Candlestick charting originated from the land of the rising sun over five centuries ago in the late 1600s when the Japanese began applying technical analysis to trade rice on the Dojima Rice Exchange. Munehisa Homma, one of the most famous to have traded on this exchange, used past prices to predict future price movements and generated an enormous amount of wealth. Homma’s trading principles in the rice markets eventually evolved into the candlestick theories used in Japan today.
The open, high, low, and close are needed to draw a candlestick. If the close is higher than the open, the candlestick is hollow, or white. If the close is lower than the open, the candlestick is filled, or black. The hollow or filled (between the open and close) section of the candlestick is called the body while the thin lines above and below the body (representing the period’s entire trading range) are called shadows. The top of the upper shadow represents the high while the bottom of the lower shadow represents the low.
To technicians, the popularity of the candlestick charts stems from its attractive visual representation as opposed to other charting techniques such as the line and bar charts. More information can be observed with a candlestick chart such as the relationship between the open and close as well as the high and low. As such, more analyses can now be performed and additional charting patterns can be used to assist the trader in the decision process. The underlying strength and overall structure of the markets are now more transparent with the aid of candlestick charts.
Types of Formations
The use of candlestick charts provides technicians with a whole new realm of charting analysis. Additional charting patterns can now be analyzed along with the traditional charting patterns, such as the head and shoulders and cup and handle formations. Some of the more popular candlestick formations include:
The most powerful of the long candlesticks is the marubozu formation, which can be white (bullish) or black (bearish). The marubozu formation do not have upper or lower shadows, meaning the low is equal to the open while the high is equal to the close for a white marubozu. When this is the case, in most cases, this indicates that the buyers were in control of the markets from the opening bell to the close. For a black marubozu, the open is equal to the high whereas the low is equal to the close. This usually represents strong selling pressure from the first trade to the last trade.
Candlestick formations with short bodies but long shadows are called spinning tops and represent indecisiveness in the markets. A tug-of-war between the bulls and the bears is under way. Even though the session opened and closed with little movement, prices fluctuated significantly higher and lower throughout the session. Neither the buyers nor the sellers gained an upper hand and the result was a deadlock.
A spinning top following a long white candlestick (e.g. white marubozu) or a long up-trend signals weakness in the buying pressure and a potential reversal may be imminent. On the other hand, after a long decline or a long black candlestick (e.g. black marubozu), a spinning top can pose as a warning sign that the bears have weakened and that a change in trend may be on the horizon.
Long and Short Shadows
Unlike the spinning top in which both shadows are approximately equal, candlestick formations with short bodies, a long upper shadow, and a short lower shadow generally indicate that buyers were in control during the session and drove prices higher until later when the resistance was met and the sellers drove prices down off their highs for a weak close.
In contrast, candlestick formations with short bodies, long lower shadows, and short upper shadows generally indicate that sellers overwhelmed the buyers for most of the session and drove prices lower until later when the buying pressure resurfaced to cause the strong close, creating a long lower shadow in the process.
The doji is considered by many to be one of the most important candlestick formations. To be considered a doji, the open and close are equal. In some cases, the open and close may differ slightly, but not by much. The length of the upper and lower shadows of a doji may vary and the result has different interpretations. A doji by itself is neither bullish nor bearish. Analysis of the direction of the market must be done for the price action preceding the doji formation.
A variation of the doji is the long-legged doji. The difference can be seen in the longer upper and lower shadows. Throughout the trading session, the price was very volatile and traded at large extremes but in the end, little changed as far as the closing price was concerned. These doji are a result of great indifference between the longs and the shorts and the market is at a standoff.
Dragon Fly and Gravestone Doji
Dragon fly doji formations are created when the open, high, and close are equal, creating an upper case T. The formation has a long lower shadow and no upper shadow. In general, for this formation, the sellers dominated trading for most of the session before the buyers came back and pushed prices back to the previous close, at the high.
On the other hand, gravestone doji formations are created when the open, low, and close are equal, creating an inverted upper case T. The formation has a long upper shadow and no lower shadow. In general, for this formation, the buyers dominated trading for most of the session before the sellers came back and pushed prices back to the previous close, at the low.
The implications of both dragon fly doji and gravestone doji, as with all candlestick formations, depend on the preceding price action. For down-trends, black marubozu formations, or at support levels, these formations may be a sign of a potential reversal in the current down-trend. Conversely, for up-trends, white marubozu formations, or at resistance levels, these formations may indicate a reversal of the current up-trend.
There are many different candlestick formations and we have covered only a few in the previous section. On its own, most formations tend to have a neutral bias as to where the market is heading. In order to forecast successfully with candlesticks, the preceding price action must first be analyzed. There are countless candlestick patterns but the most important ones include: