Basic function of Candlesticks (The power of all chart) – part-01
Basic function of Candlesticks (The power of all chart) is most important for TA world. Lets fine some function of Candlesticks.
A Potted history
Candlesticks have been around a lot longer than anything similar in the Western world. The Japanese were looking at charts as far back as the 17th century, whereas the earliest known charts in the US appeared in the late 19th century.
Rice trading had been established in Japan in 1654, with gold, silver and rape seed oil following soon after. Rice markets dominated Japan at this time and the commodity became, it seems, more important than hard currency. Munehisa Homma (aka Sokyu Honma), a Japanese rice trader born in the early 1700s, is widely credited as being one of the early exponents of tracking price action. He understood basic supply and demand dynamics, but also identified the fact that emotion played a part in the setting of price. He wanted to track the emotion of the market players, and this work became the basis of candlestick analysis. He was extremely well respected, to the point of being promoted to Samurai status. The Japanese did an extremely good job of keeping candlesticks quiet from the Western world, right up until the 1980s, when suddenly there was a large cross-pollination of banks and financial institutions around the world. This is when Westerners suddenly got wind of these mystical charts. Obviously this was also about the time that charting in general suddenly became a lot easier, due to the widespread use of the PC.
In the late 1980s several Western analysts became interested in candlesticks. In the UK Michael Feeny, who was then head of TA in London for Sumitomo, began using candlesticks in his daily work, and started introducing the ideas to London professionals. In the December 1989 edition of Futures magazine Steve Nison, who was a technical analyst at Merrill Lynch in New York, produced a paper that showed a series of candlestick reversal patterns and explained their predictive powers. He went on to write a book on the subject, and a fine book it is too. Since then candlesticks have gained in popularity by the year, and these days they seem to be the standard template that most analysts work from. We are going to leave the history lesson there, because unlike other esteemed experts on Japanese charting method we have never had the privilege of either sitting down with Japanese Expert, nor even going to Japan.
Construction of Candlestick Charts
Candlesticks vs. Traditional Bar Charts
Until the late 1980s the Western world used bar charts as the standard method for charting the markets. A bar chart displays price on the vertical axis and time along the horizontal axis; each bar represents a set time period (ex, 1M, 5M, 15M, 30M, 1H, 4H, a day or a week or a month). For the moment we’ll stick to daily charts. The four pieces of data used in a bar chart are: the day’s open, high, low and close.
Candlestick charts use the same price levels as bar charts (ex, open, high, low, close), but they display the data in a different way – as can be seen in the following figure.
By comparing the bar charts and candlesticks you can see that the principles are similar they both present in a graphical format the essential price data (open, high, low, close) for a given period. Let’s look at an actual example. The figure below shows a standard bar chart, while the following figure is the same chart but this time using candlesticks instead of bars.
By comparing the preceding two charts (Figure 1, 2, you can see that the shape of the charts is the same. Although the overall shape of the charts is the same, the candlestick chart is easier to read because the candles do a much better job of clearly distinguishing the exact relationship between the four prices for each period. For example, it is easy to see whether a period was bullish or bearish (by the color).
The Anatomy of the Candles
Let’s have a closer look at the color scheme used in the candlestick charts. A closer inspection of Figure 2.28 shows that the candlesticks are different colors depending on whether the market closed above or below the open. The fat bit in the middle is the difference between the open and the close, and is called the real body of the candlestick.
A candlestick with a green or white real body is created on a day when the market closed higher than where it opened. In other words price moved higher over the course of the day. This means, if you use the basic principles of supply and demand, there were more buyers than sellers. To put it into the market parlance that I will use from now on, the bulls won the day.
A candlestick with a red or black real body is the result of a day where the market closed below the level at which it opened. This means the sellers outweighed the buyers, or there was more supply than demand, resulting in price moving lower. In market terms it was a bearish day.
So we now know that the difference between the open and the close is called the real body, and that its color depends on whether it was a bullish or bearish day, from open to close. We would stress at this point that the color of a candlestick is nothing to do with where a market closes in relation to the previous day’s close. This is a common mistake that many people make because on quote boards prices are often displayed either as red (black) or green (white) depending on whether the market is higher or lower compared to the previous close.
Let’s finish off this walk through the construction by adding some terminology into the equation. The figure shows the other terminology you need to be aware of with respect to the different elements of an individual candlestick.
The difference between the top of the real body and the high of the day is the upper shadow (sometimes called the upper wick). The difference between the bottom of the real body and the low of the day is the lower shadow (or lower wick).
The Psychology of Charts and Trading
The idea of a chart in the first place is to illustrate where the price of a security has been. Supply and demand sets the price of something, and the chart is a graphical representation of the historical changes in supply and demand, ie, the historical changes in overall thinking towards the product being viewed, as set by buyers and sellers. Technical analysis concerns itself with looking for trends in price, and also looking for signs that these trends are ending or reversing. This is something that candlesticks can do much more quickly and much more clearly than most other technical methods. There are advantages and disadvantages with all types of market analysis, and within technical analysis there are methods that react slowly to changes and therefore don’t suit certain types of trader or analyst, whereas there are other methods that give many more signals but tend not to be so robust. Some prefer this. Candlesticks are often put into the latter category.
Overall, the answer is to combine a few things with your candlestick charts so that you come up with a trading strategy that suits your needs and your personality. Some may even decide that they don’t need to use candlesticks for a specific strategy, but instead just to give a snapshot view of the market minute-by-minute, day by day, or week by week.
Realize that a candlestick pattern is simply a means of reading data on the chart. Whether you trade stocks, Forex, options or futures it is a superior tool for technical analysis. Once you become familiar with the basic candlestick patterns you will quickly assimilate their meaning and easily interpret them.
The patterns are basically intuitive and the learning curve is small. There comes a point where you will recognize market sentiment without even identifying a specific candlestick pattern. No matter what system style or technique you may implement the fact is you will be that much more effective by making candlestick charts your tool of choice.
Candlestick charts are the most widely used for of charting for good reason. With a little practice and help, it is actually the most intuitive process for understanding current and future price action.
Basically we can divide four types of Candlestick patterns. They are
- Bullish Pattern
- Bearish Pattern
- Reversal Pattern
- Neutral Pattern.