Candlestick Charting Explained

1. Candlestick Charts: Visualizing Market Psychology

Japanese candlesticks offer a quick picture into the psychology of short-term trading, studying the effect, not the cause.

Visual data representation. Candlestick charts, originating from Japan, provide a visually intuitive way to represent price movements, using "candles" to depict the open, high, low, and close prices for a given period. The body of the candle represents the range between the open and close, while the shadows (or wicks) indicate the high and low prices reached during that period. This visual clarity allows traders to quickly grasp the market's sentiment.

Decoding market sentiment. Unlike traditional bar charts, candlesticks emphasize the relationship between the open and close prices, offering insights into the balance between buying and selling pressure. A white (or hollow) body signifies a higher close than open, indicating bullish sentiment, while a black (or filled) body signifies a lower close than open, indicating bearish sentiment.

Beyond data display. Candlestick charting goes beyond simply displaying data; it provides a framework for understanding the psychology driving price movements. By recognizing specific candlestick patterns, traders can gain a deeper understanding of the market's short-term sentiment and potential future direction.

2. Mastering the Language of Single Candle Lines

Each type of candle line has a unique name and represents a possible trading scenario for that day.

Building blocks of analysis. Single candle lines, also known as yin and yang lines, form the foundation of candlestick pattern analysis. Each line represents a specific trading scenario and provides valuable information about the day's price action.

Key single candle lines:

• Marubozu: Long body with no shadows, indicating strong bullish or bearish momentum
• Spinning Tops: Small body with long upper and lower shadows, representing indecision
• Doji: Open and close prices are equal, signaling uncertainty and potential trend change

Understanding market dynamics. By studying the characteristics of single candle lines, traders can gain insights into the interplay between buyers and sellers and the potential shifts in market sentiment. These lines serve as building blocks for recognizing more complex candlestick patterns.

3. Reversal Patterns: Spotting Trend Changes

Japanese candlestick analysis is a valid form of technical analysis and should be treated as such.

Identifying potential turning points. Reversal patterns, formed by one or more candlesticks, signal a potential change in the prevailing trend. These patterns can help traders anticipate market turning points and position themselves for profitable trades.

Examples of reversal patterns:

• Hammer and Hanging Man: Single candlestick patterns with long lower shadows and small bodies, indicating potential bottoms or tops
• Engulfing Pattern: Two-candlestick pattern where the second candle's body completely engulfs the first, signaling a strong reversal
• Morning Star and Evening Star: Three-candlestick patterns that indicate potential bottoms or tops with a "star" (small body) in the middle

Confirmation is key. While reversal patterns can provide valuable insights, it's crucial to seek confirmation from other technical indicators or price action before making trading decisions. This helps to avoid false signals and increase the probability of success.

4. Continuation Patterns: Riding the Momentum

Previous price movement helps to determine only the pattern, not its ability to foresee or anticipate future price movement.

Identifying pauses in the trend. Continuation patterns, unlike reversal patterns, suggest that the current trend is likely to continue. These patterns can help traders identify temporary pauses in the market and position themselves to profit from the continuation of the trend.

Examples of continuation patterns:

• Rising Three Methods and Falling Three Methods: Five-candlestick patterns that show a pause in the trend followed by a resumption of the original direction
• Separating Lines: Two candlesticks of opposite color with the same opening price, indicating a continuation of the prevailing trend

Strategic entry points. By recognizing continuation patterns, traders can identify strategic entry points to add to their existing positions or initiate new trades in the direction of the trend. These patterns provide opportunities to capitalize on the market's momentum.

5. Sakata's Method: A Holistic Approach

Technical analysis is, after all, as much art as it is science. But too many analysts have a mathematical blind spot, and I blame that on computers.

Ancient wisdom for modern markets. Sakata's Method, developed by Munehisa Homma, provides a holistic approach to market analysis that combines candlestick patterns with broader market principles. This method emphasizes the importance of understanding market psychology and the interplay between various factors influencing price movements.

Key components of Sakata's Method:

• Three Mountains (San-zan): Identifying major tops in the market
• Three Rivers (San-sen): Recognizing potential bottoms
• Three Gaps (San-ku): Using gaps in price action to time entry and exit points
• Three Soldiers (San-pei): Recognizing strong trends with consecutive candlesticks
• Three Methods (San-poh): Identifying pauses in market action

Combining art and science. Sakata's Method recognizes that market analysis is both an art and a science, requiring a blend of technical skills and intuitive understanding. By incorporating these principles, traders can gain a more comprehensive perspective on the market.

6. Filtering: Enhancing Reliability with Western Tools

Japanese candlestick analysis used with other technical/market indicators will improve your performance and understanding of the markets.

Combining Eastern and Western techniques. Candlestick pattern filtering involves using Western technical indicators to confirm or refine candlestick signals, improving their reliability and accuracy. This approach combines the visual insights of candlesticks with the quantitative analysis of Western tools.

Popular filtering indicators:

• Relative Strength Index (RSI): Measures the magnitude of recent price changes to evaluate overbought or oversold conditions
• Stochastics: Compares the closing price to its price range over a given period
• Moving Averages: Smooth out price data to identify trends

Reducing false signals. By requiring confirmation from other indicators, candlestick filtering helps to reduce false signals and increase the probability of successful trades. This approach provides a more robust and reliable trading strategy.

7. Trading with Candlesticks: A Practical Guide

Good journalists are supposed to maintain an open mind about the stories they cover... And successful financial reporters should avoid being either bullish or bearish.

Candlesticks for traders. Candlestick charting is more valuable to traders than to investors because the short-term strength of candlesticks merges well with the cyclical nature of pattern trading.

Key considerations for traders:

• Identify pivot points: Recognize key support and resistance levels
• Read the message: Understand the sentiment and momentum conveyed by candlestick patterns
• Confirm with other indicators: Use Western technical tools to validate candlestick signals
• Manage risk: Implement appropriate stop-loss orders and position sizing strategies

Trading is opportunistic. Trading is anticipating a potential price action, positioning to enter the early stage of the trade, adding to it as it develops, and then exiting as it matures and sets up a reversal. Trading also involves lots of reversals, and this is where candles shine the brightest.

8. The Importance of Location and Context

Candle Patterns need to be defined within parameters that people can understand and use in their everyday analysis.

Location, location, location. The effectiveness of candlestick patterns depends heavily on their location within the broader market context. A signal that appears at a key support or resistance level is far more significant than one that occurs in the middle of a trend.

Contextual analysis:

• Identify the prevailing trend: Determine whether the market is trending up, down, or sideways
• Recognize key support and resistance levels: Identify areas where prices have previously reversed
• Consider the proximity to major events: Factor in upcoming news releases or economic data that could impact the market

Interpreting signals in context. By considering the location and context of candlestick patterns, traders can filter out noise and focus on the most relevant and reliable signals. This approach leads to more informed trading decisions.

9. Understanding the Message: Beyond Pattern Recognition

An attempt to take the subjectivity out of Japanese candlesticks analysis will be primary thrust of this book.

Decoding the language of candles. While memorizing candlestick patterns is helpful, it's even more important to understand the underlying message they convey. This involves recognizing the sentiment, emotion, and momentum reflected in the shape and color of the candlesticks.

Key elements of candlestick interpretation:

• Body size: Indicates the strength of the buying or selling pressure
• Shadows: Reflect the volatility and range of price movement
• Gaps: Signal sudden shifts in market sentiment

Beyond rote memorization. By focusing on the message rather than simply memorizing patterns, traders can develop a deeper understanding of market dynamics and make more informed trading decisions.

10. Integrating Candlesticks with Western Techniques

Japanese Candlesticks are the perfect form of technical analysis for the 1990s... It will be a period that embraces a kind of hybrid Eastern philosophy and Western practicality without all the New Age hocus-pocus.

Combining the best of both worlds. The most effective approach to market analysis involves integrating Japanese candlestick charting with Western technical techniques. This allows traders to leverage the visual insights of candlesticks with the quantitative analysis of Western tools.

Strategies for integration:

• Use Western chart patterns to identify key support and resistance levels
• Employ candlestick patterns to confirm or refine entry and exit points
• Utilize technical indicators to filter out false signals and identify overbought or oversold conditions

A holistic approach. By combining Eastern and Western techniques, traders can gain a more comprehensive and nuanced understanding of the market, leading to more profitable trading decisions.

Last updated: March 3, 2025