EXAMPLES OF CANDLE PATTERNS

The broad part of the candlestick line in Exhibit 1 is called the real body. The real body represents the range between the session's open and close. If the close of the session is above the open then the real body is white. If the real body is black the close of the session is lower than the open.

The thin lines above and below the real body are the shadows. These are the session's price extremes. The shadow above the real body is called the upper shadow and the peak of the upper shadow is the high of the session. The shadow under the real body is the lower shadow and the bottom of the lower shadow is the session's low.

Candle lines can be drawn for all time-frames, from intra-day to monthly charts. For example, a 60-minute candle line uses the open, high, low and close of that 60-minute period; for a daily chart it would be the open, high, low and close for the day. On a weekly chart the candle would be based on Monday's open, the high and low of the week and Friday's close.

Notice that the candles to the right have no real bodies. These are examples of doji (pronounced doe-gee). A doji is a candle in which the opening and close are the same. Doji represent a market that is in balance between the forces of supply and demand.

While the candlestick line uses the same data as a bar chart, the colour of the candlestick's real body and the length of the candle line's real body and shadows convey an instant x-ray into who's winning the battle between the bulls and the bears.

For instance, when the real body is black, that means the stock closed below its opening price. This gives you an instant picture of a positive or negative close. Those of us who stare at charts for hours at a time find candlesticks are not only easy on the eyes, they convey strong visual signals sometimes missed on bar charts.

The logo of our firm, which is a spinning top, is “ Helping Clients Spot Market Turns Before the Competition ”. This is because one of the most powerful aspects of candle charts is that they will often provide reversal signals not available with traditional bar charting techniques. Let's take a look at this aspect with a “spinning top.”

As mentioned previously, one of the more powerful aspects of candle charts is the quick visual information they relay about the market's heath. For example, a small real body (white or black) indicates a period in which the bulls and bears are more in a tug of war. The Japanese have a nickname for small real bodies - “spinning tops” -  because of their resemblance to the tops we had as children. Such small real bodies give a warning that the market's trend may be losing momentum. As the Japanese phrase it, the "market is losing its breath."

TH: Has Eastern philosophy permeated itself into the terminology of Candlesticks?

SN: The Eastern philosophy of Yin and Yang is at the very base of Japanese Candlestick charting. Yang is bullish and Yin is bearish. The Japanese have a saying that states that when Yang reaches an extreme, we have stillness. The stillness gives rise to Yin.

This has given rise to a candle pattern called an Evening Star. The Japanese have used their understanding of psychology in the candle patterns. The Evening Star is a bullish candle, which is represented by the tall white candle. The next candle is a small real body, which shows that the market has movingmomentum or shows stillness, which is then followed by the tall black candle, which is the reversal or the Yin.

Many Japanese Candlestick patterns have their origin in the Japanese warrior society and use military analogies, such as 3 White Soldiers. So although the interpretation of the price action in the market is an art of it own, the Japanese Candlesticks have deep roots in the philosophy of the East.

Back in the 1920's technical analysts in the US began writing about the chart pattern we now know as the Head and Shoulder pattern. This particular pattern consists of 3 rallies of which the middle rally is the longest. However, the same pattern is discussed in material dating back much earlier, but it was called the 3 Buddhas pattern. You will often find 3 statues sitting next to each other in the East. The middle Buddha is the biggest and next to it on either side are two small Buddhas.

TH: Can Candle charts be applied to any market in any time-frame?

SN: The Japanese have a saying, which answers that question: The song of a bird is the same everywhere.

Candles can be used on all time frames. 90% of people who attend my seminars are swing traders. I define a swing trader as someone whose trading time-frame ranges from intra-day to up to 3 weeks. Therefore we focus the seminar work on the hourly and the daily chart.

Our institutional clients often want us to focus on the longer-term charts and we use the weekly candle charts for this purpose. Candlestick analysis is a tool more than a method. I teach traders in the big banks around the world how to read the charts using candles and the use of proper risk management through the use of the candle formations.

All of the candle formations have got an inbuilt money management parameter, in that if a certain pattern is forming in the market, the trader will know what will invalidate this particular pattern. He or she can then put his stop loss at this particular exit point.

TH: What are the advantages of candles over bar charts and line charts?

SN: Candlesticks are superior to bar charts in virtually every conceivable way. Candles will spot reversals before bar charts do. The very nature of the candles is that it will warn you of impending reversals before the reversal has even taken place.

Candles offer razor sharp entry to the market and if you use candles with traditional Western technical analysis you gain a real edge. I call it confluence of technical indicators and I teach this extensively in my seminars. If you for example combine candle pattern with, for example, volume thrusts you get a much better signal than if you use volume alone.

An example of this could be the bullish engulfing pattern, where you have a black candle followed by a white candle. This is a reversal pattern, and I will become bullish if the volume is declining on the black candle and increases on the white candle. This shows me the bulls are in control and I can initiate long positions accordingly.

Another added advantage of candle charts is the colours of the actual candle bars. Visually the candle charts will give the trader an instant indication of the bullish or bearish forces at play. Bar charts will not readily give you this.

At the end of my seminars I always ask the delegates if they will ever go back and look at bar charts. So far I have never had anyone raise his or her hands.

Candlestick Analysis

Steve Nison is a busy man. Ever since his first book “Japanese Candlestick Charting Techniques” was published in 1991 he has run his own advisory business, which gives trade recommendations to institutional investors and [[hedge fund]]s. He is also one of the most respected teachers on trading the financial markets, and his seminars are always a sell-out wherever he goes. Since the publication of his first book he has written another two best sellers on Candlestick analysis. His first book is affectionately known as the “modern-day bible” of trading.

Tom Hougaard caught up with Steve Nison during a quiet day in the market.

Tom Hougaard: How did it all start?

Steve Nison: 30 years ago I worked for a commodity broker and advisory service. All my work was based aroundfundamental analysis. Today it is hard to imagine that all investment decisions 30 years ago were based on fundamental research. I knew nothing about technical analysis before I started working in this business and while I studied for my MBA we were not taught anything about charts.

The president of the company however was well frequented with the use of charting. During our meetings with our clients I realised that he used technical analysis to derive his trading recommendations, but he explained the recommendations using fundamental analysis. 30 years ago technical analysis was considered somewhat of a black art that no one with respect for themselves would use.

While fundamental analysis can explain the forces at play in a bull or bear run, psychology will create thevolatility. Fundamental analysis can't explain this.

As John Maynard Keynes said: it is extremely dangerous to have a rational investment policy in an irrational world. I think the president of the company knew better than anyone at the time how to integrate technical analysis into fundamental research.

I started studying everything I could find on technical analysis. Back then we used bar charts and line charts to display price action, and it wasn't until I met another commodity broker some 15 years later that I discovered Japanese Candlestick charts.

In 1987 I met a Japanese broker, and while I was in her office discussing the markets she used an expression describing chart patterns that I had never heard before. She used Candlesticks on her own charts, which is the Japanese tradition, and I really got hooked on this tool immediately.

Unfortunately there was no material written in English whatsoever to aid me, and the next 3 years was spent not only translating books but also making it understandable to Western society. That meant spending a lot of time reading about and coming to understand the philosophy of the East, including the principles of Yin and Yang. I ended up learning a whole lot more than just a charting tool.

Technical analysis is the only way to measure the emotional component of the market. We know that many times an ounce of emotion can be worth a pound of facts. How else to explain the sudden shift in the market without a change in the fundamentals?

A fascinating attribute to candle charts is that the names of the candle patterns are a colourful mechanism describing the emotional health of the market at the time these patterns are formed. If you heard the expression “dark-cloud cover,” would you think the market is in a healthy emotional state? Of course not! This is a bearish pattern and as the name suggest there is darkness over the market.

TH: Did you begin to apply your new-found knowledge immediately?

SN: At the time I worked at Hutton as a commodity advisor. No-one knew I was using Candlestick charts to derive buy and sell signals, and I was extremely successful in my analysis. This fuelled my desire to learn more and more. I had good help from some fine Japanese traders who had used Candles all their trading life. One such trader was Morihiko Goto who told me that his family had used this form of charting for generations.

The Japanese stock market started back in 1870 but rice trading had been around for long before that. Charting the fluctuations of rice prices on the Osaka Exchange probably took place more than 100 years before the opening of the stock market. It is hard to pin down exactly when Candlestick charts came to life.

The retracement levels and their correct usage

While there are many more Fibonacci retracement levels, the ones that you should use are as follows:

38.2% 
By nature of the fact that we are looking for clusters for an entry point, the 38.2% will only be used for the long-term move. E.g. a 38.2% move for the longer term may cluster with the shorter term 50% or 61.8% level.

50%
The buy zone – look to buy 50% pullbacks of the short term move when there is a cluster of support/resistance at the same level.  Granted, 50% is not actually a Fib number to the best of my knowledge. However it works well and it works often. 50% represents the point of equilibrium between buyers and sellers within a trend.

61.8%
The buy Zone – as with the 50% level, you should look to buy 61.8% pullbacks of the short term move but only when this level clusters with other support/resistance at the same point. 61.8% is known as ‘The Golden Ratio’ and is perhaps the most powerful of all Fib retracement levels.

78.6%
This level should not be used for entry.  Rather your stop loss should be placed behind the short term 78.6% retracement level. The reason for this is that the further the price pulls back, the higher the probability that it is actually a reversal as compared to a retracement. Once the price pulls back over 78.6% there is a far higher probability that it will actually retrace the full 100%. Hence, a stop behind 78.6% protects your losses by having a slightly tighter stop that using the 100% level.  This also results in a more favourable reward to risk ratio.

100%
This means that the full move has reversed. Use this for stops only in a situation where you would like a slightly wider stop than the 78.6% or where the 100% adds significantly to the probability of your trade. E.g. It is a major support level.

Note that we do not use the 23.6% pullback, this is simply too small a pullback for a high probability entry point.

Trading Strategy
I use one minute charts on the mini Dow future (YM) as the short term trends are clearer but it does not really matter what you use.  For example I trade the same strategy on Forex with 15m charts and regularly analyse daily charts across a range of markets using the same technique.  Another reason I prefer the 1m chart on the Dow is that I predominantly trade the US open from 2:30pm GMT. While you may of course look at 2, 5 or 15 minute charts, the trends will be less clear and take longer to develop once the market opens. A 1m trend becomes clear very quickly and thus suits my timeframes.

Entry
Enter at the precise point of the cluster i.e. as the price touches it.  Not before and not after.  Only ever trade with the direction of the overall trend.

Your confirmation is the fact that you have a strong cluster within a strong trend.  Do not wait for the price to turn around at this level, by then it is too late.  If you wait for the price to do what you thought it would then you have missed the trade. We are using leading indicators here to predict the move in advance.

Stop
Your stop should be placed behind the 78.6% retracement level.  More conservative traders could place their stop just behind the 100% level but do not have a stop any wider than this.

Target
Your target is the old high/low or the 0% retracement level. I.e., you expect the price to retest the extreme.

A further profit target for those who prefer to scale out of trades is to use Fibonacci extension levels.

Improvements

Other technical factors to consider:

Trend Improvements
• Look for convergence and divergence between price action and indicators to assess trend strength
• Use trend following indicators such as the ADX or DMI
• Assess trends in multiple timeframes

Cluster Improvements
• Look for proven price action support and resistance at the same levels i.e. price has tested and failed at that level before
• Pivot points – a topic for another article perhaps. In my opinion pivots are the most powerful, individual technical tool at our disposal. Find a pivot at the same point as your Fib cluster and you have a VERY high probability trade. This forms the basis of what I call my Precision Trading Strategy. It also happens far more often than you may think.

There are various ways to improve upon the success of this strategy even further. There are thousands of technical tools out there and we can’t use them all but if you have something that is working for you, keep on using it. The Precision Trader philosophy is quite simple – ‘Have as many reasons as you possibly can for every single trade that you place’.  The more reasons you have occurring all at the same time, the higher the probability of the trade been a success. At the end of the day that is all you need… the confidence in your strategy that you have more chance of winning than losing.  And of course the ability to execute precisely according to your rules. Happy trading and best of luck for a very prosperous 2008!

Where the Fib line should Start from

Firstly, you should only draw a Fib retracement level when there is a trend. All trends have to retrace in order for the above definitions to be true i.e. in an uptrend price has to pullback from a HH to make a HL. You are always looking for a retracement of the current trend which ensures you have momentum behind the move. If there is no clear trend then by using Fib retracements you are swimming against the tide even before you even begin.  Fib does not work in ranging markets!  The nature of a ranging market is that it will range between two levels, hence pulling back around 100% of each prior move. 

Now that you are trading with the trend, you should start your Fib line from a HL within an uptrend or a LH within a downtrend.  Refer back to Figure 2. Each HL was a possible start point for your Fib line. You should draw it upwards in the direction of the trend. Equally, in Figure 3, each LH was a place to start a line from and draw downward in the direction of the trend. 

The most important place to start from is:

• The most recent low within a current up-trend.
• The most recent high within a current down-trend

Remember the above points as they are the most crucial steps in applying Fib correctly. This will ensure that you are only looking for retracements of the current trend in the timeframe you are trading.  For example, look at figure 3. We have now reversed the downtrend and are uptrending (made a HH & HL) so there is no point drawing a Fib line downwards any longer. In fact, if you were to draw a line on this chart right now, the only place to do it would be with the uptrend from the last LL up to point A.

Where the Fib line should End
This is the part where people most often get it wrong.  There are highs and lows all over the chart so which one do you use?  The answer is in fact very simple: The line should always end at the extreme i.e.:

• The most recent HH within an uptrend or;
• The most recent LL within a downtrend

Hence, if there is no trend there is no Fib retracement to be drawn.  Also, once a new high or low has been made (a new extreme) new fib lines need to be redrawn, your old ones are now completely invalidated as you would no longer be looking at a retracement of the current trend.  Look at Figure 4 for an example.  You MUST draw your fib line as shown from point D (the most recent high) down to point E (the most recent low or the extreme).   There is no point drawing a line from C down to X2 any longer. X2 was a valid low when it was the extreme, however now a new low has been made at E and this is the ONLY point where Fib Lines should end.

caption: Figure 4

To confirm:

To confirm: Short term move
• Within an UP trend, you MUST always draw your Fib line starting from the most recent low and finishing at the most recent high
• Within a DOWN trend, you MUST always draw your Fib line starting from the most recent high and finishing at the most recent low
• Both of the above are what I refer to as the ‘Short-term Move’

Long term move
All Fib lines must ‘end’ at the same point, you can however ‘start’ from different points, drawing to the same end point. This is what I will refer to as the long-term move. This is how we locate clusters and is also how we start to build a high probability entry point…

Locating clusters of Support and resistance
Again looking at Figure 4, we know that the line has to be drawn from D down to E as this makes sure we are only trading a pullback of the current trend.  This however leaves us with four potential retracement levels. To define a potential entry point, we must look to see if any Fib retracements cluster at the same level. To do this, you must use a different start point for your Fib line and finish at the same end point. See Figure 5 which shows the same chart as Figure 4, however this time we are drawing a second Fib line from a different start point, C, and finishing at the same end point, E. Note that the 38.2% for the larger move down (C to E) overlaps with the 50% of the short term move (D to E). This is what is referred to as a Fib cluster and become a much higher probability turning point if the price reaches there.

All thinking is emotional

All thinking is emotional state dependent

Thought and state of mind follow emotion. Emotion does not follow thought. You trigger to emotion based on a disruption of an established familiar pattern. Then you begin thinking and reasoning from this emotional cloud. How can that be? It does not sound rational at all. And it’s not. It means we create our understanding of our world from our adaptations to our deepest fears and desires.

Take the housing bubble fiasco as an example. After the housing market blew up many observers began examining just how lenders could have possibly thought that they could loan money for houses to people who could not afford to pay back the loans. In fact, these people were incapable of making even the first loan payment. Yet, the house of cards continued to build. Everybody was doing it and nobody "saw" there was a problem. The entire industry never saw the disaster coming. When it blew up, they were surprised. But other people, who had not been sucked into the delusional thinking that comes from greed (fear of missing out), saw it coming and bet against it. They were not surprised. Very bright people were seduced by greed, and in the mindset that came out of greed, they became blind to the long term consequences of the short term nature of the emotion of greed. They became drunk on greed and their thinking was compromised.

What does this look like in trading? Most traders actually lose before their trading day begins. They enter their day already in a cloud of fear. (Most will have pushed the awareness of this fear out of their mind so they can avoid dealing with it - which is the biggest mistake the trader can make.) From this state of fear, their right brain’s biological wiring for negative appraisal biases their evaluation of trading opportunities. The emotion ramps up, seizes any semblance of impartial evaluation of the trade, and either the trader jumps in impulsively to avoid having to endure even more fear or he stays on the side line of the trade, waiting for more confirmation, until the opportunity passes.

And here is the kicker. When the trader goes back to review his trades, he looks at his trades incredulously and asks, "What was I thinking? I know how to trade - how could I have possibly made such a stupid decision?" The difference between the thinking from which he later evaluates his trading day and the thinking that drove his trading during heat of the trade is his emotional state.

Even before he started his trading day, his thinking was corrupted by fear. Out of his emotional state of fear came the mindset that evaluated the market. That mindset saw danger, not opportunity. That mindset blinded him to his risk management skills, and, instead, focused his attention on the avoidance of fear. Out of that, he acted irrationally and made decisions not consistent with his trading plan.

Then, after his trading day was over and he was in a calm state of mind, he reviews his trades and could not understand what possessed him to trade so foolishly. In his rationally (that’s an emotional state just like fear) trained mind (read bias toward the left brain), he can execute trades with confidence and consistency. Unfortunately, not being able to regulate his emotions, the trader does not know how to manage his emotional equilibrium in the heat of battle. This is exactly why the military trains their soldiers in conditions that resemble the chaos of battle where the fear of death is a real and present danger. They train soldiers to the clear-headed thinking that is needed for the emotional state of fear and its management. Traders need to train in a similar way.