Chapter 6:
Introduction to Candlesticks
To understand my strategies in the next section, we need to quickly review price action and the fundamentals of candlestick charts. The Japanese began using technical analysis and some early versions of candlesticks to trade rice in the 17th century. Much of the credit for candlestick development and charting goes to a legendary rice trader named Homma from the town of Sakata, Japan. While these early versions of technical analysis and candlestick charts were different from today’s version, many of the guiding principles are very similar. Candlestick charting, as we know it today, first appeared sometime after 1850. It is likely that Homma’s original ideas were modified and refined over many years of trading, eventually resulting in the system of candlestick charting that we now use.
In order to create a candlestick chart, you must have a data set that contains (1) open price, (2) highest price in the chosen time frame, (3) lowest price in that period, and (4) closing price values for each time period you want to display. The time frame can be daily, 1-hour, 5-minute, 1-minute or any other period you prefer. The hollow (white) or filled (red) portion of the candlestick is called “the body”. The long thin lines above and below the body represent the high/low range and are called “shadows” (also referred to as “wicks” and “tails”). The high is marked by the top of the upper shadow and the low by the bottom of the lower shadow. If the stock closes higher than its opening price, a hollow candlestick is drawn with the bottom of the body representing the opening price and the top of the body representing the closing price. If the stock closes lower than its opening price, a filled (usually red) candlestick is drawn with the top of the body representing the opening price and the bottom of the body representing the closing price.
Candlestick Examples
Compared to other forms of representing price action, many traders consider candlestick charts more visually appealing and easier to interpret. Each candlestick provides an easy-to-decipher picture of price action. A trader can immediately compare the relationship between the open and close as well as the high and low. The relationship between the open and close is considered vital information and forms the essence of candlesticks.
Here is my ninth day trading rule:
Rule 9: Hollow candlesticks, where the close is greater than the open, indicate buying pressure. Filled candlesticks, where the close is less than the open, indicate selling pressure.
Traders can be divided into three groups: buyers, sellers, and the undecided. Buyers want to pay as little as possible and sellers want to charge as much as possible. Their permanent conflict is reflected in bid-ask spreads. “Ask” is what a seller asks for merchandise. “Bid” is what a buyer offers for that merchandise. Prices are created by masses of traders—buyers, sellers, and undecided people. The patterns of prices and volume reflect the mass psychology of the markets. The goal of a successful day trader is to discover the balance of power between buyers and sellers and bet on the winning group. Fortunately, candlestick charts reflect this fight in action. A successful day trader is a social psychologist armed with a computer and charting software. Day trading is the study of mass psychology.
The presence of undecided traders puts pressure on bulls and bears. Buyers and sellers move the prices fast because they know that they’re surrounded by a crowd of undecided traders who could step in and snatch away their deal at any moment. Buyers know that if they think too long, another trader can step in and buy ahead of them. Sellers know that if they try to hold out for a higher price, another trader might step in and sell at a lower price. The crowd of undecided traders makes buyers and sellers more willing to deal with their opponents.
Buyers are buying because they expect prices to rise. Sellers are selling because they expect prices to fall. Buying by bulls pushes markets up, or as I phrase it, “Buyers are in control.” Selling by bears pushes the markets down, or as I express it, “Sellers are in control.” Undecided traders make everything happen faster by creating a sense of urgency among buyers and sellers.
Candlesticks tell us a great deal about the general trend of a stock and the power of buyers or sellers in the market. Candles are always born neutral. After birth, they can grow to become either bearish, bullish or, on rare occasions, neither. When a candle is born, traders do not know what it will become. They may speculate but they do not truly know what a candle is until it dies (closes). After a candle is born, the battle begins. The bulls and the bears fight it out, and the candle displays who is winning. If buyers are in control, you will see the candle move up and form a bullish candle. If sellers are in control of the price, you will see the candle move down and become a bearish candle. You may be thinking that this is all very obvious, but many traders don’t see candles as a fight between buyers and sellers. That little candle is an excellent indicator that tells you who is currently winning the battle, the bulls (buyers) or the bears (sellers).
Candles with large bodies toward the upside, like the figure below, are very bullish. As you can see, it means that the buyers are in control of the price action, and it is likely that they’ll keep pushing the price higher. The candle not only tells you the price, it tells you that the bulls are winning and that they have power.
Bullish Candles
A series of bullish candles shows bulls (buyers) are in control of the price.
On the other hand, bearish candles are any candles that show a bearish body. So what does the bearish candle tell you? It tells you that the sellers are in control of the price action in the market. It tells you that the sellers are currently in control, so buying or a “long” position would not be a great idea.
Red candles that have this big red body mean the open was at a high and the close was at a low. This is a good indicator of a bearishness in the market.
Bearish Candles
A series of bearish candles shows bears (sellers) are in control of the price.
Just by learning to read candlesticks, you will begin to generate an opinion on the general attitude for a stock. This is called “price action”. Understanding who is in control of the price is an extremely important skill in day trading.
A major goal of a serious day trader is to discover the balance of power between bulls and bears and to bet on the winning group. If bulls are much stronger, you should buy and hold. If bears are much stronger, you should sell and sell short. If both camps are about equal in strength, wise traders stand aside. They let the bulls and the bears fight with each other and enter trades only when they are reasonably certain which side is likely to win.
You never want to be on the wrong side of the trade. It is important therefore to learn how to read candlesticks and how to constantly interpret the price action while you are trading.
There are hundreds of imaginatively-named chart patterns that you will find with a Google search including Head-and-Shoulders, Cup-and-Handle, Abandoned Baby, Dark Cloud Cover, Downside Tasuki Gap, Dragonfly, Morning Star, Evening Star, Falling Three Methods, Harami, Stick Sandwich, Three Black Crows and Three White Soldiers. Believe me, I did not make any of these names up. These candlesticks are really out there. As intriguing as their names might be, many of them, in my opinion, are useless and confusing. Therefore, I skip discussing most of them in this book.
In my opinion, trend lines and most charting patterns are quite subjective, and can result from wishful thinking and self-deception. You can draw a trend line across any prices or zones in a way that can change its slope and its message. If you’re in a mood to buy, you can draw your trend line a little steeper. If you feel like shorting and squint at a chart, you’ll “recognize” a Head-and-Shoulders Pattern. None of those patterns are objective, and I am skeptical of claims regarding even classical formations, such as Cup-and-Handle and Head-and-Shoulders. The biggest pitfall with this kind of pattern charting is wishful thinking. Traders will find themselves identifying bullish or bearish patterns depending on whether they’re in a mood to buy or sell.
In the next section, I’ll give you a quick overview of the two most important patterns for day trading (spinning tops and Dojis) and then, in Chapter 7, I will explain how you can trade using these patterns.