the evening star represents that darkness is about to set or prices are going to decline. An uptrend has been in place which is assisted by a long white candlestick. The following day gaps up, yet the trading 35range remain small for the day. Again, this is the star of the formation. The third day is a black candle day and represents the fact that the bears have now seized control. That candle should consist of a closing that is at least halfway down the white candle of two days prior. The optimal Evening Star signal would have a gap before and after the star day.
Criteria
1. The uptrend should be apparent.
2. The body of the fi rst candle is white, continuing the current trend. The second candle has small trading range showing indecision formation.
3. The third day shows evidence that the bears have stepped in. That candle should close at least halfway down the white candle.
Signal enhancements
1. Long length of the white candle and the black candle indicates more forceful reversal.
2. The more indecision the middle day portrays, the better probabilities that a reversal will occur.
3. A gap between the fi rst day and the second day adds to the probability of occurrence of reversal.
4. A gap before and after the star day is even more desirable. The magnitude, that the third day comes down into the white candle of the fi rst day, indicates the strength of the reversal.
Pattern psychology
The psychology behind this pattern is that a strong uptrend has been in effect. Buyers have been piling up the stock. However, it is the level where sellers start taking profi ts or think the price is fairly valued. The next day all the buying is being met with the selling, causing for a small trading range. The bulls get concerned and the bears start taking over. The third day is a large sell off day. If there is big volume during these days, it shows that the ownership has dramatically changed hands. The change of direction is immediately seen in the color of the bodies.
2.2.3.2 Morning star
Morning star is the reverse of evening star. It is a bullish reversal pattern formed by a tall black body candle, a second candle with a small real body that gaps below the fi rst real body to form a star, and a third white candle that closes well into the fi rst session’s black real body. Its name indicates that it foresees higher prices.
Description
The Morning Star is a bottom reversal signal. Like the planet Mercury, the morning star, signifi es brighter things – that is sunrise is about to occur, or the prices are going to go higher. A downtrend has been in place which is assisted by a long black candlestick. There is little about the downtrend continuing with this type of action. The next day prices gap lower on the open, trade within a small range and close near their open. This small body shows the beginning of indecision. The next day prices gap higher on the open and then close much higher. A signifi cant reversal of trend has occurred. The make up of the star, an indecision formation, can consist of a number of candle formations. The important factor is to witness the confirmation of the bulls taking over the next day. That candle should consist of a closing that is at least halfway up the black candle of two days prior.
Criteria
1. Downtrend should be there.
2. The body of the fi rst candle is black, continuing the current trend. The second candle is an indecision formation.
3. The third day is the opposite color of the fi rst day. It shows evidence that the bulls have stepped in. That candle should close at least halfway up the black candle.
Signal enhancements
1. Long length of the black candle and the white candle indicates more forceful reversal.
2. The more indecision that the star day illustrates, the better probabilities that a reversal will occur.
3. A Gap between the fi rst day and the second day adds to the probability of occurrence of reversal.
4. A gap before and after the star day is even more desirable.
5. The magnitude, that the third day comes up into the black candle of the fi rst day, indicates the strength of the reversal.
Pattern psychology
While a strong downtrend has been in effect, there is a large sell-off day. The selling continues and bulls continue to step in at low prices. Big volume on this day shows that the ownership has dramatically changed. The second day does not have a large trading range. The third day, the bears start to lose conviction as the bull increase their buying. When the price starts moving back into the trading range of the fi rst day, the sellers diminish and the buyers seize control.
2.2.3.3 Doji
Doji lines are patterns with the same open and close price. It’s a signifi cant reversal indicator.
The Importance of the Doji
The perfect doji session has the same opening and closing price, yet there is some flexibility to this rule. If the opening and closing price are within a few ticks of each other, the line could still be viewed as a doji.How do you decide whether a near-doji day (that is, where the open and close are very close, but not exact) should be considered a doji? This is subjective and there are no rigid rules but one way is to look at a near-doji day in relation to recent action. If there are a series of very small real bodies, the near-doji day would not be viewed as signifi cant since so many other recent periods had small real bodies. One technique is based on recent market activity. If the market is at an important mar ket junction, or is at the mature part of a bull or bear move, or there are other technical signals sending out an alert, the appearance of a near-doji is treated as a doji. The philosophy is that a doji can be a signifi cant warning and that it is better to attend to a false warning than to ignore a real one. To ignore a doji, with all its inherent implications, could be dangerous.The doji is a distinct trend change signal. However, the likelihood of a reversal increases if subsequent candlesticks confi rm the doji’s reversal potential. Doji sessions are important only in markets where there are not many doji. If there are many doji on a particular chart, one should not view the emergence of a new doji in that particular market as a meaningful development. That is why candlestick analysis usually should not use intra-day charts of less than 30 minutes. Less than 30 minutes and many of the candlestick lines become doji or near doji
Doji at tops
A Doji star at the top is a warning that the uptrend is about to change. This is especially true after a long white candlestick in an uptrend. The reason for the doji’s negative implications in uptrend is because a doji represents indecision. Indecision among bulls will not maintain the uptrend. It takes the conviction of buyers to sustain a rally. If the market has had an extended rally, or is overbought, then formation of a doji could mean the scaffolding of buy ers’ support will give way.Doji are also valued for their ability to show reversal potential in downtrends. The reason may be that a doji refl ects a balance between buying and selling forces. With ambivalent market participants, the market could fall due to its own weight. Thus, an uptrend should reverse but a falling market may continue its descent. Because of this, doji need more confirmation to signal a bottom than they do a top.
New Terms
Bull:
An investor who thinks the market, a specific security or an industry will rise.
Bear:
An investor who believes that a particular security or market is headed downward is indicative of a bearish trend. Bears attempt to profit from a decline in prices. Bears are generally pessimistic about the state of a given market.
Bull market:
A financial market of a group of securities in which prices are rising or are expected to rise. The term “bull market” is most often used to refer to the stock market, but can be applied to anything that is traded, such as bonds, currencies and commodities.Bull markets are characterized by optimism, investor confi dence and expectations that strong results will continue. It’s difficult to predict consistently when the trends in the market will change. Part of the difficulty is that psychological effects and speculation may sometimes play a large role in the markets The use of “bull” and “bear” to describe markets comes from the way the animals attack their opponents. A bull thrusts its horns up into the air while a bear swipes its paws down. These actions are metaphors for the movement of a market. If the trend is up, it’s a bull market. If the trend is down, it’s a bear market.
Bear Market
A market condition in which the prices of securities are falling, and widespread pessimism causes the negative sentiment to be self-sustaining. As investors anticipate losses in a bear market, selling continues, which then creates further pessimism.This is not to be confused with a correction which is a short-term trend that has duration shorter than two months. While corrections are often a great place for a value investor to fi nd an entry point, bear markets rarely provide great entry points as timing the bottom is very difficult to do. Fighting back can be extremely dangerous because it is quite difficult for an investor to make stellar gains during a bear market unless he or she is a short seller. Fundamental Analysis: A method of evaluating securities by analyzing statistics generated by market activity such as past prices and volume is defi ned as ‘Fundamental Analysis’. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity.
Morning star:
A bullish candlestick pattern that consists of three candles that have demonstrated the following characteristics:
• The first bar is a large black candlestick located within a defi ned downtrend.
• The second bar is a small-bodied candle (either black or white) that closes below the fi rst black bar.
• The last bar is a large white candle that opens above the middle candle and closes near the center of the first bar’s body.
This pattern is used by traders as an early indication that the downtrend is about to reverse.
Technical Analysis:
This is a method of evaluating securities by analyzing statistics generated by market activity, such as past prices and volume. Technical analysts do not attempt to measure a security’s intrinsic value, but instead use charts and other tools to identify patterns that can suggest future activity
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