Candlestick

History of Candlestick Patterns

Candlestick charts have become very popular in the West during the last 25 years.  The irony in this recent fame is that the East had already been successfully using candlesticks to determine future price movements over the last couple hundred years.  Candlesticks were originally used by Japanese traders who were looking to profit in the rice market.  The most renowned trader of his time was Homma Munehisa (aka Soky Homma).  Homma like many wealthy entrepreneurs throughout history had a good mix of smarts with the right timing in order to amass a significant fortune.  When Homma entered the trading business, the secondary or futures market for rice was still in its infancy.  Many traders at the time would use various methods to anticipate future price movements, tracking of the weather was often their favorite.  Homma quickly realized this form of trading with the crowd was never going to lead to real success. So, Homma began tracking four key elements of the rice futures contract: (1) open, (2) high, (3) low, and (4) closing price.  From this Homma used these four data points to construct a visual depiction of the trading day's action.  Unlike traders of today where everyone is able to see candlesticks and react to them accordingly, Homma found his edge and was able to make enormous gains by staying one step ahead of the crowd.  Beyond these four price points Homma also named many of the candlestick formations with war time overtones.  This is because the 200 years leading up to his trading activity, Japan was a developing nation with numerous conflicts throughout the region over territory and politics.  This sort of military environment, transferred over into Homma's interpretation of the market where it was you the trader versus your enemy the market.  The close kinship of the candlestick terms and the military can be seen in the title of formations like belt hold lines, counterattack lines and three white soldiers.  The work that was done by Hommas during the mid to late 1700s was the foundation for the current candlestick methodology used by traders all over the world.

Candlestick Charting

Candlesticks are comprised of two components: (1) body and (2) shadows.  The body represents the price action between the opening and closing price for the trading session.  The shadow represents the high and low of the trading session relative to the opening and closing prices.  Please see the below illustration of a candlestick:

Notice how the price action resembles that of an actual candle, hence the term candlestick.  Candlesticks like any other price drawn on a chart can be displayed in any time frame (tick, minute, daily, weekly, etc.).  In Japan when a security closes lower during the trading session, this is represented with a black body.  While updays are displayed with white bodies.  In the west, we associate green with positive and red with a loss.  Therefore western trading platforms will display positive movement with green candlesticks, while downward moves print red candlesticks.  Below is a chart example of how candlesticks look in a traditional Western trading application:

While the construction and display of candlesticks are governed by strict rules, how to interpret these cluster of candles is often the center of debate.  In order to bring some consistency to the art of candlesticks, they are generally placed in four categories: (1) reversal patterns and (2) continuation patterns.

Candlestick Reversal Patterns

Reversal patterns are formations which go counter to the direction of the primary trend.  Reversals can occur on both long-term and short-term time frames.  The key thing to note about reversal patterns is that they do not turn on a dime.  Securities will often gyrate against recent highs or lows until the strenght of the current move dissipates.  Reversal patterns can be comprised of as few of 1 candle up to dozens.  One of the simpliest candlestick reversal patterns is the hanging man and the hammer.

The long shadow in the candlestick is a clear sign that extreme price levels were unsustainable, which resulted in sharp price reactions.  The key with hanging man and hammers, is that they do not create instant changes in price direction.  The process for shifting from one trend to another takes a number of tests and retests.  But these reversal patterns can effectively be used as a red flag for potential changes yet to come.

Candlestick Continuation Patterns

Continuation patterns are breathiers in the direction of the primary trend.  Any movement in the market does not occur in a straight line.  The market requires that price action move back in forth between key support and resistance levels in order to build steam for the next wave up or down.  One of the most challenging technical analysis techniques is to determine when the market is in a consolidation phase or in the beginning of a new primary trend.

Below is the bearish mat hold, which is a bearish continuation pattern.

Notice how there were a number of green bars in the formation, prior to the larger red bar which exceeded the previous swing low.  The key thing to note when trading continuation patterns is that the retracement in the counter direction of the primary trend should be shallow and on light volume.  This weak attempt should then be followed up by an expansion in price and volume of the primary trend.