The generosity of significant players in the market never ceases to amaze me! In particular Daniel Gramza, Martin Pring, David Chia, Harry Stanton and Chris Tate (www.artoftrading.com.au) have been incredibly supportive and offered practical advice and suggestions for putting together this publication. All of these men have already established outstanding reputations in the trading industry, so they have very little to gain by being interviewed for this book, or offering an appropriate word of encouragement. Their support has refreshed my view of human nature!

Gary Stone and the team at ShareFinder Investment Services supplied the Market Master software that I used to create the charts in Chapter 8. Gary’s knowledge of the relative strength comparison and the SIROC indicator has greatly assisted my own trading results. ShareFinder can he contacted at PO Box 7374, Beaumaris, Victoria, 3193. Ph: 1300 STOCKS. You can access a free demonstration disk of Market Master software by referring to www.sharefinder.com.au.

Chris Bedford, my husband, edited and corrected much of the finer detail of this book. His patience is greatly appreciated.

Thanks to The Trading Game Pty Ltd for providing the data required to create the charts throughout this publication. For more information about data, share trading, training and education, refer to www.tradinggame.com.au.

For more information about candlestick charting, please refer to my website www.tradingsecrets.com.au.

PART I
Candlestick Pattern Secrets

Chapter 1

Let’s Get Started

Have you ever seen one of those ‘magic eye’ computer-generated three-dimensional pictures? At first glance it seems to be one-dimensional and quite flat in appearance. However, when you squint and stare at the picture for long enough, an incredible three-dimensional object reveals itself in vivid detail! “Oh, I can see it! It’s a space ship with little aliens inside … it’s amazing,” you exclaim, while the poor person beside you says dejectedly, “Where? Where? I can’t see a thing … ”

Once you know the trick of seeing the images, all of a sudden you can see them easily and everywhere, much to the frustration of your less-enlightened friends. The method of accessing the hidden image is almost impossible to explain until you can do it yourself.

Candlestick charting is very similar. Once you can see the information in the chart, you will probably never want to look at another type of chart again. You will excitedly talk about ‘dark cloud cover’ and ‘raindrops’ until your friends begin to think that you have taken a second job at the weather bureau.

You are about to discover a technique that has the potential to completely alter the way you view charting, yet is complementary to all of the other methods of technical analysis you might use. Technical analysis is defined as the examination of price and volume action on a chart. I predominantly use technical indicators to reach conclusions about the likely direction of share price activity, rather than relying on fundamental data (e.g. balance sheet items such as profit and loss).

Candlesticks form an integral part of my trading activities. If you would like a powerful technique that can pinpoint trend changes prior to many other indicators, show you when a trend is likely to continue and add depth to your existing trading techniques that you never believed would be possible, then candlestick charting is for you.

I have personally found candles to be an invaluable analytical tool. In fact, if all of the technical analysis techniques that I use were forcibly taken away from me due to some bizarre twist of fate, and I had to choose only one to assist in my trading efforts, I would choose the candlestick! Luckily though, I can use the candlestick alongside all of my other favourite analytical methods.

Many advanced traders have developed a high level of sophistication using candlestick analysis. Novice traders will also be greatly assisted by learning about candlestick pattern recognition techniques. Wherever your skills lie on the trading scale from beginner to advanced, the candlestick offers the promise of enhancing your profit potential.

WHY USE CANDLESTICKS?

The visual display of a candlestick chart provides a valuable method of analysing price information. As you attune your eye to candlestick patterns, signals will practically jump off the chart and wrestle you to the ground. You have everything to gain and nothing to lose by using candlesticks, because all of the information in a standard bar chart is already included in a candle chart—it is just represented in a different graphical format. Personally, I always choose candlestick charts in preference to any other chart format because of the depth of information that they present.

An advantage of candlestick charts, compared to standard bar charts, is the level and variety of reversal and continuation patterns that these charts reveal. The majority of these patterns are unique to candlestick charting and are not available by using any other method.

By understanding the psychology behind each pattern, you can reach into the heart of a candle and determine its probable impact on share price action. If you understand the psychological principles driving the creation of a candlestick, you are more likely to understand its potential impact. This skill can be generalised to any new candlestick pattern that you may come across in the future.

There is a continual tug of war in the market, which displays an imbalance of buyer and seller pressure. Whenever a market is in a state of imbalance, the prices will reflect either a bullish or a bearish sentiment. If the market was in perfect agreement about the price a share should be, there would not be any movement in the share price throughout that session. This is a generic principle whether discussing shares, options, warrants, futures or any other market-driven instrument. For this reason, the patterns that are generated by the candles are applicable across any market. This can only add to the widespread acceptance of candlesticks in Western markets in the future. Once you have completed this book, you will be able to use these methods to trade in any market, whether you prefer to trade shares, derivatives or futures. For the sake of simplicity, however, I will predominantly refer to trading shares for examples throughout the book.

There are several candlestick patterns that suggest a trend reversal is imminent, and others designed to imply trend continuation. I’ll show you each of the patterns that I use, and provide you with many opportunities to recognise and practise your newfound skills. By taking the time to understand each concept before you continue reading, and completing the exercises available, you will learn the secrets of using candlesticks.

A QUICK HISTORY LESSON

From 1500 to 1600, Japan was a country constantly at war. Military confrontation had become a way of life as feudal lords fought to control rival territories. This period of time became known as ‘Sengoku Jidai’ or ‘The Age of War’. This helps to explain why many candlestick terms have military connotations.

Over a period of 40 years, three charismatic generals—Nobunga Oda, Hideyoshi Toyotomi and Leyasu Tokagawa—unified Japan. Once relative peace had been established, several new opportunities for expansion developed.

It was during this time that the concept of the Japanese candlestick was being explored and used in the rice markets. Because there was no standardised currency, rice became the predominant medium of exchange. In the late 1600s the Rice Exchange was formed to regulate trading proceedings. By 1710 there were more than 1,300 rice dealers. Rather than just deal in actual rice, rice coupons were issued, and these became one of the first forms of futures contracts ever traded. (The ‘Tulipomania’ that swept the Netherlands in the early 1600s also involved a form of futures contract. During this period in the Netherlands, tulips became the standard medium for exchange and became even more valuable than gold. So, even though we think of ourselves as sophisticated modern traders, many of the basic concepts behind the instruments that we trade today had their origins hundreds of years ago.)

The popularity of these rice coupons in Japan was significant. A ‘bale’ of rice was the standard amount to be traded. By 1749 there were 110,000 bales of rice traded via ‘empty rice coupons’ (where the rice was not in physical possession), even though it is estimated that there were actually only 30,000 bales in all of Japan.

In 1724, Munehisa Homma was born into a wealthy farming family. Homma had an aptitude for business and he ultimately became a dominant trader in the Japanese rice market. Although candlesticks were not actually developed by Homma, he studied the psychology of investors and formulated several key trading principles. These concepts eventually evolved into the candlestick charting techniques that we know today.

Candlestick charts were, of course, originally plotted painstakingly by hand. This labour-intensive step, as well as the fact that many Japanese traders could not release their trading methods due to language barriers, meant that the use of the candle was not widespread until recent times. It is only since the early 1990s that candlesticks were discussed in Australian trading circles without the audience expecting a follow-up discussion on macramé and knitting lessons! (After I told my friends that I was interested in candlesticks, some were convinced that I had a penchant for handicrafts!) Luckily, candlesticks are now included in the majority of charting packages as a standard method of analysis, alongside the more traditional bar charts and line charts.

A Japanese mentor of mine from the corporate world has two favourite sayings: “Business is war” and “Know your enemy like your brother”. Competition and future product developments were all viewed in the light of this philosophy. The ‘war’ in the case of the trading world is between the bulls and the bears. To ‘know your enemy’ you must understand the psychological principles that the other side is subject to. Studying candlesticks provides an opportunity to get inside the mind of other traders and to use this exclusive knowledge to develop advanced analytical skills. Hopefully you will also learn how to handle your own emotions while trading.

Today in Japan, it is incredibly rare to find an analyst who consistently views bar charts. The candlestick is the predominant graphic layout, just as the bar chart is for traders in Western society.

READING GUIDE

While you are reviewing the charts in this book, you may see some patterns that I have not labelled. This will occur with increasing regularity as you begin to recognise more and more candlestick patterns. To get the most out of this book, take notes and mark the charts as you see fit. This will assist in your candlestick recognition ability, as well as reinforcing many of the principles that we will he discussing.

Do not let the age of the chart influence your analysis and understanding about the essential principles. The lessons contained in these charts are timeless. Each chart is depicted for the purpose of providing a deeper explanation than you could derive from a purely theoretical approach.

Be aware that some candlestick patterns may not be perfectly formed according to the exact definition, but the impact of these candlesticks may still be relevant. The patterns do not have to look precisely the same as they do in the figures to provide a valid signal. There is some level of subjectivity in defining candlestick patterns, as there is with all technical analysis techniques. For this reason it is appropriate to consider the recognition suggestions for candlestick patterns as ‘guidelines’ instead of ‘rules’. I will indicate when a pattern requires a stringent adherence to the definition, as opposed to the majority of patterns that can be interpreted more loosely.

Wherever possible throughout this book I will be using the English name of the pattern, rather than the Japanese name. This will probably be simpler for you to remember, rather than struggling with a potential language barrier. Steve Nison, the author of Japanese Candlestick Charting Techniques, initially coined many of the Western names for candlestick patterns. He translated many original Japanese texts in order to release the secrets of the candle to Western society. Wherever possible, I will maintain consistency with the Nison translation and definition of the candlestick patterns displayed in this text. There are a few times where I must deviate, based on my own interpretation of a pattern. I will clearly identify those occasions to assist in consistency of terminology.

In my descriptions about the candlestick patterns, I refer to periods or sessions. These terms are interchangeable and time-specific, meaning if you are looking at a daily chart, one session or period will refer to one day. On a weekly chart, a single trading session or period will represent one week. Even if I refer to a daily chart, the principles of the candlestick pattern discussed will still be relevant to all other time increments, e.g. weekly or monthly charts. The same principles behind the formation and the impact of the candle will hold true, regardless of the timeframe chosen. This is important to note in order to understand the implications of the next few sections of this book.

Candlesticks provide signals revealing the immediate emotional intensity of the traders involved with that instrument. However, it is wise to remember that there is a fine line between love and hate. A share that is adored by everyone may quickly be subject to selling pressure within a very short timeframe. For this reason the impact of the candlestick pattern is to be considered as short-term in nature. A candlestick pattern will usually have an impact of between one and ten periods.

The other important piece of terminology is the word candlestick pattern or formation. Pattern and formation are interchangeable terms. A candlestick pattern may consist of one period, or several periods. I will explain this further as we explore the different patterns together.

Throughout this publication, in some of the charts depicted, I have chosen an ellipse or a circular shape to draw your attention to a candlestick. Other charts show a rectangle, or an arrow pointing to the particular pattern. There is no significance related to the shape that I have chosen. I merely chose the shape that visually blocks the least surrounding candles on the chart, in order for you to gain a clear view of all other candles shown.

Every form of trading involves an inherent level of risk. I am happy to share with you all that I have learned about this method, but understand that no single technique will provide correct signals every time. Unfortunately, there is no Holy Grail. I cannot promise that you will make money by simply reading this book. Trading excellence will take time and practice to develop. It is my goal to provide you with an insight about how to use this tool to enhance your own trading endeavours, but your own application of the techniques will determine your level of success.

CANDLES, LINE CHARTS AND BAR CHARTS

The three charts as shown in Fig. 1.1, Fig. 1.2 and Fig. 1.3 all represent the same information and the same time scale, however their graphical format ensures that each chart looks very different.

FIG. 1.1—NAB Daily Bar Chart

FIG. 1.2—NAB Daily Line Chart

FIG. 1.3—NAB Daily Candlestick Chart

The individual building block of a bar chart is a single bar. Drawing a single bar requires an opening price, a high, a low and a closing price, (see Fig. 1.4). The vertical line shows the high and low of that period. The two horizontal lines depict the open and the close. The open is the horizontal line on the left of the vertical line, and the close is the horizontal line on the right of the vertical line.

FIG. 1.4—A Single Western Bar

When many of these single-period bars are plotted on a chart with the time represented on the horizontal axis and the share price shown on the vertical axis, a traditional bar chart is created, (see Fig. 1.1).

A line chart connects the closing prices for each period, providing even less information, but it is perhaps a simpler chart to interpret in comparison to the bar chart, (see Fig. 1.2). This type of chart is usually provided in newspapers when a journalist depicts share price action.

A single-session candlestick represents the same data that you will find in a single bar, however it looks completely different. The origin of the name is obvious when looking at the chart. A candlestick chart looks like a series of candles with wicks, (see Fig. 1.3). (The wick, however, can be at either end of the candle.) Every part of the candle has specific implications.

The thick part of the candle is called the real body. This shows the range between the opening and the closing price, (see Fig. 1.5). The colour of the candle has very important implications. When the real body is white (or empty), it means that the close was higher than the opening price. When the real body is black (or filled in), it means that the close was lower than the opening price.

FIG. 1.5—A Candlestick

The thin lines above and below the real body of the candlestick are called the wicks, shadows or tails (regardless of on which side of the real body they are located). The upper shadow is the high for that period, and the lower shadow is the low for that period. The shadows are usually considered to be of less importance than the thick part of the candle, as they represent extraneous price fluctuations. They provide an indication about the extremes of emotion experienced by the bulls and the bears throughout that period.

OPEN AND CLOSE

The open and the close are the most emotionally-charged points of the day and therefore they are significant in candlestick analysis. There is a saying that “the amateurs open the market and the professionals close the market”. The amateurs have had all night to absorb the rumours and news items about certain shares, and their anxious flurry of activity on the opening of the market reflects this. It is a well-known fact that in most markets around the world, the period of highest volatility for the day is the first hour of trading. This is definitely a feature of the Australian sharemarket. In the first hour of trading, there is a veritable scramble of punters trying to establish their positions. The more anxious the trader, the earlier he or she will place an order with a broker. Once this early-morning scramble calms down, the market settles into a less volatile period during the middle of the day.

The final hour of trading on the Australian sharemarket also experiences a definite increase in volatility as buyers and sellers review the price action that occurred during the day. They must quickly assess whether they can live with their trading decisions overnight, so they must be decisive and brave to buy or sell at the final hour. Emotions again run high as traders buy and sell their shares in accordance with their view of the direction of the market for the following day.

Traditionally the close of the day has been a critical component for many technical analysts in the options and futures markets. The closing prices establish the severity of margin calls for traders in options and futures, so many traders would prefer to close their positions rather than experience any negative consequences. (This explains why many traders utilise a line chart to analyse their shares as this type of chart places emphasis on the closing prices.)

If the professionals close the session at a higher price than the opening price (established by the amateurs), this has a powerful bullish impact. If the professionals close the market lower than the initial opening price, this has a bearish implication.

OTHER TIMEFRAMES

The same thought process also comes into play when viewing a weekly chart. A weekly chart shows the open as being the open on the first trading day for the week (usually a Monday) and the close as being the close on the last trading day for the week (usually a Friday). Many traders review their charts over the weekend and place their orders as soon as the market opens on a Monday. On a Friday, traders need to decide whether they can live with their open positions over the weekend, or whether to exit them. For this reason, candlestick charting is useful when using a weekly chart or a daily chart.

Other timeframes are also appropriate when using candlestick charting, e.g. monthly charts or intra-day charts. I personally believe that candles are best used on intra-day charts, daily charts or weekly charts of volatile shares with reasonable volumes being traded. If the share is not especially volatile, or has low volume, an intra-day candlestick chart is unlikely to reveal any meaningful patterns. Monthly charts, while useful for overall trend definition, generally provide slower signals. They are mainly suitable for the longer-term investor (one year or greater).

THE WHITE CANDLE

The colour of the candle depicts whether it is bearish or bullish.

When a white candle is evident for a session, the bulls were in control and they managed to push the price to higher levels, (see Fig. 1.6). Some charting software packages use the colour green on screen to represent these bullish candles. In nature, green is the colour of growth (in plants, anyway), so it is easy to remember the meaning of a green candle.

FIG. 1.6—The White Candle

Using colours in a candlestick chart is my personal preference. The colour assists in quick identification of candles that are very close together on a chart. When there are many candles present on a chart, sometimes it is difficult to distinguish which candles are white and which candles are black. (Examples throughout this book, however, will appear in white and black.)

The basic psychology behind the white candle is that traders have decided, throughout the session, that they have a definite liking for this share. If the candle is long, and especially if it closes at its high for the session, it is as if the traders are all yelling in unison: “We adore this share. We like this share so much that we’d like to wallpaper our living room with buy certificates of this stock!”

When the day closes higher than it opened, it is a positive bullish sign in terms of market sentiment. There is demand for the share and buyers are willing to pay higher and higher prices. The price is driven up as demand outstrips supply. Greed compels people to purchase the share in the hope that prices will continue to be driven skyward.

Beanie Babies

To illustrate the point, here is a recent example of what happens when demand outstrips supply. The ‘Beanie Babies’ are a popular addition to the ever-expanding range of children’s toys on the market. These cute little stuffed toys are collectable items which sometimes command up to $US350 per item! The manufacturers cleverly limit the supply of each series, in order to increase demand for individual versions of the toy. They also, from time to time, ‘retire’ (or discontinue) models by taking them off the market.

In the middle of 1999, a horror newsflash was broadcast on the Beanie Baby website, and in major newspapers such as The Australian. It announced that Ty Inc., the company responsible for bringing Beanie Babies into the world, would retire all Beanies on 31 December 1999. To coincide with this announcement, they released a new Beanie Baby called ‘The End’ which was, ominously, black. Within minutes, chat rooms were packed with Beanie Baby lovers begging for answers. Prices at the online Beanie auction soared to record highs, and traffic at beanie.com tripled. The market was overwhelmed with buyers. Even my niece Melissa was overcome with Beanie fever. She suggested that I take the money that I have invested in shares and buy as many Beanie Babies as I could get my hands on!

This same psychology applies to the formation of a white candle. As is evident, when demand is greater than supply, the price will be driven upwards.

THE BLACK CANDLE

When the real body is black (or filled in), the close is lower than the opening price, (see Fig. 1.7). Some charting software packages use the colour red, instead of black. If you have ever been trapped in a losing trade, it can feel like your funds are ‘bleeding’. The use of the colour red in this situation has similar connotations.

FIG. 1.7—The Black Candle

When the share closes lower than its opening price for the day, it is a sign that traders are liquidating their holdings.

This has the effect of driving the share price down. The sellers have fear in their hearts and flood the market with their shares. Hence, the market sentiment is pessimistic, creating a far greater supply of shares. This causes the closing price to be lower than the opening price, and the result is the creation of a black candle.

If the share closes at its low for the day, the traders are in effect saying: “I have to dump this share at all costs! I totally dislike this share now and it is time to desert the sinking ship!” A black candle clearly shows that the bears were in control for that period.

WHEN TO USE CANDLESTICKS

Candlesticks are great for:

• identifying continuation patterns
• determining short-term trend direction changes, i.e. reversal patterns.