CANDLESTICK charting has stood the test of time, with Japanese rice merchant Munehisa Homma (1724-1803) credited as its founder. As a model of price movements, candlesticks are an elegant means of displaying complex information. The candle or “real body” marks a price’s opening and closing positions for a given time period, while the thin wick or “shadow” marks the highest and lowest prices reached in that time. If the price closed lower than it opened, the candle is red; it is green if it closed higher (see graphic, below).
David Jones of IG Index says candlesticks let traders see very quickly who won the battle on the day, the bulls or the bears, based on the colour. “They are a more useful approach than looking at the traditional high/low, open/close format of bar charts,” says Jones, “which were the default option for many years.” Line and bar charts just don’t cut it for short-term traders – they “need more information when it comes to deciding on which way to trade and where to place stop losses.”
CMC’s Michael Hewson thinks the size of the real body – the area between the open and the close of the candle – can give us important clues of market sentiment. He explains that this is the area where most of the trading activity has occurred and is therefore sometimes known as the true value area. Because of the distinction between an uptrend (green) and downtrend (red), the “colour of the real-body can quickly underline the directional changes in any given market over any given time frame.” Hewson explains: “The smaller the real body the weaker the candle – typically this is when the market consolidates and uncertainty exists – with traders squaring positions and looking for a potential reversal or corrections.”
IN THE SHADOWS
Big shadows can tell traders a lot about the extent of intra-period moves, says Michael van Dulken of Accendo Markets, and whether sentiment changed markedly during the period. Ian O’Sullivan of Spread Co says long shadows at the bottom of the candle show that during the day the bears pushed prices lower, but the bulls retook control and pushed the candle back higher to close, (or even above the opening price). He says “this can often be a very bullish sign if at a bottom of a slide, signalling a bullish reversal.” Candles with long lower tails are known as bullish hammers. On the opposite side, it can be bearish if at the top of a rally the prices push higher, then are pushed lower leaving a long upper shadow, says O’Sullivan, “hence the bearish hammer name given to this kind of formation.”
EGGS AND BASKETS
Candlestick charts sometimes give too much information, says van Dulken, getting too busy when moving averages and trendlines are added. This, he says, can draw focus away from underlying trends, which may be more easily visible on a standard closing price line chart. He also notes that traders will often still need to look at an intra-period chart to see if the low or high was at start or end of the period.
Hewson is a champion of candlestick analysis, but says: “Predicting trend changes has always been a tricky process and candlestick analysis is primarily about identifying trend exhaustion.” Experts agree candles should be used with other charting techniques.
Homma, the acknowledged founder of candlestick charting, is regarded by some as the most successful trader in history, every year raking in pounds by the billion. Both a lucrative and enlightening discovery.