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Trading with Japanese Candlestick Charts

Japanese candlestick charts are arguably the most commonly used charts. It has not always been that way. Candlestick charting techniques were only introduced to western traders in the late 70s by Steve Nison.

A bit of history of Candlestick Charting

Candlestick charting was invented by a rice merchant named Munehisa Homma in Kyoto, Japan in the late 1700s. The merchant made a fortune trading rice and rice warehouse receipts, the first futures contract ever, using only historical daily price information that he visualized using what we now call Candlestick Charts. The Japanese Candlestick Charts have since than only been used used by Japanese traders until the American Steve Nison introduced the techniques to the West in the late 70s. He is still the Western authority on Candlestick Charting. You can find out more about him on www.candlecharts.com. I have one of his books:

Japanese Candlestick Charting Techniques
by
Steve Nison



What is a candlestick

A candlesticks is a representation of the open, high, low and close price within a certain time-frame. In that sense it is the same as a bar in a bar chart. The thing that is different about a Candlestick is that the part between the open and close, called the body, is colored. If the open is above the close, or in other words the price was falling, the candle is usually colored black or red. If the the candle was rising it is usually colored white or green. This way it is easy to see if price has been falling or rising.
Wicks and bodies
The body of a candle is the part between the open and the close. A wick is formed when the high or low is formed away from the open and / or close.
Advantages of a candlestick chart over other chart types:
  • A picture says more than a thousand words. 1 candlestick can tell a complete story about a trading session
  • Provides the same information as OHLC bar charts but is more clear. black/red is down white/green is up
  • Provides 4 times more information then a line chart.
  • Reduces noise. By just looking at the daily candles and you can ignore a lot of the intra-day noise and still understand what happened.
There are also disadvantages in trading with candlesticks:
  • Analyzing candlestick charts is more art than science and is subjective in nature. Therefore trading results from one trader to another, trading the same method, can vary substantially.
  • Learning how to trade successfully with candlesticks requires a lot of screen time, although some people pick it up more quickly then others.

What does a candlestick tell us?

A single candlestick tells us about the war between the Bulls and the Bears. It tells us who won or if the battle was undecided. Or in other words: it tells us if there has been more selling or more buying in the market during a specific period of time, or that there has been an equilibrium.
So candlestick patterns tell us:
  • who is gaining ground
  • if there is a turn around in power
  • if there is a break through power
It shows us possible reversals, consolidations, indecisiveness, possible breakouts, etc.

Introduction to basic Candlestick patterns

I will introduce you to some basic candlesticks and combinations of candlesticks. A lot of the terminology used to describe the rational behind the patterns comes from warfare. This is of course due to the fact that the techniques were developed when Japan was just transitioning from a period of constant war to a more unified and prosperous period. I always ask myself the question: Who is gaining ground? The bulls or the bears? It helps me to understand the patterns even if they are not perfect textbook examples. So I suggest you try and do the same and see if that works for you.

Doji or indecision candle
A doji is a candle where the open and close are (almost) exactly the same, while the high and low can be far apart. At the close of the candle there have been no more buyers then sellers. A doji in it self is not a reversal nor a continuation signal. It shows the market is undecided, which means other factors can easily move the market. A doji in a strong trend has a high probability of signaling a continuation, while a doji at or around support and resistance may signal that there is a high probability for a reversal.
Dojis

Hammer
A hammer is a candle that forms after a significant down move. It has a long lower wick and a small body. The story here is that the bears tried to push lower, but failed to maintain their position while the bulls pushed back up. Basically the buyers are communicating they are willing to buy big time at the level where the wick has formed.
Hammer

Shooting star
A shooting star is the exact opposite of the hammer.
Shooting star

Hanging man
A hanging man candle appears after an up trend. It has a long lower wick and a small body. It kinda looks like a hanging man, hence the name. The story here is that the bears pushed lower and the bulls pushed back without making new significant ground. This may have exhausted the bulls. And as they have lost their appetite to fight the markets is more likely to reverse.
Hanging man

Inverted hammer
The inverted hammer is the exact opposite of the hanging man.
Inverted hammer

Engulfing patterns
The engulfing pattern is a reversal pattern that consists of two candles. There is the bearish engulfing and the bullish engulfing pattern. The bullish engulfing pattern appears after a down move. The fist candle is a bearish candle and the second candle is a bullish candle. The second candle has a body that completely engulfs the previous candle. The story here is that the bulls strike back and were able to gain back more ground then they had lost in the previous candle(s). This indicates new buyers stepped in and therefore price is likely to go higher again. Bearish engulfing patterns are the exact opposite.
Bullish and bearish engulfing patterns

Piercing pattern
The piercing pattern is almost the same as the bullish engulfing pattern with the difference that the second bull candle only pierces more then half way into the territory of the last bearish candle. This is a less powerful reversal signal then the engulfing pattern.
Piercing pattern

Dark cloud cover pattern
This is a bearish piercing pattern. It forms after an up trend.
Dark cloud cover

Continuation pattern
Here is a common continuation pattern. I am not sure what to call it but let's call the one outside - three inside - one outside pattern, because that is what it is. The bullish continuation pattern consists of a long bullish candle followed by three smaller inside candles. These can be bullish and bearish. The last candle is again a long bullish candle. The story here is that the market is taking a pause and consolidates before moving on. Again the bearish variant is the same pattern but then in the opposite direction.
Bearish and bullish continuations

Probability not guarantee

Neither of these patterns guarantee the predicted reversal or continuation. They merely tell the story of what is going on in the market right now and what has a high probability of happening next. This is all based on the idea that the market is run by humans and humans are creatures of habit, which makes it likely the patterns keep repeating themselves.

How to find all these candlestick patterns

Looking out for all of these patterns can be a lot of work. I just explained to you 9 patterns, but there are many more. Let's say you only look for these patterns on 10 forex pairs and on 3 time frames (1hr, 4hr, daily). This means you will be on the look out for 270 combinations. For this reason I like to focus on the daily charts only. However if you want to trade more frequently you could use pattern recognition software to help you.
MyFXBook provides an excellent pattern recognition service here. If you make an account you can get notifications via email whenever there is a pattern formation. You can also use the service to train your pattern recognition skills. To speed up the process you can look for patterns on lower time frames like the 1 minute, 5 minutes and 15 minutes. Every time you get a notification email you can check the charts to confirm. By repeating this process over and over again your brain will get used to recognizing the patterns.

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