the time to mount a good defencesakata and the methods he developed are sometimes known as...

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Copyright © Colin Nicholson

Candlestick Charting Mini-Course

Contents

Page Section

1 Introduction 2 Chart Construction 7 Interpretation of Candle Lines

12 Reversal Patterns 29 Continuation Patterns 34 Resolving Candles into One Line

Introduction Candlestick charting originated in Japan sometime in the seventeenth century with the development of an organised rice market in Osaka.

However, the development of analysis of patterns on candlestick charts is generally ascribed to Munehisa (Sohku) Honma in the mid eighteenth century. Honma used his analysis to enlarge a fortune in the world’s oldest futures market, which originated in 1710. Honma operated out of the port city of Sakata and the methods he developed are sometimes known as ‘Sakata’s Rules’.

Honma’s trading principles gradually evolved into today’s candlestick methodology. While the main use of candlestick charting is still in Japan, Steve Nison wrote a short booklet Understanding Japanese Candle Charts for Merrill Lynch, Pierce, Fenner & Smith in 1990, which outlined the techniques and subsequently elicited extraordinary interest. In 1991, he expanded the original booklet into a book Japanese Candlestick Techniques. This book and CandlePower by Gregory Morris in 1992 have popularised the techniques in the west.

Most technical analysis software will now draw candlestick charts.

Candlestick charts do not display any information that is not already shown on a conventional bar chart. However, they have advantages in being more visually appealing and in making it very easy to see relationships in the data. Their benefit is in terms of the insight afforded into trading psychology — particularly concentrating on the short term. Candlestick charts give some insights into price behaviour that are not captured by other methods. They are of particular use to supplement those other methods, especially for short term trading.

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Chart Construction Candlestick charts may, like bar charts, be drawn for any time period. That is, intra-day (such as five minutes or hourly), daily, weekly, monthly. Steve Nison uses all these time frames and takes the view that the same principles are valid for all time periods. However, this view is not shared by Gregory Morris, who has problems with intra-day charts: ‘Candle patterns reflect the short term psychology of trading, including the decision process that occurs after a market is closed. This is why open and close prices are so important. Using intra-day data without the benefit of a break is questionable at the very least.’ (CandlePower p. 211).

Readers will have to make up their own minds on this point after considering all the material that follows. In this mini course we will not deal with intra-day charts.

Candlestick charts require plotting of an opening, closing, highest and lowest price for a period. These are plotted in a single column in a very distinctive manner. The emphasis in candlestick charting is on the opening and closing prices and the relationship between them.

Data

Open

21

Open

24 High 26 High 26 Low 18 Low 18 Close 24 Close 21

Step 1: Mark Open And Close And Form Candle

A short horizontal line is drawn across one column of chart paper to mark both of these prices. The area of the chart paper column between them is then turned into a rectangle (called the real body), by joining up the left ends of the open and close lines and the right ends of the open and close lines as shown.

26 25 Close 23 22 Open 21 20 19 18

Open Close

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Step 2: Fill In The Candle If Open Was Above Close

If the market closed at a price above the opening price, the real body is left open or white. However, if the market closed below the opening price, the real body is filled in or black.

26 25 24 23 Open lower 22 so leave 21 open. 20 19 18

Open higher so fill in.

Step 3: Mark High and Low and Draw Shadows

The high and low prices for the day are then marked with dots in the centre of the chart paper column and a line drawn from these points to the boundary of the real body. The result is rather like a candle with a wick (called a shadow) on each end.

26 High 25 24 23 22 21 20 19

Low

High Low

There are some other possibilities when drawing candlestick lines:

High and Low and Low equal to open close equal open equal High equal to close

Either the open or the close may be equal to the high or the low. In this case there will not be a shadow at that end of the real body.

The open and the close may be equal. In this case the real body is reduced to a single line. This candlestick line is known as a doji.

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Example The following example demonstrates not only how a candlestick chart is drawn, but how it looks compared to a conventional bar chart. Work through the plots until you understand how the chart was drawn. Data for BHP 27.12.95 to 5.1.96:

Date Open High Low Close

271295 1922.8 1923 1910 1918 281295 1913.4 1914 1904 1909 291295 1906.4 1920 1895 1900 020196 1900.2 1926 1899 1924 030196 1927.6 1955 1927.6 1953 040196 1955.7 1955.8 1934 1942 050196 1941.3 1943.6 1923 1936

BHP– BROKEN HILL PTYCO 271295-050196 1960

1950

1940

1930

1920

1910

1900

1890

27 28 29 1 2 3 4 5

DEC 95 JAN 96

BHP– BROKEN HILL PTYCO 271295-050196 1960

1950

1940

1930

1920

1910

1900

1890

27 28 29 1 2 3 4 5

DEC 95 JAN 96

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When opening prices are unavailable So far, we have seen how to construct a candlestick chart when we have all the required information. That is, the open, high, low and close prices for the period. However, in some markets it can be difficult to obtain the open price. It is still possible to construct candlestick charts, though with some reservations.

The procedure when the open is not available is to substitute the previous period close for the open price, except:

• When the previous period close is higher than the current period high,

substitute the current period high

• When the previous period close is lower than the current period low, substitute the current period low

This procedure allows you to draw a candlestick chart, and also preserves the gaps. Gaps are called windows in candlestick charting and are an important feature of candlestick charts.

However, the greatest care should be taken when using candlestick charts drawn without availability of the open price. This is because a number of candlestick patterns cannot exist without the actual open price. That is, the previous period close can not be used instead.

For example, the dark cloud cover pattern requires the current period to open above the previous period’s high (note high, not close). If you use the previous period close as the current period open, it can never open above the high of the previous period. The best it can do is open equal to the previous period high, if the previous period closed on the high.

The patterns that cannot exist without an open price according to Gregory Morris are: inverted hammer, dark cloud cover, piercing line, meeting lines, upside gap two crows, two crows, unique three river bottom, kicking, matching low, side by side white lines, three line strike, in neck line. Not all of these will be dealt with in this mini course.

As will be shown later in the discussion, an important part of candlestick analysis is bound up with the psychology of the way people react and make decisions between sessions. The opening of any market reflects all the pent- up emotions that develop overnight. The conclusion must be that candlestick charts can be drawn without the open price, but they must be suspect for pattern analysis. This does not mean that such candlestick charts are entirely useless. Pattern analysis is only part of the candlestick technique. Moreover, many analysts use candlestick charts in place of bar charts, for no other reason than that they show the open close relationship so clearly. They are a particularly graphic way of seeing the common reversal day.

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How candles are represented In the rest of this mini course, candles will be shown as they have been drawn above. However, three other methods will be used in the theoretical diagrams:

means that the candle may be either white or black means that the preceding candles need to be trending

as shown, but the type of candle is not relevant

or means that the candle may be larger in the direction of the dotted outline.

Two types of charts are used in this mini course.

The theoretical charts have been drawn as diagrams and are used simply to demonstrate the theory.

Actual examples are used wherever possible and have been generated using Insight Trader software.

Insight Trader software is written and sold by Dr Bernard Chapman through Insight Trading Pty Ltd PO Box 315 Blaxland NSW 2774 Phone/fax 02 4751 2932.

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Interpretation of Candle Lines Before we look at candle chart patterns, we need to explore the meaning of individual candle lines.

Some candle patterns are made up of only one candle line. We will look at them again later when we look at reversal patterns.

Interpreting the meaning of individual candle lines is the starting point for analysis of candlestick charts. Every type of candle line has its own separate name and carries much information about trading for the period it covers.

We have just mentioned how emotional the opening of a market can be. In fact, all candlestick analysis reflects the short term psychology of the market. As trading develops during a period, emotions will wax and wane and traders will be buffeted between emotional extremes. These extremes are the high and the low prices for the period.

Individual candle lines are often referred to as ‘yin’ and ‘yang’ lines. However, this is strictly Chinese terminology. The Japanese equivalents are ‘inn’ and ‘yoh’.

• ‘Inn’ lines are those with black real bodies and are essentially bearish,

as the close is lower than the open, such that bears have won the session.

• ‘Yoh’ lines are those with white real bodies and are essentially bullish,

as the close is above the open, such that the bulls have won the session.

Long periods and short periods

Long refers to the height of the real body — a large difference between the open and close prices. Of course what is long is a relative term. Candle lines can only be classified as long in the context of the most recent candles on a chart. Only the recent action is considered, as candlestick analysis is essentially short term. Anything up to ten periods will be sufficient.

Short periods are identified using the same procedure as for long periods above. There will be a great number of candles that do not fall into either category.

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Marubozu (close-cropped) These are long candle lines without shadows at either end of the real body, or at the top or bottom of the real body.

Black and White Marubozu

The first sub-type has no shadow at either end of the long real body. The black line shows a very weak market in which the bears have dominated trading. The market opened at a level and buyers were never able to get the price above it. To the contrary, sellers drove the price down for the entire session and so dominated buyers that the market closed on the low for the period. Interpretation depends on the context in which the candle appears: it could be a sell-off period, so it will be bearish in a down trend continuation pattern and bullish in a base reversal pattern. Indeed it is often the first day in a bottom reversal pattern. The white line has the exactly opposite meaning and implications.

Opening and Closing Marubozu

The opening marubozu has no shadow at the open end of the long real body. The white line is bullish, telling us that the market opened at a level and traded higher throughout the session. At no time were the sellers able to get the price below the open, while the buyers were able to get the price higher than the close during the period. The black line is bearish, with the bears in control throughout the period.

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The closing marubozu has no shadow at the close end of the long real body. The white line is bullish, telling us that the bulls were in control during the session and closed the market on the high. The black line is bearish, with the bears in control and able to close the market on the low.

Spinning tops

The spinning top patterns have small real bodies and both the upper and lower shadows are greater than the length of the real bodies. Both the black and the white patterns are considered neutral when they occur in a trading range, as they indicate considerable indecision between both buyers and sellers. This is demonstrated by both bulls and bears being able to move the price to extremes during the session, but they did not have enough conviction to keep it there and the overall result for the period was only a small move.

Doji Doji patterns have the smallest possible real bodies. Either the open and close prices are the same, in the perfect pattern, or they are very close to being equal. The length of the shadows can vary and is not really significant. As with other patterns, the importance of doji patterns is relative to the candle lines leading up to them. If the immediately previous candle lines have small real bodies, even a perfect doji would not be important.

Doji patterns convey an important warning and are ignored at the analyst’s peril. A doji warns of a possible change in trend, especially when following a good up-trending move and a long white day, because it tells us that indecision has emerged. However, this import should be confirmed by bearish patterns following the doji. The doji patterns seem to be less reliable as a warning in a down trend, because up trends must be driven by buying power, but prices can continue to fall through lack of interest. At a suspected bottom, analysts will always look for confirming bullish candles to follow a doji before treating it as a reversal signal.

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Long Legged Doji or Rickshaw Man

The long legged doji has relatively long upper and lower shadows and a minimum real body at or close to the mid point in the range for the period. This pattern tells us that there was a great deal of indecision in the market from all participants.

Gravestone Doji

Here, the minimum real body is at the low for the day. It presages a possible change in trend due to the indecision that arises when the market opens on its low, trades significantly higher during the session, but closes on its low. Obviously, the longer the shadow, the greater the indecision and the more bearish the pattern. It is a particularly powerful signal after a significant up trend.

Dragonfly Doji

In this pattern, the market has opened on its high, traded significantly lower during the period, but closes again at the high. This pattern is very bullish at the end of a down trend.

Four Price Doji

This is a rare pattern in active markets, where all four prices, open, high, low and close, are the same. It will occur most often in thin markets where there is only one trade in the period or in futures markets that are locked at limit up or limit down. Where found in a reasonably liquid market, it represents total uncertainty among both buyers and sellers as to market direction.

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Star

A Star has a small real body that has a gap between its real body and the previous period’s long real body. The shadows from either real body should be within the gap in a perfect pattern, but, as always with candlesticks, the shadows are relatively unimportant and it will not matter if the shadows overlap the real bodies. The colour of the real body of either candle line is also not material. The star implies that there was uncertainty in the market.

Paper umbrella

Paper Umbrella

Paper umbrella candle lines carry strong warnings of a trend reversal, either up trend or down trend. They are very similar to the dragonfly doji. The requirement is a small real body, no upper shadow and a relatively long lower shadow.

The study of individual candle lines tells much about market psychology. Obviously, they will form part of reversal patterns, where they continue to carry the implications noted above.

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Reversal Patterns As already explained, candlestick charting is essentially short term in character. Its strength is in identifying reversals. There are some continuation patterns, which we will look at later and also some larger patterns. However, the strength of candlesticks comes in identifying reversals by analysing patterns comprising from one to several candle lines. There are a lot of them in the literature and we will not be able to discuss them all here. However, we will look at the ones that tend to occur most often and indicate sources for further study.

One of the most important concepts to grasp about candlestick reversal patterns is that the candles that form before the pattern have no role to play in the interpretation of the pattern other than to determine the trend context of the pattern. It is the subsequent candles that confirm or deny the implications of the pattern. However, the immediately prior trend is important in setting up a psychological environment in which the reversal pattern can develop.

Many candlestick reversal patterns have opposites, some with the same name. Their import depends, as we just said, on the prior trend.

The second most important thing to grasp about candlestick reversal patterns is just what ‘reversal’ means. Indeed, the word ‘reversal’ is a poor word, but it is already so strongly rooted in technical analysis that we are stuck with it. Properly understood, a reversal pattern is telling us that the trend is likely to end. This may not mean a change to movement in the opposite direction. It might mean that, but it might equally mean that the price just goes into a trading range. In fact, it is rare for trends to end abruptly and move off immediately in the opposite direction.

A good way to look at the probabilities is this:

• A trend (up or down), when it ends, can develop into either a trading

range or another (opposite) trend.

• A trading range, however, when it ends, can only become a trend.

This is why experienced traders trade break outs from a trading range and have no interest in picking tops and bottoms of the market: They know the probabilities favour development of a trend. Inexperienced traders, on the other hand, try to pick the tops and bottoms of the market, the high and low points in the trends: A large proportion of the time the market will not immediately trend in the opposite direction, but enter a trading range.

So reversal patterns in candlestick charting are only signalling a change to the trending mode, not necessarily a new and opposite trend. After some uncertainty, the trend may well resume. This is akin to the Dow Theory idea of assuming that the trend will continue until there is clear evidence to the contrary.

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However, this discussion must acknowledge that bar and point and figure charting also identify large ‘reversal’ patterns, that signal the start of a new trend. However, these patterns are nearly all trading ranges or combinations of trading ranges. This does not in any way conflict with what we have just discussed: A trend has given way to a congestion area, which itself becomes a reversal signal indicating the direction of the next trend.

Hammer and hanging man

Hanging man Both these patterns have the same

features. A paper umbrella: a small real body at the top of the range, a lower shadow at least twice the length of the real body, no upper shadow, or a very small one and either a black or a white real body.

Hamme r The only difference is where they appear

in the price range: a hammer occurs after a down trend. A hanging man occurs after an up trend. Both warn that the trend may be ending. The real body of both candles may or may not overlap the previous candle.

Patterns will vary in terms of perfection when compared to the idealised diagrams. The ideal diagrams are guidelines rather than rules. In this case, the shorter the real body, the longer the lower shadow and the shorter the upper shadow, the more significant the pattern. Also, a hammer with a white real body will be more bullish than a black real body. Likewise, a hanging man with a black real body will be more bearish than a white real body.

It is desirable to have confirmation of the pattern occur in the next period. However, it is especially important for the hanging man. The hanging man pattern has seen the market open near the high, but sell off sharply during the period, before closing back near the high. The significance of the pattern lies in the vulnerability of the up trend shown by the willingness to sell off. This is a warning of weakness, not a certainty. We need confirmation that the trend is in trouble. The ideal would be for the next period to gap down on the opening and form a black real body. This situation means that all those who bought in the hanging man real body are now in losing positions.

The interpretation of the hammer is that the market opened near the high and sold off, before closing near the high. Had the down trend been healthy, we would have liked to see the sell off sustained. The ideal confirmation will be a

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gap up on the opening and development of a white real body such that all those who sold in the hanging man pattern are now in losing positions.

WBC – WESTPAC BANK 010595-21079556

550

540

53

520

51

A 50

490

1 8 15 22

29 5

B

12 19

26 3

10 17

480 47

MAY JUN JUL 95 In the chart above, we can see two patterns that might be classified as hammers, marked A and B.

A is not perfect, because it has a small upper shadow. It followed a sharp down trend and followed a bullish day. There was confirmation the next day, which gapped up on the open. However, it was not a strong confirmation in that it is a black candle. The second day after the hammer is even more bearish, an opening marubozu, signalling that we were only looking at a rally and that the down trend might resume.

B is even less perfect in that it had a rather larger than desirable real body and a slightly too short lower shadow. However, it followed a significant down move and was confirmed by a near dragonfly doji, which is really a special case of a hammer and therefore extremely bullish. The close-open window was then closed by two short days, before another bullish day appeared and marked the start of a rapid up move.

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NCP – NEWS CORPORATION 101195-28129578

760

A 740

72

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68

66

640

10 13 14 15 16 17 20 21 22 23 24 27 28 29 30 1 4 62

5 6 7 8 11 12 13 14 15 18 19 20 21 22 25 26 27 28 NOV DEC 95

In the chart above, marked A, is a hanging man line. It followed a strong advance. The day following the hanging man confirmed its import, being a doji, whose very small real body was black and entirely below that of the hanging man. Both the hanging man and the doji represent uncertainty. Few up trends can be sustained without conviction on behalf of buyers.

Engulfing pattern The first two patterns we looked at, the hammer and the hanging man are formed in a single candle line. However, most candlestick reversal patterns are formed from more than one candle line. This is the first of them and one of the most commonly found and easy to identify.

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Bullish engulfing Bearish engulfing

Engulfing Patterns

The bullish engulfing pattern follows a down trend and is composed of a black real body followed by a long white real body that is longer than and extends both above and below the first real body. That is, it completely ‘engulfs’ the first real body. The shadows are irrelevant in this pattern. What has happened is that the bulls have completely overwhelmed the bears. The bears have opened the market lower than the previous day and may even have driven it lower at first, but the bulls have taken over and taken the market higher than the previous day’s range and closed it there. The import is for a reversal of the trend. The bearish engulfing pattern is simply the reverse. It follows an up trend and is formed when a long black real body completely covers a white real body. This shows that the bears have taken control of the market from the bulls and a reversal of the trend is signalled.

As has already been emphasised, some latitude must be allowed in defining these patterns. For example, the two exceptions shown below are widely regarded as genuine engulfing patterns:

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These are also engulfing patterns

In the first, a very small black real body has been engulfed. It might also have been a doji. In the second, a doji has been engulfed. It, in turn might also have been a small black body.

Some features that would, if present, increase the likely import of engulfing patterns:

• If the engulfing period has very high volume • If the pattern follows a very fast trending move • A very short real body, engulfed by a very long real body • If the second period engulfs more than one prior real body

The engulfing pattern is one that is very useful in that it signals a reversal that would not be signalled by a bar chart reversal.

First, consider one of the strongest of all bar chart reversals, the key day reversal. This requires a move to a new high and then a close below the previous period’s low. However, an engulfing pattern can develop and give a strong signal, without a key day reversal being present, as shown below:

Notice how the second day opened up on the previous close, but did not make a new high. Nor did it close below the previous low. However, a very strong bearish engulfing pattern has been formed.

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SGB – ST GEORGE BANK 011195-050196770

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In the chart above, there is a very interesting example of a bullish engulfing pattern marked A. The market has run up in November and early December, before gapping down as the stock went ex dividend. It then rallied for three days before coming off for another three days, testing the ex dividend day low. The engulfing pattern then formed, signalling that the low would hold and the up trend would probably resume. This prognosis was confirmed the following day with a bullish closing marubozu.

This chart also makes another important point - That the analyst must be aware of ex dividend days in stocks and contract expiry dates in futures and, if necessary, make adjustments to the charts, or factor this event into the analysis.

Dark cloud cover

Dark cloud cover

Dark cloud cover is a bearish reversal pattern. Thus it only occurs after an up trend. It requires two candle lines: a long white line, followed by a black line that opens near its high and above the upper shadow of the white line and closes near its low and significantly into the range of the white line’s real body. The more the black line’s real body covers the range of the white line’s real body, the stronger the pattern. If it more than covered the white real body, it would be an engulfing line, an even stronger pattern. So the closer it is to an engulfing line, the better.

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Dark cloud cover variation

Also, the closer the black line is to a black marubozu, the stronger the pattern. It follows too, that the stronger the white line, the more significant the pattern. So, Steve Nison suggests that two opposing marubozu would be a very strong reversal signal.

The psychological basis behind the dark cloud cover is that the buyers are strongly in control. Then comes a session in which the market gaps open, indicating that the buyers are still in control. However, they are unable to go on with it and the sellers take control and close it well down into the range for the previous day. Many of those who are long from the previous session are now losing.

All the standard bar chart analysis concepts can be used in conjunction with this pattern, such as the top of the black line being at a resistance level, or the black line developing on heavy volume.

NET – NETCOMM LTD 011195-05019615

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A

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The above chart is interesting for several reasons, including the example of dark cloud cover marked A. This clearly meets the description of following a good up trend and a strong white candle line. The only weakness is that its shadows are rather too long for a perfect pattern. Day A opened much higher than the high of the white line preceding it and closed well down in the range of the white line. Day A turned out to have signalled the end of the trend, the market having gone into a trading range and probably a down trend early in the new year.

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The significance of the dark cloud cover pattern in this case is heightened by reference to the preceding and following action on the chart. The number of small real bodies and four price doji would suggest a thinly traded stock.

However, in mid December the character of trading changed with a strong price movement and significantly larger white candles. This would suggest urgent and aggressive buying. The dark cloud cover pattern was a signal that this buying spree might have finished. Indeed, subsequent action confirmed the import of the pattern, with the chart reverting to its more usual character.

Note also the hanging man that developed two days before the dark cloud cover. The intervening white candle is also interesting as, although it closed higher than the previous closes, the upper shadow failed to make a new high. This already showed some lack of strength from buyers, which was confirmed the following day.

Piercing pattern

Piercing pattern

The piercing pattern is the bullish equivalent of the dark cloud cover. It occurs in a down trend and is a bullish reversal pattern. A piercing pattern requires a black candle in a down trend, followed by a long white candle that opens below the low of the black candle and closes above the mid point of the black real body. There is a slight difference between the requirements of the piercing pattern and the dark cloud cover. In the dark cloud cover, it was only necessary for the second period in the pattern to penetrate significantly into the range occupied by the real body of the first day. In the piercing pattern, it is necessary that the second day close above the midpoint of the first period’s real body.

All the other comments about relative strength of the dark cloud cover apply also to the piercing pattern.

The psychological environment of the piercing pattern is that the bears are enjoying a down trend. A new period opens by gapping down below the previous period’s low. However, there is a change in the balance of supply and demand, such that the bulls take control and close the market well above the previous close. This creates great uncertainty among the bears.

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NCP – NEWS CORPORATION 110696-220896760

740

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A 600

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24 JUN

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AUG 96 The above chart shows a strong piercing pattern at A. Close examination and reference to the underlying data show that day A did open lower than the low of the black marubozu. The white candle is itself a near marubozu and retraced well over half of the previous day’s range.

The action subsequent to the piercing pattern is also interesting and gave clues to what might happen. The day following the pattern was a four price doji, which showed extreme uncertainty. However, of more importance, the doji opened what we will meet later as a window. Subsequent action retested the window but then gapped upward again, confirming that the down trend was over for the time being. As an aside, from classical bar charting you should be able to see several types of gap on this chart and an island cluster reversal pattern.

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The star family of reversal patterns

Star i n an up trend

Star in a down trend

Doji star in a n up trend

Doji sta r in a down trend

The diagram above shows the basic star pattern. The star pattern is formed by a long real body followed by a small real body that has gapped away from the long real body. The colour of either of the real bodies is not important. If the star is a doji, it is called a doji star.

The star is a warning signal of a change in the prior trend. The doji star is a more potent signal than the basic star.

The psychological environment of the star patterns is that there has been a swing in the balance of supply and demand. Uncertainty has entered the market as to its direction. The side that was in command has failed to push the trend further.

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COP – COMEX COPPER 161294-020291544

14

B

14

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136

A 134

132

16 19 20 21 22 23 26 27 28 29 30 2 3 4 5 6

13 9 10 11 12 13 16 17 18 19 20 23 24 25 26 27 30 31 1 2

DEC 94 JAN FEB 95

The chart above shows two stars.

A is a star in a down trend and

B is a star in an up trend.

LEAD – LME LEAD 011295-291295750

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1 4 5 6 7 8 11 12 13 14 15 18

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DEC 95 The chart above shows a doji star in a down trend at A.

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GLD – COMEX GOLD 080595-21069539

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390 B

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8 9 10 11 12 15 16 17 18 19 22 23 24 25 26 29 30 31 1 2 5 6 7

8 9 12 13 14 15 16 19 20 21

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MAY JUN 95 The chart above shows a doji star in an up trend at B.

Specific star patterns

Morning star

Evening star

Doji morn ing star

Doji evening star

In the above diagram, we see the family of specific star patterns. We will look at each one in turn. However, there is one general point to note and that is that the common star pattern is a two candle pattern. That is, it requires only two candles to form it. However the specific star patterns shown in the above diagram all require three candles to form them. We will also find that the colour of some of the real bodies in these patterns is important.

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The morning star The morning star only occurs after a down trend. It is so named because it appears before the sun rises. It requires a long black real body followed by a star of either colour. This star must then be followed by a long white real body that penetrates significantly into the territory occupied by the black real body. Ideally, there will also be a gap from the real body of the star and the real body of the white candle, but this is not essential. The important thing is how far the white candle covers the black candle.

This pattern is a warning that the buyers have taken control of the market. The gap into the small real body tells us that the bears began in control, but could not sustain the move. This is confirmed the following day, which leaves all the bears that opened positions in the period before in a losing trade and under pressure as the market moves higher.

The evening star This is simply the opposite of the morning star in every respect. It is so named because it appears just before darkness sets in.

This pattern demonstrates one of the times when candlestick charting provides a signal not given by conventional bar charting. The evening star is like an island top in bar charting. However, the evening star only requires a gap between the real bodies, not between the highs and the lows as in the island top. The following diagram illustrates this point:

gap gap

Island top Evening star The morning doji star This is the same as the morning star, except that the star is a doji.

The doji evening star This is the exact opposite of the doji morning star.

Doji stars are a very strong alert that the prior trend is likely to change. Remember that doji candles show indecision in the market. Their potency comes from the psychological swing from one side being strongly in control, followed by a dramatic period of indecision about the direction of the market. If the next period gaps against the prior trend, tremendous pressure is exerted

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on those who opened losing trades in the doji day. They are likely to scramble to reverse their trade, exacerbating the reversal.

However, there is a very important caveat in the doji star patterns. The colour of the third candle in the pattern is critical. If it is the opposite of the diagrams, that is, in the direction of the prior trend, instead of against it, the pattern is negated.

The shooting star

This is a two candle pattern and can best be described as a star in the shape of an inverted hanging man. This is a weak reversal pattern.

Shooting star The inverted hammer

Inverted hammer

This is not a star pattern, but is placed here because it is like an inverted shooting star. This pattern most definitely requires confirmation in the period after the pattern as do most bottom reversal patterns.

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Harami in an up trend

Harami in an down trend

Harami cross in an up trend

Harami cross in a down trend

Other reversal patterns We have dealt with the strongest of the candlestick reversal patterns. Doji in general are also strong reversal patterns and were dealt with earlier. There are other reversal patterns, which space does not permit us to deal with in detail. The following brief notes and diagrams should give the basic idea.

Harami (pregnant) The harami implies that the immediately preceding trend is concluded and that the bulls or bears are now in a state of truce. The harami pattern is the reverse of the engulfing pattern. Note that the real body of the second candle must be inside the real body range of the first candle, but the shadows may extend.

. Tweezers Tweezers are two or more candlestick lines with matching highs or lows, i.e. the same price is tested within a few sessions. They are a minor reversal signal that take an additional importance if the two candles also form part of another pattern.

Tweezers bottom with Hammer

Tweezers bottom with Piercing pattern

Basic Tweezers top

Basic Tweezers bottom

Tweezers top with Harami cross

Tweezers top with Hanging Man

Tweezer tops and bottoms can have infinite variety — these are representative.

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Bullish belt hold If the market is at a low price area and an opening marabozu appears, it forecasts a rally. The psychology is that the opposite forces have taken control unequivocally.

Bearish belt hold If prices are high, the appearance of an opening marabozu is a top reversal. The psychology is the same as for the bullish pattern.

Upside gap two crows This is a bearish pattern. Crows are an ill omen to the Japanese. Two black candles at the top of an up trend is bearish.

Three black crows This also is a bearish pattern. Three falling black candles at the top of an up trend is very bearish.

Bul lish Bel t Hold

Bearis h Bel t Hold

Ups ide Gap Two Crows

Three B lack Crows

Larger, longer term patterns There are also other larger, longer term top and bottom patterns that are similar to conventional bar chart reversal patterns, called three Buddha top, inverted three Buddha, three mountains, three rivers, tower tops and bottoms, dumpling tops and fry pan bottoms.

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Continuation Patterns Candlestick analysis is primarily concerned with reversal patterns. However, there is a significant part of the discipline that deals with continuation patterns. Continuation patterns form when the market consolidates in a trading range, before resuming the prior trend. By studying the continuation pattern, it is possible to be expecting a continuation move and be ready to act. More importantly, we can know when the continuation pattern has failed and become a reversal pattern, and act accordingly.

Windows In candlestick charting, a gap in conventional bar charting parlance is called a window. Instead of ‘filling the gap’, we talk of ‘closing the window’ in candlestick terminology.

A window is where there is a gap between the range for one period and the range of the period before it. Thus, in an upward window there will be an un- traded price range between one period’s high and the next period’s low. In a downward window, there will be an un-traded price range between one period’s low and the next period’s high.

Window Window in a down trend

Window in an up trend

Window

It is what happens after a window that is important. Windows are important support/resistance areas. Therefore:

• Candlestick methodology believes that subsequent corrections to the

trend prior to the window will come back to the window, which will act as support/resistance

• Ideally therefore, subsequent action should not close the window, if the

prior trend is to continue

• If the window is closed, however, it may still act as support/resistance and it is the action immediately after it is closed that is critical

• If, after a window is closed, price action is of the character of the prior

trend, then the prior trend is still likely to continue

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• If, however, price action is contrary to the character of the prior trend, then the continuation pattern has failed

Downward continuation

Upward continuation

In the left hand diagram above, we see an upward window. Subsequent action pulls back to the window, but it acts as support and the up trend continues.

In the right hand diagram, we see a downward window that is closed by subsequent action, but there is no follow through by the bulls. Moreover, after the window is closed two very bearish candles appear and the down trend continues.

Break outs from a trading range or an old high/low in the form of a window are seen as important signals in candlestick charting. Where such a break out is in the form of a small black candle, the implications of the break-out are magnified:

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In the chart below we see a number of windows in a down trend:

RIO – RIO TINTO 241094-2911914800

178

176

A 174

B C 1720

1700 D

1680

166

1640 E

162

F 1600

158

24 25 26 27

28 31

1 2 3 4

7 8 9

10 11

14 15 16 17

18 21

22 23 24

25 28

1560

1540

OCT NOV 9

At A we see a small downward window that is immediately tested the following day, but it acts as resistance and the down trend continues.

At B, a larger window emerges, followed by a rally two days later at C that tests the resistance represented by the window. The window is not closed and the down trend continues with yet another window at D.

There is another small window at E and the down trend continues until a last window appears at F.

After this window, the bears open the market sharply down, but the day turns into a disaster for them, trading higher all day and closing on its highs well above the window, forming a very bullish candle. The down trend is over.

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Upside Gap Tasuki

Upside GapTasuki

This is a three candle pattern. The market is in an up trend. A white candle opens a window and is followed by a black candle of similar size that may or may not close the window, but closes under the real body of the white candle. The ideal buying point is the close of the black candle. However, subsequent action is important and the bullish implication is cancelled if the window is subsequently closed and bearish action continues.

Downward Gap Tasuki

Downward Gap Tasuki This is simply the exact opposite of the upside gap tasuki.

Both the upside and the downward gap tasuki patterns are relatively rare.

Win dow

High-price gapping play

High-Price Gapping Play The requirement here is for a sharp up move in the market followed by a trading range near the high for the move, composed of relatively small real bodies. This tells us that the market is undecided. An upside window from the high of the previous candle is a very strong bullish signal.

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Low-price gapping play Low-Price Gapping Play This pattern is the exact reverse of the previous pattern.

Window

WMC – WMC LTD 240892-171192500

480

460

440

420 B C

40 D

A 380

4 31 7

14 21 28

5 12 19 26

E 2 9 16

36 340

AUG SEP OCT NOV 92 The above chart shows an interesting example of the low-price gapping play. The market sold off steadily to A, where there was an aggressive rally ending in a doji. This was followed by a sharp fall for two days. This gave way to eight days of small candles as uncertainty gripped the market as to whether it would retest the low at A. Then came the low-price gapping play as a window was opened with a very strong bearish day that took out the real bodies at A. The market was going lower.

There are other continuation patterns in candlestick methodology, but time precludes us dealing with them here. Moreover, other than windows, they are much less significant in candlestick charting technique than the reversal patterns.

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Resolving Candles into One Line This is an interesting idea from Gregory Morris’s book, CandlePower. What he puts forward is that multiple candle patterns can be resolved into one candle, which generally retains the implications of the overall pattern. This is best demonstrated with an example:

High

Open Close

Low In the diagram above, we have a bullish engulfing pattern. This is a two-period pattern in which the first black candle has its real body ‘engulfed’ by the second period’s white real body.

What we do to resolve it into one candle is to take the two candles as if the two-period pattern was only a single session. Thus:

• The open for the two period session is the open of the first candle.

• The close of the two period session is the close of the second candle.

• The high for the two period session is the highest upper shadow on

either candle

• And similarly for the low. Therefore, as the diagram shows, the bullish engulfing pattern resolves into a hammer, which is also a bullish reversal pattern.

Conclusion This mini course has been designed to give you a taste of what candlestick charting has to offer. Clearly, it offers insights into the behaviour of markets that are not available from conventional charting methods. Candlestick charting is essentially short term in nature and is best used over periods that have discrete breaks between them to capture the psychological effects of decision making between market sessions.

Many technical analysts are now using candlestick charts in preference to conventional bar charts and are using other indicators with them to filter the patterns and provide additional confirmation. This is another whole topic of its own and is beyond the scope of this mini course.

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