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Candlestick Charting

Terminology

Bar Chart

The Bar Chart is a common chart style used in financial markets to study and monitor how a stocks price moves over time. While a daily Line Chart only shows the Last price for the day, a Bar Chart shows the price range for the day as well as the stocks opening price.

Double Bottom

The Double Bottom is a chart pattern that occurs in an down trending stock where a price sell off only reaches the same price level as the previous price sell off before rallying off again. If the stocks price climbs above the high of the prior sell off, then this indicates that the trend has reversed and a new uptrend has formed. Some stock traders and investors will use this as a signal to buy the stock.

Moving Average

The Moving Average is an averaging calculation performed on the closing prices and is plotted as a second line on a line chart, bar chart or candlestick chart. This moving average line smoothes out the daily fluctuations in the closing price and makes trends more visually obvious.

Candlestick Charting basics - picture of candlestick bars in an uptrend coming out of a computer screen heading into the blue cloudy sky

Candlestick Basics

Makes it easy to distinguish between up days and down days

Candlestick charting has gained popularity since the 1990s and is a common alternative method of displaying a stock's price on a chart. Candlesticks charts are very similar to the standard Bar chart which shows the days trading range with its opening and closing prices. The main difference is that candlesticks show the open to close price range in a more visually predominate manner. They are referred to as Candlesticks since they resemble a candle with its wick.

The origin of Candlestick charting goes back several centuries and was developed in Japan. Like other chart styles, candlesticks up until the 1990s were plotted by hand on graph paper which made it a tedious task. When personal computers became popular, it allowed charting programs to automatically plot the candlesticks which removed the tedious manual task and thus allowed its popularity to increase significantly.

While reading a candlestick chart takes a bit of getting used too, once the stock investor or trader grasps the basic concept, candlesticks provide a highly visual method of analyzing a stock's price information which is particularly useful for pinpointing short-term trend reversals and continuations.

Candlestick charting is extremely effective for short-term trading and is commonly used by stock traders such as day traders and swing traders. Stock investors utilizing short-term active investing strategies can also make good use of this style of charting in order to supplement their fundamentals and to time their entries and exits.

The open and close are the most emotionally charged times of the day as the market participants scramble to establish and liquidate their positions. These are the times where the intraday volume and volatility is usually the highest. Candlestick charting is particularly good at visually highlighting the open and close price range.

The construction of a bullish and a bearish candlestick is illustrated in Figure 1. The bar chart equivalent is provided for comparison.

Figure 1. Candlestick construction

Candlestick Charting basics - diagram showing Candle body tail construction for up day and down day

Referring to Figure 1. the open to close range is referred to as the body which is the Candle component. If the close is above the open, the body is shown hollowed and if the close is below the open, the body is shaded. If the close is equal to the open, then there is no body and the Candlestick looks exactly the same as a Bar chart. The thin vertical line extending above and below the body are referred to as the shadow or alternatively as the tail. These are the Wick components of the candlestick.

A unique situation occurs with candlesticks when the open is at the low and the close is at the high, as the body takes up the whole range with no lower or upper tail. This also occurs when the open is at the high and the close is at the low.

Traditional candlestick charting shows the outline of the body in black and shows the shading in black. Some of the modern charting software packages allow the colors to be customized with one of the popular color themes showing a shaded candle in green for an up day and a shaded candle in red for a down day. While some users of candlestick charting prefer these color schemes, they can also be a little distractive and there are stock traders who still prefer to use the customary black and white to display their candles.

Modern charting may allow the candles to be colored, but

many traders still prefer black and white for its clarity

The hollow body candle is traditionally referred to as a white candle and a shaded body candle is traditionally referred to as a black candle. Candlestick charting places a lot of emphasis on the whether the body is filled or not, since this determines the bearishness or bullishness of the stock in question. The bearishness or bullishness can be easily and readily determined visually by glancing over the stock's candlestick chart. A stock chart displaying a large proportion of white candles is bullish. Conversely, a stock chart displaying a large proportion of black candles is bearish.

White candles are bullish since the close is above the open and candles that have a short or have no upper tail are even more bullish. Similarly, black candles are bearish since the close is below the open and candles that have a short or have no lower tail are even more bearish. Some examples of bullish and bearish candles are illustrated in Figure 2.

Figure 2. Increasing bullishness and bearishness of candles

Candlestick Charting basics - diagram showing bullishness and bearishness of candles

A typical candlestick chart displays a variety of lengths for the candle bodies. These relative body lengths can be broadly grouped as short, common and long. A candle is considered short if the length of the body is noticeably less than the typical body lengths of other candles. Also the upper and lower tails are relatively short. A candle is considered long if the length of the body is noticeably more than the typical body lengths of other candles. The upper and lower tails may be relatively long with a long body candle.

These candle body lengths are illustrated in Figure 3. for bullish candles and in Figure 4. for bearish candles.

Figure 3. Bullish candle body lengths

Candlestick Charting basics - diagram showing various Bullish candle body lengths, short, common and long tail

Figure 4. Bearish candle body lengths

Candlestick Charting basics - diagram showing various Bearish candle body lengths, short, common and long tail

Any candle with a body length of at least a common candle that has a significant increase in volume compared to the recent trading volume is known as a Dominate Candle (which can be either a white candle or a black candle).

Candles that do not have an upper or lower tail are also referred to as a Shaven candle (which can be either a short, common or long body candle). Candles that have a relatively long upper and lower tail compared to the body length are generally referred to as Spinning Tops. Candles that have a negligible body length are generally referred to as a Doji.

Candlestick chart

An example of a candlestick chart is shown below in Chart 1. which shows examples of the Common candle along with some Short and Long candles for comparison.

Chart 1. Candle Chart with various Candle Lengths

Candlestick Charting basics - stock chart showing various Bullish and bearish black and white candle patterns in uptrend and down trend for symbol TJX

Traditionally, Candlestick charts are displayed in Black and White as shown in Chart 1. above. For an up day were the Close is above the Open the body is shown with a black outline and a white inside. For a down day with the Close below the Open the body is filled in black.

Nowadays with computers and color screens together with charting software it's easy to display the candles with a colored theme.

The above candlestick chart is shown again below with the up day candles colored green and the down day candles colored red.

Chart 2. Candle Chart with various candle Lengths

Candlestick Charting basics - stock chart showing various Bullish and bearish colored candle patterns in uptrend and down trend for the same stock code as above TJX

The decision whether to use the traditional black and white candle colors or to use a colored theme is an individual preference. The pricing information shown is exactly the same.

Summary

Candlestick charting is more commonly used with daily charts, which is a popular choice by stock traders. Other time frames can also be used such as intraday periods with 5 minute candles. Also weekly or even monthly time frames can be plotted with candlesticks. The weekly candlestick has merits for long-term investors who are looking for a more opportunistic entry price for their proposed stock purchases. Some day traders prefer to use candlestick charts for their intraday charts as it provides a visual cue as to when a reversal in trend is likely.

The use of candlestick charting is a personal choice amongst stock investors and traders. The primary benefit of candlestick charting is that it's highly visual in displaying trend reversals which the skillful chart reader can use to their advantage. However, like all stock analysis techniques it is best if candlestick charting is combined with other stock analysis techniques rather than used in isolation.

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