Wayne Thorp recently spoke at the 2015 AAII Investor Conference. For information on how to subscribe to recordings of the presentations, go to www.aaii.com/conferenceaudio for more details.
Bar charts are the mainstay of security charting for most investors. However, over the past few years we have introduced some of the more popular alternative chart types, including equivolume (January 2002 AAII Journal) and point & figure (August and November 2000 AAII Journal; all available at AAII.com).
This article focuses on one of the oldest chart types in existence, Japanese candlesticks, and shows how they can be used to shed light on future price activity.
The roots of candlestick charting can be traced to the rice markets of Japan in the 1700s. During this period, the foundation of this type of technical analysis was laid and evolved into candlestick charts that began being used in the 1800s.
Candlesticks were not introduced to mainstream Westerners until Steve Nison published his book on candlestick charting in 1991, “Japanese Candlestick Charting Techniques” (Prentice Hall Press). The advent of personal computers, along with technical analysis software and Web sites, served to fuel their popularity.
Candlestick charts can be used in various markets, from futures and options to equities.
Patterns and signals from Japanese candlesticks tend to focus on determining trend reversal points without forecasting the magnitude or price objectives of these new trends.
A more in-depth discussion of such patterns will be a subject for future issues. In the meantime, let’s take a closer look at the basic elements of candlesticks.
Candlestick charts can be illuminating, but they can also quickly become tedious if plotted by hand. Fortunately, there are numerous technical analysis and charting software packages and Web sites now available that support candlestick charting. Table 1 lists some of the more popular sources for candlestick charting.
In order to draw candlestick charts, you must have open, high, low, and close price data. Some data services and Web sites only offer high, low, and closing prices. However, if you are creating candlestick charts with a Web site, this will not be a concern. If you are using software and a data source, you will want to be sure your data feed supplies open prices. Without open prices, it is impossible to create true candlestick charts.
Some services can create candlestick charts by substituting the previous day’s close for the opening price. However, this will cause you to miss chart gaps (open windows, in candlestick terminology) that occur when price movements are dramatic enough that the trading range of one day has no prices in common with that of the previous day’s trading range. Based upon volume conditions and the position of the gap relative to the prevailing trend, gaps have different interpretations, although they do represent an important charting tool for both standard bar charts and candlestick charts (for more information on gaps, refer to “When Nothing Says Something: Understanding Price Gaps,” in the May 2002 AAII Journal). The bottom line is that in order to draw meaningful candlestick charts, you will need opening price data.
The easiest way to show how to create a candlestick chart is to relate it to the more widely known bar chart. Both charts portray the open-high-low-close prices. For bar charts, the vertical line depicts the high and the low for the period (day, week, month, etc.). The horizontal line or “tick” to the left of the vertical line is the opening price, while the horizontal line to the right of the vertical line is the closing price. Figure 1 shows a bar chart and a candlestick chart, both of which were created using the same data. Yet even though the numbers are the same, the two charts are distinctly different.
In Figure 1, the main part of the candlestick is the “real body,” which represents the range between the opening and closing price for the period.
When the real body is filled in, in this case in black, it means that the closing price for the period was lower than the opening price
(Figure 2). These black candlesticks are considered bearish in nature, indicating selling pressure.
If the real body is white or empty, it means that the close was higher than the open (Figure 3). The Japanese traditionally colored these candlesticks in red, but since it does not copy well, it is commonly left blank. Some Internet charting services such as BigCharts (www.bigcharts.com) color “white” candlesticks red. These candlesticks are considered to be bullish since they indicate buying pressure.
The thin lines that often stick out from the top and bottom of the real body are the “shadows,” sometimes also called wicks. The shadows represent the extremes in price for the period. For example, on a daily candlestick chart, the top and bottom of the real body represent the open and close price, depending on whether the closing price was above or below the open. In other words, for a white candlestick, where the close is above the open, the top of the real body marks the closing price, while the bottom of the real body represents the opening price for the day. The opposite is true for a black candlestick (where the close is below the open). A shadow above the real body of a white candlestick indicates that prices moved in a range that was above the eventual closing price and a shadow below the real body means that the price range for the day extended below the open.
As illustrated in Figure 1, the shadow that extends above the real body is the upper shadow and the shadow that extends below the real body is the lower shadow.
When looking at candlestick charts, most of the attention is paid to the real body. The shadows or wicks are of secondary importance.
As with bar charts, you will find candlesticks of varying length. In general, however, the longer the real body of the candlestick, the more volatile the price movement for that period.
Candlesticks with short real bodies generally occur in periods of indecision in the market, or during periods of consolidation. These are periods where volume tends to be low and trading ranges slight as the market decides what the next move will be (up or down). It is important to note that candlesticks represent only price movement, meaning that there is no volume element captured in the candlestick itself.
Long white candlesticks represent strong buying pressure. The longer the real body, the further the closing price is above the open. While the general rule is that white candlesticks are bullish in nature, a more complete picture is drawn when viewed in the context of the broader, longer-term trading activity. If a long white candlestick appears after an extended decline in prices, this may mark a potential reversal or the establishment of a support level.
In contrast, long black candlesticks show strong selling pressure. Here, a longer real body means that the close is farther below the open and is indicative of selling pressure. Black candlesticks can appear after a prolonged uptrend that leads to an overbought situation. Such a candlestick may foreshadow a reversal, or mark a level of future resistance.
There are times when there is no upper or lower shadow.
If a candlestick has no upper shadow, it is said to have a “shaven head.”
If a candlestick does not have a lower shadow, it is said to have a “shaven bottom.” Figure 4 shows both a shaved head and shaved bottom candlestick.
There are other times when a candlestick has neither an upper shadow nor a lower shadow. These are called “Marubozu,” illustrated in Figure 4.
A white Marubozu forms when the opening price equals the low for the period and the closing price matches the high price. Here, buyers took control immediately at the open and remained in control throughout the course of the period.
Black Marubozus form when the opening price equals the high price for the period and the close equals the low price. In this case, sellers were in control throughout the period.
On the opposite end of the spectrum from long candlesticks are those with small real bodies, or “spinning tops,” shown in Figure 5. Small real bodies in general reflect little activity—buying or selling—during the period and are a mark of indecision in the market. However, longer shadows indicate that buyers and sellers were active enough to pull prices across a wide range. In the end, however, neither the buyers nor sellers could wrest control from the other and the period ends in a draw, with the opening and closing prices relatively close.
Spinning tops that follow a run-up in prices or a long white candlestick indicate weakness among buyers and a potential reversal or interruption in the uptrend. Likewise, a spinning top following a decline or a long black candlestick may indicate weakness among sellers and a possible reversal in the trend.
The length of the upper and lower shadows are of little importance with spinning tops. What is of greater importance is the narrow range between the opening and closing prices for the period.
A specialized type of spinning top is the “doji.” Whereas spinning tops have a narrow real body, a doji has no real body at all (or very little). This means that the opening and closing prices are essentially the same. Figure 6 shows several doji examples.
The “perfect” doji has the same opening and closing price. However, this rule is not set in stone and, as a result, a doji can have opening and closing prices that are a few ticks apart. Also, note that the upper and lower shadows can be long or short and that a doji does not have to be a perfect cross.
Determining whether a near-doji is actually a doji is a subjective process. It is useful, when attempting to determine whether a doji has occurred, to examine the preceding price activity and candlesticks. If an apparent doji forms after a series of candlesticks with small real bodies, its significance is suspect. Furthermore, the more times doji appear in a given chart, the less likely that any of the doji will provide a meaningful signal.
The biggest strength of doji is in signaling the end of an uptrend, since doji represent indecision in the market. If a doji forms after a prolonged upward move in prices, especially following a long white candle, this is a very strong sign that prices have run their upward course and a reversal may be near. On the other hand, doji are less useful in signaling the bottom of a downtrend.
Candlestick charts are yet another way to present open, high, low, and close price data. By examining this data in a visual format, you can more easily get a feel for the mood of the market.
The usefulness of candlesticks lies in their ability to illustrate the relationship between opening and closing prices and, in turn, their ability to potentially capture the possible direction of prices. In the future, we will touch upon exactly how you can use these charts in your trading.