One of the better trading methods within the broad subject of technical analysis is Japanese candlesticks charting. You will have seen them on most price charts, but may not have understood their importance.
They are for more than just making a chart looking cool; for the trader who knows how to use them, they provide important information about the state of the market being studied.
Traditional bar charts and candlesticks both use the exact same data. But Japanese candlesticks present that data in a powerful way, which makes it easy to spot shifts in supply-demand.
Bar charts are great for identifying traditional chart patterns such as tops and bottoms, candlesticks are more effective for the short term.
A very brief history of Japanese candlestick charting
Candlestick charting originated in the rice futures markets of 17th century Japan.
Munehisa Homma, a rice trader from a wealthy family at the time, was the first person to record rice prices in a visual format, and apparently profited handsomely because of it.
By the time the Japanese stock market opened in 1870, a fully developed system of Japanese candlesticks had already been developed.
Up until the 1990s, few in the west had heard of them, however. It wasn’t until Steve Nison’s Japanese candlestick charting techniques book was published that the west became aware of them.
Since then Steve Nison has written extensively on their use and is, without doubt, the west’s leading expert.
Similarities with price action
For those using candlesticks, there are similarities with price action trading. And vice versa.
Both take a bar by bar approach to market analysis; with the most recently closed session holding important clues to what will happen next. Price Action signals are often nothing more than reworked versions of the older oriental patterns but given a western spin.
One candlestick, bar or session consists of four data points.
The open, high, low and close; or simply put OHLC.
The candlestick is made of two parts: the shadow, and the real body.
The shadow (or wick), in western parlance, is the session’s range. And is made up of an upper shadow and lower shadow.
The range stretches from the highest price traded and the lowest price traded within the same session.
A thin vertical line connects the two points, resembling the wick of a candle. An upper shadow is the portion of the shadow above the real body. The lower shadow is the portion below the real body.
The real body is the more complex part.
It represents the opening price of the trading session and the closing price of the same session connected by a square or rectangle shape. The shadow of the candle will pierce vertically through its central point, as can be in the three examples below.
Much information can be gleaned from the length of both the shadows and the bodies.
Generally speaking, long bodies depict bullish or bearish conditions, whilst short bodies mean uncertainty, indecision or low volatility.
But, there is an art to reading candlesticks which involve us looking at previous sessions in relation to the latest.
What defines bullish and bearish candlesticks?
Candlestick charts are recognisable by their colourful visuals.
Blue and red; green and red; or black and white are the usual colour combinations. But much depends on the charting software and/or the preferences of the trader using it.
On this blog, the preferences are for blue and red. Blue being bullish, and red being bearish
A bullish candle (blue) occurs when the close is higher than the open.
A bearish candle (red) occurs when the close is lower than the open.
It’s important to know that a candle pattern tells us nothing about how the market arrived at the final pattern for the time period.
For a bullish (blue) bar, we do not know if the market traded lower most of the session, and then rallied hard in the last hour of trading, or whether it started strong and remained so.
For a bearish (red) bar, we don’t know if the market traded high most of the session, and then fell hard in the last hour of trading, or whether it started we weak and remained so.
If we need to know how a pattern occurred reached its final pattern, we have to look at a lower time frame.
Candlesticks are used for every possible period; 1-min or 5-min charts, all the way up to daily, weekly and even monthly for very long term analysis.
Like most things in technical analysis the longer the timeframe the more accurate the signal. I wouldn’t put much credence in 5-min patterns.
Personally, and probably for most traders too, the best trading periods are 8 hour and daily charts.
However, if you have patience and consider yourself a long-term trader weekly charts offer excellent opportunities with very low-risk but high reward setups.
One important point, the newcomer must remember is that a session must be completed before analysed.
That sounds obvious, but nice looking candlestick patterns can develop before the end of the session, and inexperienced traders are known to jump the gun, hoping to outsmart the market.
This is not advised, much happens in the final moments before the close, and the final pattern can look different than what you observed not a long time before.
Japanese candlesticks vs price action trading?
There is very little difference between the two.
But the strange esoteric names given to candlestick patterns do not really impress on you what type of market action is currently taking place. That may be a minor point for some, but not me.
I mean could you tell what is happening when you hear the name Dark Cloud cover or a Doji for the first time?
No, I thought not.
My whole approach to trading is to simplify and there is nothing simple about the names of these patterns. If you happen to be a 17th-century Japanese feudal lord you might fair better, but unfortunately I am not.
Also, I think some of the patterns or ‘patterns within patterns’ are overly complex.
Real experts, like Nison, can go back over an extended period of time, pinpointing all the patterns that make one larger pattern. This I think is quite amazing but defeats the point for a newcomer who is trying to keep it all simple.
That is why I prefer price action patterns but of course, use Japanese candlesticks to display them.