Candlesticks Alone Are Only Half The Story

Everything old is new again.  Whereas the “Japanese Candlestick” method of financial price display was invented centuries ago for use in the rice trade, it has recently found a new life and acceptance in the Western financial world.  The reasons are primarily twofold: it reveals the underlying psychology of the market to a degree which is unparalleled; and it is exceptionally adept at spotlighting reversals of trend.

The conventional bar chart displays the price movement of a stock, for example, during any given time period, in the form of a straight vertical line or bar.  The top of the bar is the high price of the session; the bottom of the bar is the low price of the session.  The opening price is shown by a little tick on the left-hand side of the bar, while the closing price is shown by a little tick on the right side of the bar.  This is convenient for drawing a chart which connects the closing prices of a series of sessions, but it is rather sterile and seems quite mechanical.  The eye has to “dig into it” to see what it all means.

The Candlesticks goes the bar chart one better, by showing the price difference between the opening price and the closing price as a cylinder.  The bar line is “fattened out.”  Extremes of price travel above and below the opening prices are shown as “shadows,” also called “wicks” or “tails.”  In Candlestick interpretation, the most important part of the session is shown as the cylinder – the distance between the opening price and the closing price.  If the closing price of a given session is lower than the opening price, then the cylinder is filled in, or “black.”  If the closing price is higher than the opening price, then the cylinder is left blank, or “white.”  The cylinder – being the distance between the opening price and the closing price – is known as the “real body” or “body.”

This creates a picture which the eye instantly recognizes and the brain processes.  The picture reveals the psychology of the traders to a degree which the bar chart cannot approach.  It can be fascinating to watch the course of price development in real time, with “streaming data,” and thereby see the ebb and flow of bullish and bearish sentiment as they come to life on the computer screen.  The exact same information is at hand; it is simply presented differently and more intuitively.

There is a difference in the definition of an “outside day” as between the Candlestick method and the “Western,” or “bar chart,” method: Whereas an “outside day” in Western terminology would mean that the entire price range of one day was totally eclipsed by the price range of the following day, in Candle terminology an “outside day” occurs when the real body of one session is eclipsed by the real body of the following session.  The inverse is true with respect to an “inside day.”  Prices represented by the AC

The Candlestick bars also create patterns, whether singly or in combinations of two or of three, which have come to be recognized as predictors of trend reversals.  One of the more prevalent single patterns is the “Shooting Star,” which occurs at the top of a long ascent in prices, usually having gapped above the most recent price range.  This pattern is characterized by a small real body at the very low end of the total price range of the session, and a long upper shadow.  The Shooting Star has bearish implications.  Another frequently-seen pattern, this one of three waves, involves a tall white candle at the top of a long rise in prices, followed by a candle bar with a small real body (sometimes itself a Shooting Star) at or above the real body of the first bar, which in turn is followed by a candle bar featuring a long black real body.  This three-bar pattern is known as the “Evening Star,” and is bearish.  Its inverse is the Morning Star, which is found at the bottom of a long price decline.

Candlestick analysis uses, incorporates, and values all of the “Western” patterns, such as the Head & Shoulders Top, the Triangle, the Double Bottom, the Island Top, and the Gap.

The Candlesticks, by themselves, are remarkably accurate predictors of a change of trend; but they do not predict the extent of the price move following the change.  Good as they are, they are not perfect.  They are an incomplete tool.  Something is still missing.  They can be brought closer to perfection by using them as the base of analysis and then adding a series of Indicators which can tend to confirm or negate the interpretation of the candles from the standpoint of the fundamental psychology of the market.  Some practitioners rely on the candles alone to tell the story.  Others disdain candles and rely upon Indicators.  Others use the candles as the starting point, and then build upon that base by interpreting the meaning of the Indicators, alone or in combination; and some reviewers carry the analysis to its ultimate by observing the relationships between the waves of the indicators as they are depicted on the chart.

This is the point at which technical analysis comes into its own, and is able to forecast the future direction of prices even more accurately than using Candlesticks alone or Indicators alone, or even using the Candlesticks and Indicators together but without analyzing the relationships between the waves.  It proves the old adage that “two eyes are better than one.”  Indeed.  The more tools which are brought to bear in the interpretation of price charts, the more accurate the result is likely to be.