In 1996, Gunduz Caginalp and Henry Laurent, from the Mathematics Department of the University of Pittsburgh, published a brief paper, “The Predictive Power of Price Patterns,”
based on samplings of candlestick patterns. They concluded, among other things, that “a trader who has the same information as others plus the knowledge of this method will have a competitive advantage.” It is said that the practice of candlestick charting was started in eighteenth-century Japan by a man named Munehisa Honma, who controlled a large family rice business. He used this technique to monitor the daily movements of the price of rice.
Candlesticks charting has become increasingly popular since its introduction to the West in the 1970s by Steve Nison, who has published many great articles and books on the subject, including his earliest book, Japanese Candlestick Charting Techniques.
Over the years and with advanced software programs, candlestick analysis has developed into a more visual and descriptive study, and candlestick patterns can now be incorporated into any customized trading system. For instance, in a customized system, if all candles are plotted in red color in a downtrend, the software could further decipher and separate the patterns of the red candlesticks into bullish and bearish candles. A bullish candle will have a hollow red candle while a bearish candle will be a filled red candle. Very often in a downtrend, the appearance of a hollow red candle signifies a support area and probable reversal area. On the other hand, if the candles in a customized trading system are plotted as blue in an uptrend, filled blue candles will often indicate resistance and a probable reversal area.
Candlesticks plot price movements over a set period. Regardless of the time frame, a minimum of two candlesticks is required to identify the probable market direction and its relative strength and weakness. Identifying patterns that always work is difficult. Readings of candlestick patterns should not be based on a single candlestick but should be made in combination with other candlesticks. Candlestick patterns are more predictive when the markets are at extreme overbought or oversold levels. A momentum oscillator would be a handy tool to check such extremes.
Figures 3.4 to
3.8
show useful patterns that are frequently found in candlestick charts.
FIGURE 3.4
Engulfing patterns are similar to outside day patterns in classic bar charts. Engulfing
candlesticks are more significant if they have larger engulfing candlesticks. A bearish engulfing pattern at or near the top would mark the peak, and when it appears in a downtrend would seem to indicate further declines of the market. Bullish engulfing patterns tend to indicate support areas, especially when occurring at the low of a downtrend. A breakout from an engulfing pattern generally is short term, lasting no longer than 10 trading days.
FIGURE 3.5
Dark cloud cover is a bearish pattern and is generally found at the end of a congested trading area or at the end of an uptrend. Piercing line is a bullish pattern and is more dependable when it is found at the bottom of a declining market. These two patterns are easy to miss.
FIGURE 3.6
Evening star and morning star are both three-candlestick reversal patterns. Evening star is found at the end of the uptrend, while morning star is a bottom reversal looking upward for the sunrise or rising prices.
FIGURE 3.7
Three black crows is a top reversal signal consisting of three long black candlesticks closing consecutively lower near their lows. Three white soldiers is a bottom reversal signal that has three white candlesticks closing consecutively higher near their highs.
FIGURE 3.8
A harami pattern implies the preceding trend is coming to an end. It is a reversal pattern.
Harami patterns, as shown in Figure 3.8
, are the opposite of engulfing patterns. They are referred to as inside days in bar charts.
When a large white candlestick is followed by a small white candlestick at or near the top of an uptrend, it is common for this bearish pattern to break downward. The failure of the second candlestick to push price higher outside the range of the first candlestick indicates that buyers are losing stamina. Conversely, when a large black candlestick is followed by a small black candlestick, it is a bullish pattern and is expected to break upward. The reason is that the second candlestick manages to hold off the downward drive of the first candlestick. Market practice says to follow the break from harami patterns when the previous day’s high or low is exceeded, because a trend will normally continue in the direction of the break. This pattern is often tricky and confirmation of the next day’s candlestick is important. We should also use our momentum oscillator as a filter to check whether the stock is oversold or overbought.
Figure 3.9
shows two candlestick patterns, hangman and hammer. Hangman appears after a long uptrend where the market is overbought. Hammer is found at the low of a long downward trend where the market is oversold. Comparing the two patterns, hangman indicates a potential confirmation of an uptrend reversal, but it is not as dependable as a hammer pattern, which occurs at the low of a downtrend. When it comes to hangman, it is common to see confirmation in the form of a gap down the next day. Hammer with a long shadow shows that the bears have failed to push price lower and is more reliable, especially when its shadow is much longer than its body. With the hammer, a gap up opening the next day with strong support of buying may be all that is necessary to enter a trade.
FIGURE 3.9
A bearish hangman and a bullish hammer share the same pattern, having a top-heavy body and long lower shadow. The color of the actual body is unimportant. The key difference is where they appear in a chart.
Figure 3.10
shows the application of candlestick patterns as described in the preceding.
FIGURE 3.10
Candlestick patterns occurring at critical points at a turn of trend. Note also the increase of volume and price projection from the break of the neckline, which becomes the resistance line when price attempts to reenter previous levels. In the momentum oscillator window, a bearish divergence pattern confirms the continuation of the bearish trend; and a bullish divergence alerts to the bottoming of price.