Tips on Technicals - Candlestick Charts
| Indicator type: |
Primary charting style, similar to bar charts |
| Used to: |
Plots price action, similar to bar charts |
| Markets: |
All cash and futures, not options |
| Works Best: |
Since it relies heavily on open, high, and low prices it cannot be used on markets that update only once per interval (day, hour, etc.) |
| Formula: |
N/A |
| Parameters: |
N/A |
| Theory: |
Candlesticks are so named because they resemble candles. The wide part is called the "real body." It represents the range between the open and close. When the real body is black (filled in), it means the close was lower than the open. If the real body is white (empty), the close was higher than the open.
The wicks of the candle are called "shadows" and represent the high and low. The shorter the upper shadow on a black body, the closer the open was to the high. A short upper shadow on a white body means that the close was near the high. |
| Interpretation: |
Many candle patterns are similar to those of bar charts but they have several advantages, including their descriptive names. For example, the equivalent of a bearish one-day reversal, where price gaps higher on the open, makes new highs but changes course to end up closing lower, is called a "dark-cloud cover." As its name implies, the market is about to get stormy and investors should make preparations (i.e., sell). Trend lines and other technical indicators that are applied to bar charts are equally valid for candles. However, candlesticks provide an extra dimension. |
Basic Candlestick Shapes
Long Black Body
This represents a bearish period in the market. Prices experienced a wide range, and the market opened near the high and closed near the low of the period.
Long White Body
This is the opposite of a long black body, and represents a bullish period in the market. Again, prices experienced a wide range. However, the market opened near the low and closed near the high of the trading period.
Spinning Tops
These are small real bodies, and can be either black or white. The small body represents a relatively tight range between the open and close for the period. In a trading range environment, spinning tops are neutral, but they may become important as parts of other chart patterns.
Doji Lines
These illustrate periods where the opening and closing prices for the period are the same. The length of the shadows can vary. Doji lines are important in a variety of patterns.
Reversal Indicators
Umbrella lines
These candles can be recognized by two features, a real body at the upper end of the entire trading range, with little or no upper shadow and a lower shadow that is at least twice the length of the real body. The color of the real body is not important.
Umbrellas can be either bullish or bearish depending on where they appear in a trend. If they occur during a downtrend, they are called hammers and are bullish, as in "the market is 'hammering out' a base." If an umbrella appears in an uptrend it's bearish, and is referred to as a hanging man. The latter's ominous name is derived from its look of a hanging man with dangling legs.
Engulfing Patterns
The engulfing pattern is a strong reversal signal, especially after a prolonged trend. It's similar to the western reversal pattern. Only the real body is important in this formation; shadows are virtually ignored.
The bearish engulfing pattern has a black real body that engulfs the prior day's white real body. This pattern is bearish during an uptrend. Conversely, a white body at the bottom of a downtrend that engulfs the prior day's black body is a potentially bullish signal.
Piercing Lines and Dark Cloud Covers
The piercing line is a bullish pattern. This combination is composed of a long black body followed by a white body. The white body should open lower and then close above the center of the black body. Here, the market gaps lower on the opening and then retraces to close above the midpoint of the previous period's black body. If the white body does not "pierce" this halfway point, more weakness can be expected in the market.
As mentioned earlier, the dark cloud cover is a bearish pattern. This is the opposite of a piercing line. A strong white body is immediately followed by a black body. A dark cloud cover must have a black body opening above the high of the previous white body as well as closing below the white body's center.
Upside Gap Two Crows
This is a bearish pattern. After a long white body we see a series of two black bodies. There is an upside gap between the white body and the first black body. Shadows are ignored. The second black body closes lower than the first. Although an upside gap is usually bullish in contemporary western analysis, this pattern is bearish in candles.
Tweezer Tops and Bottoms (Kenuki)
A tweezer formation is simply two lines with matching highs or lows. The tweezer could be composed of candle lines with real bodies and/or dojis, and could occur on consecutive or nearby periods. The pattern is similar to the double top or bottom in traditional western technical analysis.
In a rising market, a tweezer top is formed when the highs, including any upper shadow, match on consecutive or nearby periods. This would be a bearish reversal indicator.
In a falling market, a tweezer bottom is formed when the lows are the same (including any lower shadows). The tweezer is more important when it confirms either another bearish line (for a top) or bullish line (for a bottom).
Stars (Hoshi)
There are various star combinations. All are reversal indicators and are more important after prolonged trends or large moves. A star is a small real body or a doji made on a gap that follows a long real body. Even if the shadows overlap, the formation is still considered a star, since only the real bodies are important.
Morning and Evening Stars
The morning star pattern is a signal of a potential bottom in the market. It is aptly called a morning star because it appears just before the sun rises (in the form of higher prices). After a long black body, we see a downside gap to a small real body. This is followed by a white body that closes above the midpoint of the black body made just before the star. The morning star is similar to a piercing line with a "star" in the middle.
The evening star formation is the reverse of the morning star. Aptly named because it appears just before darkness sets in, the evening star is a bearish signal. Basically, the evening star is similar to a dark cloud cover with a "star" in the middle.
Doji and Shooting Stars
The doji star appears after a prolonged move, and is composed of a gap and a doji line (remember a doji is when the open and the close are the same price). This is often the sign of an impending top or bottom. Doji stars often mark imminent turning points in the market, but more conservative traders should wait for the next day's body to confirm a change in price trend.
The shooting star pattern appears at short-term tops in the market, and is a bearish signal. As its name suggests, the shooting star is a small real body at the lower end of the price range with a long upper shadow.
Harami Lines
This is similar to an inside day in contemporary western analysis. But while an inside day is usually considered neutral, the harami line or cross is an indication of a waning of momentum. The small body of the harami line is contained within the long body directly preceding it. If the harami line is also a doji, it is referred to as a harami cross.
These patterns indicate that the market is at a point of indecision and a trend change, or a reversal, is possible. We have found the harami cross pattern is useful in forecasting trend changes, especially after a long white body in an uptrend.
Meeting Lines (Deai)
Meeting lines occur when the market gaps higher or lower on the open, and then closes unchanged from the previous period. For example, in an uptrend, a white body is followed by a black body, and the closing prices meet. The reverse is true in a downtrend. A meeting line formation indicates that the prior direction of the market is uncertain.
Continuation Indicators
The following candle formations are indications that price trends should continue. Price gaps within the patterns occur in each of these formations:
Upside Tasuki Gap
In a rising market, a white body gaps higher. This is then followed by a black body which opens within the white body, and closes lower, but does not fill in the gap. It is important that any lower shadows also do not fill in the gap. The market should be bought on the close of the black body (as long as the gap was not closed). Normally, the black body would be considered bearish. In this pattern, however, it is viewed as a temporary setback.
Windows (Ku)
A window is the same as a gap in contemporary western analysis. While we say "filling in the gap," the Japanese expression is "closing the window." Our experience is that gaps often become support or resistance areas; windows (i.e., gaps) are viewed in the same context. Shadows are also considered in closing the window.
Rising and Falling Three Methods
This is a rare, but important, candle pattern. The rising method is bullish in an uptrend. A long white body is followed by a pullback via a series of three or so small white or black bodies. Finally, another strong white body, which makes a new high close for the move, completes the formation. The falling method is bearish in a declining market.
Side-by-Side White Lines (Narabiaka)
In a rising market, two white bodies with the same opening prices form on an upside gap. This pattern is bullish and the gap should represent a strong support area. It is especially important as a break from a low price congestion area. However, side-by-side white lines following a downtrend are bearish, and viewed as temporary short covering.
Miscellaneous Doji Indicators
Doji lines reflect indecision. If you see two or more doji lines within a short time in a market where this normally does not occur then a forceful move is possible. Double dojis may foretell an increase in market volatility. Option traders who are confident of price direction could use this signal to buy options (assuming volatility levels are attractive). They could benefit from premium expansion based on increased volatility and a significant price move. For those not confident about the direction of the break, a long straddle or strangle (or similar long volatility plays) may be considered.
Doji days can become support or resistance, usually on a short-term basis. A series of three doji lines after a prolonged move could signal an important top or bottom.
