by Michael Thomsett
Are you candlestick-literate? The widely used candlestick chart is easy to read but also contains some less obvious but valuable
clues about momentum and reversal.
Reading candlestick charts is not difficult. The "stick" consists of two important attributes:
1. Real body. This is the rectangular box that is at the center of the formation. If it is white, that means the day’s trading moved up; and if it is black, trading moved down. The top and bottom borders of the rectangle represent opening and closing prices (on the white real body, opening price is the bottom and closing is the top; on the black, it is the opposite).
The advantage to the differently colored directional real bodies is that you can spot momentum instantly. When you see a predominantly white-body dominated chart, you know the strength is toward the upside. You can also see whether that momentum is increasing or topping out. With black-dominated charts, you know immediately that the bears are in command.
The extent of the real body is also revealing. A long candlestick tells you that trading covered a very broad range during the day. This demonstrates that trading favors the direction - a long white candlestick is strongly bullish and a long black candlestick is strongly bearish. The size of the real body comes up over and over in candlestick analysis. On the opposite extreme to the long real body is the doji, in which opening and closing price are the same or every close together. Instead of a rectangle, you end up with a horizontal line. This is just as revealing, demonstrating that the struggle between buyers and sellers ended up as a stalemate.
2. Upper and lower shadows. Beyond the real body are extensions of trading. Although opening and closing prices are defined by the borders of the real body, prices usually go both above and below those levels during the session. This activity is seen in the shadows, vertical lines extending above and below the real body. Also called the "wicks" of the candlestick, these show you the full trading range of the day.
The extent of the shadows is just as important as the real body. An exceptionally long extension on either side (or on both sides) tells a lot about strength or weakness among both buyers and sellers. Even when there is no shadow, the overall meaning of the formation can be interpreted to reveal what is likely to happen next.
Many single-session candlesticks (like the long candlestick or its opposite, the doji) are valuable because they reveal a lot about price pattern, momentum, and the possibility of reversal. The trend itself is also easily recognized in the two-session or three-session series of candlesticks. These often foreshadow trend reversal or show up at the beginning of a new trend.
The most easily recognized of these trends is the three-session "white soldiers." This is a consecutive three-session grouping of white real bodies. Each one opens at a higher price than the one before, and also closes at a higher price. The white soldiers pattern is a basic bullish pattern that every day trader and swing trader recognizes. It sets up and continues the short-term trend in an upward direction. The opposite is the downtrend. The "black crows" consists of at least three black candlestick sessions. Each one opens lower than the previous one, and also closes lower. Just as the uptrend is set by the white soldiers, the short-term is an easily spotted short-term downtrend.
All chart analysis is about trends and momentum. However, candlesticks serve an equally valuable function by acting as confirmation signals. When you spot a well-known traditional technical indicator (such as a gap moving above resistance or below support, a double top or bottom, or a head and shoulders pattern, for example) you always face a dilemma: How do you know whether the pattern is the real thing or a false indicator?
Most chartist seek confirmation is some way or another. But the most reliable confirmation is going to be found in candlestick formations. These are found in dozens of variations, but they provide reliable confirmation of what appears to be going on through the well-known technical price patterns. When you have a recognized reversal pattern and confirmed reversal in a candlestick pattern, it improves your accuracy and timing vastly. The combined use of dissimilar indicators is the best way to ensure that you make your move at the best possible time. Nothing is going to give you 100% accuracy; but methodical confirmation practices take your percentages way up.
The invisible gap
A final word about how to read candlesticks: A hidden value can be found in looking for invisible gaps. Most chartists agree that gaps - especially repetitive gapping patterns - are among the most reliable trend indicators. This is especially true when gaps take price outside of the established trading range. However, gaps show up more often than most traders think. Candlestick charting makes it easier to spot these invisible gaps.
The typical gap is seen in the visible space between one day’s closing price and the next day’s opening price. So a candlestick chart reveals these highly visible gapping formations. However, what about when real bodies overlap between sessions? Does this mean there is not a gap? Yes, but only when both sessions are the same color. Whenever two sessions are of opposite colors, there is a chance you have an invisible gap. The closing price is found at the top of the white candlestick or at the bottom of the black candlestick. So invisible gaps occur whenever the following pattern shows up:
- The first session’s white candlestick is followed by a black candlestick opening higher.
- The first session’s black candlestick is followed by a white candlestick opening lower.
The invisible gap doesn’t show up at first glance because the gap between opening and closing price appears to remain within the previous session’s real body. To find the gap, you have to remember the direction of price movement between the two days, and pay attention to the distance between closing price and the next session’s opening price.
Some gaps are insignificant, of course. But when invisible gaps create a series of gapping sessions, especially as price moves in one direction consistently, it makes the trend much stronger. Even experienced chart readers can miss invisible gaps.
Candlestick charting offers a rich variety of reversal, continuation, and confirming indicators. The formations they provide are worth further study. Traders will discover that candlestick analysis improves their entry and exit timing dramatically.
About the Author
Michael C. Thomsett is author of Trading with Candlesticks
and numerous other books on technical analysis, stock trading and options.
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