There are three major advantages of candlestick charts compared to bar charts.
- Candlestick charts are much more “visually immediate” than bar charts. Once you get used to the candle chart, it is much easier to see what has happened for a specific period be it a day, a week an hour, or one minute. With a bar chart, you need to mentally fill in the price action. You need to say to yourself, “The left tick says that’s where it opened, the right tick where it closed. Now I see. It was an up day.” With a candlestick chart, it is done for you. You can spend your energy on analysis, not figuring out what happened with the price.
- With candles, you can spot trends more quickly by looking for whether the candles are clear or colored. Within a period of the trend, you can easily tell what a stock did in a specific period. The candle makes it easier to spot “large range” days. A large candlestick suggests something “dramatic” happened on that trading day. A small range day suggests there may be relative consensus on the share price. When I spot a large range day, I check the volume for that day as well. Was volume unusual? Was it say 50% higher than normal? If so, it is very likely that the large range day may set the tone for many days afterward.
- Most important, candles are vital for spotting reversals. These reversals are usually short term –precisely the kind the trader is looking for. When traditional technical analysis talks about reversals, usually it is referring to formations that occur over long periods of time. Typical reversal patterns are the double top and head and shoulders. By definition, these involve smart money distributing their shares to naive traders and normally occur over weeks or even months. Candlesticks, however, are able to accurately pick up on the changes in trend which occur at the end of each short term swing in the market. If you pay meticulous attention to them, they often warn you of impending changes.
Candlesticks anticipate short terms reversals
The message of candlesticks is most powerful when the markets are at an extreme, that is when they are overbought or oversold. I define overbought as a market that has gone up too far too fast. Most of the buyers are in and the sellers are eager to nail down profits.
An oversold market, on the other hand, is one in which the sellers have been in control for several days or weeks. Prices have gone down too far too fast. Most of the traders who want to sell have done so and there are bargains — at least in the short term — to be had.
There are many overbought and oversold indicators, such as CCI, RSI, and Williams’ % R. However, one of the best is stochastics, which essentially measures the stock’s price in relation to its range usually over the past 14 periods. CCI typically agrees with stochastics and is useful for providing confirmation of its signal. I also almost always put a Bollinger Band on charts I analyze. John Bollinger created this tool to include 19 out of every 20 closing prices within the bands. Therefore, a close outside the band is significant. A close outside the upper band usually says the stock is overbought. When it is outside the lower band it is oversold.
When both stochastics, CCI, and the Bollinger bands agree a stock or index is overbought or oversold, I take their alignment very seriously. There is a good chance a reversal is overdue. A significant candlestick tells me more exactly when the reversal might be here.
Why candlesticks work?
A chart may be thought of as picture of the war between supply and demand. When a stock is moving up, the buyers are in control. There is more demand than supply. Purchasers are eager to acquire the stock and will pay up, hitting the ask price to do so. When a stock is declining, the reverse is true. Sellers are fearful and will not dicker over a few cents, being more likely to accept the bid. Candlesticks graphically show the balance between supply and demand. At key reversal junctures, this supply/demand equation shifts and is captured in the candle chart.
The rule of two
Generally, no one candlestick should be judged in isolation. The general principle is even if you see a key reversal candlestick, you should wait at least part of one more day before acting. If for example, you spot a candle called a doji, seek verification from the action of the next trading day. If there is a down gap and prices begin to decline then it is prudent to take your position.
Candles in action: The Dow Jones Analysis
As stated, in candlestick theory, there are many candles that signal important reversals. To conclude this section, we will focus on only four (!) candlesticks which called every major turn in the Dow Jones Industrial Average over nearly a six-month period! Think how much more accurately you could have traded the market if you knew these candle’s names and implications as well as had recognized them when they occurred.
The good news is these are reversal signatures and are apt to occur again. Your ability to recognize them could lead to large trading gains. First, I will explain the candlesticks, then apply this theory to the analysis of the graph.