Candlestick charting can be traced back to the 1700’s as a tool used for rice trading. One of the great rice traders of the 1800’s, Homma is widely credited for developing the candlestick charting basics used today. In the west, Candlestick Charting has grown in popularity and use, thanks to the efforts of Steve Nisson and Greg Morris. Candlestick charts are visually appealin g and can be a valuable tool in the technicians toolbox as it gives insight into current investor sentiment, allowing for the determination of short term tops and bottoms.
The candle is comprised of two parts, the body and the shadows. The body encompasses the open and closing price for the period. The candle body is black if the security closed below the open, and white if the close was higher than the open for the period. The candlestick shadow encompasses the intraperiod high and low. (Note: In candlestick charting the following periods are often used; 5 min, 15 min, 1 hour, daily and weekly). Long shadows, show that the trading extended well beyond the opening and/or closing price, while short shadows, show that trading was confined closely to the open and/or closing price.
Long, and Short Bodies; Marubozo and Spinning Tops
A long body, is a candlestick with a very long body when compared with other recent candles. White bodies show intense buying pressure, where as black bodies show intense selling pressures. Long white candles are generally bullish, but are also found at blowout tops, so they must be interpreted with surrounding candles. Similar long black candles are generally bearish, but are also found at capitulation bottoms. Long bodies with no upper and lower shadows are called Marubozo’s. Marubozo’s are more powerful than long candles as they show a steady advance (or decline if black)throughout the trading period. A short candle is the opposite of a long candle and usually implies consolidation, as the stock traded in a narrow range during the period. Short candles with long upper and lower shadows are called spinning tops, and are potential reversal signs, as it shows that despite trading in a wide range, the security closed close to the open. A spinning top becomes a doji as the closing price approaches the open price.
Doji’s are powerful reversal indicating candlesticks and are formed when the security opens and closes at the same level, implying indecision in the stock price. Depending on the location and length of the shadows, doji’s can be categorized into the following formations: doji, long legged-doji, butterfly doji, gravestone doji, 4 price doji, etc. Doji’s become more significant when seen after an extended rally of long bodied candles (bullish or bearish) and are confirmed with an engulfing.( a long candlestick formed over the next period which engulfs the doji body). A long legged-doji is formed when the stock opens at a level, trades in a considerable trading range only to close at the same level as it opened. Long legged-doji’s become more powerful when preceded by small candles, as a sudden burst of volatility in a relative unvolatile stock, can imply a trend change is coming. Dragonfly Doji’s are doji’s that opened at the high of a session, had a considerable interperiod decline, then find support to rally back to close at the same level as the open. Dragonfly Doji’s are often seen after a moderate decline, and are bottom reversal indicators when confirmed with a bullish engulfing. Gravestone Doji’s are the opposite of the Dragonfly Doji and are top reversal indicators when confirmed with bearish engulfings. As the name implies, gravestone doji’s look like a gravestone, and could signal impending doom for a stock. 4 price doji’s occur when the stock opens, trades and closes at virtually the same level for the period. These are very rare, except with thinly traded securities.
An engulfing occurs when the candle body engulfs the previous candles body. White engulfing candles are bullish engulfings, where as black engulfing candles are bearish engulfings. Bullish engulfings are commonly found at short term bottoms, where as bearish engulfings at tops. Many candlesticks, such as dojis, hammers, hanging mans need confirmation of a trend change with an engulfing (bullish engulfing at bottoms, bearish engulfings at tops).
Hammers/ Hanging Man
Hammers and hanging man’s are short body candle’s with little or no upper shadow, and a lower shadow at lease twice as long as the candle body. Hammers are formed after declines, and hanging man’s after advances. When confirmed they become powerful reversal signals, especially the hammer. The expression “hammers out a bottom” refers to when after the open, the downtrend in a stock continues, until at some point, enough buying interest is generated, to bring prices close to where they open. Confirmation comes from a bullish engulfing, showing the trader that the up trend is established. The color of the hanging man/hammer is unimportant, but some consider white hammers and black hanging man’s more potent reversal signals.
A gap occurs when a candlestick body doesn’t fall within the range of the previous candlestick body, a more loosely interpreted definition of a gap, requires no overlap between the shadows, making it obvious on a bar chart as well. You will often hear “All Gaps Get Filled”, which is untrue. While the vast majority of gaps do get filled, you can find some charts, where a gap has never filled. Depending on how you define a gap, should base your definition of a gap fill. For instance I consider a gap when 2 bodies don’t overlap, so I wait for a body fill to call the gap close. If one was using the criteria of shadow overlap, a gap fill would occur with a shadow fill. Gaps are typically continuation patterns, and sometimes mark the 50% point of a move. They become more significant as the stock approaches the level of the gap as it often acts as a magnet. During a gap fill, it is considered bearish closing below the bottom of the gap and bullish closing above it. Once formed gap’s will often serve as strong support/resistance levels even after being closed for some time. Exhaustion gaps signify the end of market bottoms and tops, where initially overwhelming buying pressure, is soon consumed by selling pressure (and vice versa for bottoms). Exhaustion gaps have significant volume associated with them, and are often closed within 3 trading days. Sometimes an exhaustion gap will be followed by another gap at the same levels, some examples are shooting stars, doji stars, abandoned baby, etc. These 2 gap formation are powerful reversal signal’s. Three Gap Play occurs when a stock gaps in the direction of the trend for close to 3 consecutive periods, with the final gap is an exhaustion gap that is larger then the previous gaps with respect to size and volume. After the exhaustion gap, the trend changes all of the gaps immediately get filled. After the final gap is filled, the stock turns and continues well beyond the initial exhaustion gap. Although pretty rare, they can be very profitable if recognized early and swing traded.