Irni siaimii

Technical analysts use three basic kinds of charts: line charts, bar charts, and candle charts. (Polnt-and-flgure charts are an additional alternative, but they don't show a session's high, low, open, or closing prices.) Line charts an?

Because candles need opsn. high. low. and close, we can't use candle charts on mutual funds or tick-by-tick charts, since these have only closing prices.

Because candles need opsn. high. low. and close, we can't use candle charts on mutual funds or tick-by-tick charts, since these have only closing prices.

made up of points that usually represent the closing price of a financial instrument. connected by a single line.

Just as a bar chart uses the top and bottom of each bar to Indicate high and low prices of the time frame Indicated, so does a candlestick, or candle line (these two terms are interchangeable).

A single bar displays a small perpendicular line on Its left to designate the opening price and another on the light to show its closing price. When using candlesUcks. however, we draw in a real body to connect the opening and closing prices. This gives us a quick and complete picture of the stock's action and denotes prevailing sentiment

The irnl body—the rectangular portion of the candle line—represents the range between the opening and closing prices. A white real body tells us that the close Is higher than the open since the top of the white real body Is the session's close and the bottom of the white real body Is that session's open. A black (filled) real body shows that the close was lower than the open. The bottom of the black real body Is the session's close, and the top of the black real body Is that session's open. The session can be any time frame, from a minute to a month.

The vertical lines that extend above and below the real body are called the upper and lower shadows. The top of the upper shadow is the session's high; the bottom of the lower shadow is the session's low. The candlestick line uses the same data as a bar chart but the color of the candlestick's real body and the length of the candle line's real body and shadows convey a

When a real body, either white or black, closes at the high of the session, it has no upper shadow. Therefore, the Japanese say that candle has a "shaven head." When a real body closes at the low of the session and has no lower shadow, that candle has a "shaven bottom."

When a real body, either white or black, closes at the high of the session, it has no upper shadow. Therefore, the Japanese say that candle has a "shaven head." When a real body closes at the low of the session and has no lower shadow, that candle has a "shaven bottom."

The top of theupp^r shadow and the bottom of the lower shadow represent the highs and lows of a session, whether the real body is black or white.

The top of theupp^r shadow and the bottom of the lower shadow represent the highs and lows of a session, whether the real body is black or white.

snapshot of who's winning the battle between the bulls and the bears. For instance. when the real body is black, that means the stock closed below Its opening price. This gives you an Instant picture of a positive or negative close. Those of us who stare at charts for hours at a time find that candlesticks are not only easy on the eyes, they also convey strong visual signals sometimes missed on bar charts.

Exhibit 1.1 shows basic candlestick formations, hi (A), stock XYZ opens at 30 and closes at 35, with a high of 37 and a low of 29. In (B), XYZ opens at 35, closes at 30, and again has a high of 37 and low of 29.

Candlesticks, like bars, each represent a specified time frame. On a weekly chart, each candlestick represents one week; on a dally chart, each candlestick represents one day, and on a 15-mlnute intraday chart , each candlestick represents a 15-mlnute unit of time.

One of the most Important benefits of usUig candles Is that they give Instant pictures of how traders and Investors feel about a certain stock or market. A long, protracted real body translates Into very stovng opinion, either bullish or bearish. Conversely, as you will see In the chapters that follow, short real bodies mean that stock participants have no strong opinion; the bulls (buyers) hold the price up. while the bears (sellers) press It down.

Notice the long, white real body In Exhibit 1.1 A This white real body, showing the closing price multiple points above the opening price (In this case, 5 points), indicates extremely positive or bullish sentiment In (B), the

Shadows

Shadows

Close = 30

High =37

Lower ■ ^ Opsn = 30 shadows-^T Cl' Low = 29 Lew = 29

Close = 30

i:\IIIIUT I. I Constructing the Candlestick Line long, black real body, with the closing price several points below the open, reveals negative or bearish sentiment.

The upper shadow In Exhibit 1.1a tells you that buying pressure pushed XYZ up to a high of 37. Still, while the stock closed relatively high on the session, buyers were imable to hold It at 37 Uito the close. The lower shadow shows tliat selling pressure forced the stock to a low of 29. Nonetheless, buyers came In to offer support there and propelled It up to close at 35, 6 points higher than the low.

While we're talking about open and closUig prices, we know tliat the Japanese place great importance on these critical time periods as they pertain to the trading day. They believe, as do most Western analysts, that the first hour of tradmg usually sets the tone for the day. One Japanese saying states, "The first hour of the morning Is the rudder of the day."

On opening, the market lias absorbed and digested the events that took place since the prior day's close. The results are often volatile. The Impact of market reaction can cause radical price changes for equities, or even entire industry- groups. By the hour's end. the flurry of activity may subside a bit, and market participants have a point of reference with which to work.

An American market adage contends, "The amateurs open the market, and the professionals close It." Although It's an overstatement to assume the market's open is populated strictly by novices. It's true that the close of the day usually produces heavy emotional involvement. EMilng the last hour, many market players adjust their positions. This Is the time when traders, Investors, and Uistltutlonal managers decide whether or not to hold positions overnight. Margin calls on the futures markets are calculated by their price at the close. No wonder the last hour can produce volatile price swings fueled by strong emotions and heightened volume.

Since both the opening and closing hours can be turbulent periods. If you choose to take part, remember to use caution and discipline.

In the next section, we'll discuss one of the most critical uses of candle charts: giving you early indications that the trend may be changing. Whether a mature, extended trend, or a shorter, intermediate-term trend Is In place, candle lines and patterns display powerful clues that a shift in control from bulls to bears, or vice-versa, is in process or could be Imminent For a trader, this information is crucial. For an Investor, recognizing these all-Important signals could make the difference between keeping hefty gains or giving them back to the market. The material you learned in tills section will aid you In learning how to interpret these potent signals.

Ketlen Questions for Chapter One. Section Two: Candlestick Construction

1. What Is the rectangular portion of the candlestick called? a. Upper shadow h. Lower shadow c. Real body d. The wick

2. What Is the thin line above the real body of the candlestick line called?

a. Upper shadow b. Lower shadow c. Real body d. Lower wick

3. The upper shadow of a black candle line represents the range between the session's a. high and open.

h. low and close.

d. open and close.

4. The lower shadow of a white real body candlestick represents the range between the session's a. open and close.

d. None of the above. 3. A black real body on an hourly chart means a. the close of this hour was under the close of the last hour.

b. the close of this hour was lower than the open of tills hour.

c. the close of this hour was higher than the open of the last hour.

d. the open and close of tills hour were the same.

6. On a dally chart, a white real body means that today's a. close is higher than yesterday's close.

b. close Is higher than today's open.

€. open Is higher than yesterday's opening price, d. close Is lower than todays open.

7. What portion of the candlestick line do you think Is referred to as the "essence of the price movement"?

a. The upper shadow b. The lower shadow c. The close d. The real body

H. The last hour and close of the stock market are Important because a. tills Is the time when market participants, from Individuals to institutions. may close out existing positions or open new ones.

b. fund managers switch sectors c. traders with short positions cover them d. the closing bell on the floor of the NYSE Is rung by a prominent person 5>. Using data poUits in Exhibit 1.2, draw the candlestick lines

Open

High

low

Close

Session 1

23

28

23

24

Session 2

30

30

24

27

Session 3

27

29

26

27

Session 4

21

26

21

26

Session 5

24

27

21

23

i:\IIIIH1 1.2 Data Points i:\IIIIH1 1.2 Data Points

10. In Exhibit 1.3, for line x. ar ea 3 represents the a. close, h. open.

Line x Line y

EXHIBIT 1.3 Questions 10 and I I

Line x Line y

EXHIBIT 1.3 Questions 10 and I I

11. For line y In Exlilblt 1.3, area 3 represents the a. close. l>. open, c. low. <i. high.

\nswers for Chapter One. Section Two:

Caiidlosllrk (lonsl ruction

1. c. The rectangular section of the candle line Is called the real body. The real body represents the range between the session's open and close. When the real body is black (I.e.. filled), that means the close of the session was lower than the open. If the real body Is white (Le., empty). It shows the close was higher than the open.

2. a. The thin lines above and below the real body are shadows These shadows represent the session's price extremes. The shadow above the real body Is called the upper shadow, and the shadow below the real body Is the lower shadow. Accordingly, the peak of the upper shadow is the high of the session, and the bottom of the lower shadow Indicates the low of the session.

3. a. When the real body Is black. It means the close of the session was lower than the open. Accordingly, the top of a black real body represents the session's open. The range between the top of a black real body and the upper shadow represents the open and high of that session, respectively.

4. b. If the real body Is white (I.e., empty), It means the close was higher than the open. This means that the bottom of a white real body Is the open, and the lower shadow on a white candle session Is the range between tliat session's open and low.

3. I). A black real body means that the session's close Is under the session's open. The top of the black real body represents the open of the hour, and the bottom of that real body represents the close of the hour.

o. D. A white real body means that the cuiront session's close Is higher than the current session's open. In classic Japanese candlestick charting, when candle charts were hand drawn. Instead of a white real body, the Japanese colored It red. However, unless one uses a color printer, the red and black real bodies would all be printed In black. This is why we have white and black real bodies, instead of red and black real bodies.

7. d. On Japanese charts, even an individual candle line luis meaning. Therefore, one of the first clues to the vitality of the market Is the size and color of the real body. To the Japanese, the real body Is the essence of the price movement. This Is a critical and powerful aspect of candle charts: Through the height and color of the real body, candle charts show the relative posture of the bulls and the bears.

fl. à. The close Is a time of m^Jor commitment. The closing price Is used for many important calculations. Imagine a weekly chart in which the closing price above the previous week's resistance could Indicate a m^Jor breakout in the offing. The close Is also the time when market participants decide whether to close out existing positions, hold current ones, or open new ones.

Session Session Session Session Session 1 2 3 4 5

IAMBI I 1.4 Answer to Question 9

10. a. A white (or empty) real body means that the close is above the opening. Consequently, the top of a white real body Is the close of the session.

11. t>. A black real body means that the close Is under the open, and consequently the top of the black real body Is the opening of the session.

smiovniKii:

liiisic Mai hrI SInilevies arly recognition of potential trend reversals Is one of the most impor tant skills a trader/Investor can cultivate. As you study candle charts and learn to recognize single candle lines and patterns, you will appreciate how candles offer an early heads up on possible trend reversals. In fact, most signals given by candle formations are reversal signals

Candle charts often display reversal signals In a few sessions rather than over the longer time periods often needed for bar chart reversal signals. Using candle charts, you'll Identify market turns quickly, which should help you to enter and exit the market with speed and accuracy.

In tills section, we present the basics of trend reversals and how candles play such an important role. Also discussed are concepts Inherent to trend changes and reversals: support and resistance levels and all-Important breakouts and price closes above and below those levels.

• How candles play a powerful role in recognizing early reversal signals

• How candle lines and patterns confirm support and resistance

• The importance of confirmation

• Why the closing price plays a key role in breaks above resistance and below support he} lenu» lo mtich for:

• Trend reversal

• Consolidation

• Support and resistance

♦ Retracement

The ability to recognize a potential trend reversal Is one of the most important skills you can cultivate. Your ability to read candle lines and patterns will increase that skill many times over.

In the sections that follow, we'll delve Into specific candle lines and patterns and the signals they give In the contexts of uptrends, downtrends and trend shifts, or reversals. At the present, however, we're going to get a top-down overview.

To start with, let's examine the anatomy of a trend reversal. A Japanese proverb states. "Darkness lies one Inch ahead." You need only watch the financial television networks to see the great degree of Importance traders and Investors place on foretelling market tops and bottoms to arrive at an early Insight on upcoming moves As you know, the common goal Is to buy low and sell high or. In the case of selling short to sell high, buy low.

On charts. Western trend reversal patterns Include double and triple tops and bottoms, key reversal days, head-and-shoulders. cup-wlth-liandles. and Island tops and bottoms.

Although market cycles of alternating uptrends and downtrends interspersed with peaks and valleys are Inevitable, you should remember that trends don't always end abruptly. In fact, trends usually occur slowly, in stages, as the underlying psychology shifts.

Remember the old market saying, MThe trend Is your friend." Successful trading entails staying on the light side of the trend (although most find this Is easier said than done). Trend change or reversal signals are the market s way of warning. It means market psychology is In transfomiatlon and you need to adjust your trading style to reflect that environment change.

For example. If you see a reversal signal, you might consider Initiating a new position only If that signal Is In the direction of the nuyor trend. Say your stock lias been climbing in a strong uptrend. Then. It either consolidates sideways for a few sessions or moves down (retraces) to prior support. At this time you get a bullish candle signal. Since the m^Jor trend has been up. one can use the bullish candle signal to Initiate a long position. A bullish candle signal in a bear trend should be used either to cover shorts or as an alert that

When I say a bearish or bullish reversal with the candlesticks, it does not imply that the market will reverse from down to up (in the case of a bullish reversal) or from up to down (with a bearish reversal). It just means that the market has gone from up to neutral (with a bearish candle signal) or from down to neutral (in the case of a bullish candle signal). In other words, with these reversal signals, the odds of a turn havs increased but are not assured.

When I say a bearish or bullish reversal with the candlesticks, it does not imply that the market will reverse from down to up (in the case of a bullish reversal) or from up to down (with a bearish reversal). It just means that the market has gone from up to neutral (with a bearish candle signal) or from down to neutral (in the case of a bullish candle signal). In other words, with these reversal signals, the odds of a turn havs increased but are not assured.

the market may rally and to use that rally to sell since the m^or trend Is down.

Trend reversals or shifts are a modification In market psychology. In a strong uptrend, such as you see In Exhibit 1.5A. the bulls are in control. Shoulder-to-shoulder, optimistic bulls turn out in force, buying available supply and supporting ever-rising prices of stock XYZ. When a retracement, or sideways consolidation occurs (as It does from 1 to 2), the bulls stand aside, tucking theU' shares in their pockets. The stock rests for a tUue, then resumes Its climb upward. Three shifts in psychology took place during each of these three movements In stock XYZ's strong uptrend.

In Exhibit 1.5B, the same bulls propelled XYZ higher with gusto. The market tops out at 3 (of course, we don't know It Is a top until a few sessions later, when the stock descends). Again, those with long positions may have

Trend reversal signal — Trend reversal signal •

trend resumes trend breaks down after correction i:\BIBi r 1.3 Top Reversals taken some or all of their profits. This time, however, the retraoernent turned into a trend reversal, barely stopping along the way.

Points 1. 2. and 3 in Exhibit 1.5 are reversals, and. as we don't know the extent of the move after the reversal starts, the candles will often be the first clue of a change In trend.

Besides scanning for possible trend changes, another critical component is asking, "Where are support and resistance?" Support and resistance on a chart can take multiple forms It may be a prior high or low depicted in a price level or pattern. It may appear as a Western Indicator, such as a trend line, moving average, or something as basic as the most recent high or low.

We know that a market often tops out at. or near, the same price range at which It pulled back at a previous time. It may also fall to a prior low price, then bounce off of that support level. If a candle signal confirms a support Une, it would increase the potential bullish Implications of that candle signal more than If that candle signal did not confirm support. Conversely, if a bearish candle signal emerges at a resistance zone, the chances of a turnaround have increased. As such, the rule is that the more technical signals—whether they are candle or Western or a combination of both—the more likely is a reversal. An example Is shown In Exhibit 1.6 In which a bullish candle signal called a hammer (discussed later) confirms a support line.

In Section One of tills chapter, we talked about the Importance of the market's dally close. Let's take tills a step further. Like most technical analysts, the Japanese place great emphasis on a security's closing price, especially If that price closes above resistance or below support. Think of It this way: If a stock, for Instance, closes above a prior high. It means market participants are willing to pay more for It right then, and they are willing to hold it overnight. Tliat means they are committed, and commitment Is an extremely Important factor In the movement of the financial markets. An Intra-day break of support or resistance does not have the same significance as a severing of support or resistance on a close.

Say you are studying a dally chart of a stock. Imagine It had moved sideways in a basing mode between $40 and $50 for the last five weeks or so.

i:\IIIIH I 1.0 Candle Signal Confirming Support

i:\IIIIH I 1.0 Candle Signal Confirming Support

In the context of support and resistance comes a simple and powerful technique (which, by the way, is not based on Japanese candlestick charts) that I have called the change of polarity principle. This concept applies perfectly to a core principle of technical analysis: Old resistance becomes new support, and old support becomes new resistance. Although this term is not generally applied to the concept. I telieve it describes it well. On a chart of anytime frame, you can often see how that once a markets breaks over a muItitested resistance area, the prior resistance area is converted into new suppDrt. In contrast, markets that fall through prior support have trouble climbing back through it again since that previous support is frequently converted into resistance (see Exhibit 1.7).

In the context of support and resistance comes a simple and powerful technique (which, by the way, is not based on Japanese candlestick charts) that I have called the change of polarity principle. This concept applies perfectly to a core principle of technical analysis: Old resistance becomes new support, and old support becomes new resistance. Although this term is not generally applied to the concept. I telieve it describes it well. On a chart of anytime frame, you can often see how that once a markets breaks over a muItitested resistance area, the prior resistance area is converted into new suppDrt. In contrast, markets that fall through prior support have trouble climbing back through it again since that previous support is frequently converted into resistance (see Exhibit 1.7).

Suddenly, the bulls wrest control of the market and the stock closes at $53. Do you see how important that closing price is? It means people are willing to buy and hold the stock at a higher price. The market has established new demand for the stock.

Conversely, if a market trades sideways In a box range (as the Japanese call consolidation patterns) for some period of time, then breaks down to close below that support area. It means that buyers were unwilling to step in and hold the price at that level. The bears are In control, and that market may fall to lower prices. If. however, a session's candle broke price support by dipping below It. but then closed Inside the box range, that Is not as bearish. This sort of session tells you that buyers stepped In before the close, and demand was strong enough to push the price back into the prior box range by session's end.

Now you understand how valuable tool candle formations are In the context of trend reversals, along with components inherent Ui those reversals, support and resistance.

Old resistance become* new support.

Prior support becomes re* resistance

Old resistance become* new support.

Prior support becomes re* resistance lAIIIBi r 1.7 Change of Polarity

In the next section, you'll leam about powerful candle lines called spinning tops and dojl and how potent they can be. We'll also discuss additional ln-depth market psychology as revealed by candles. Deciphering market psychology accurately Is a \ltal part of your future success as a trader/Investor.

ClllXIt \Q1R I MU KM VMHM,_

Review Questions for f.luipter One. Section Three: Basic Market Strategies

1. Which Is most true?

j. All candlestick signals are reversals b. Most candlestick signals are reversal signals r. All candlestick signals are continuation signals, d. Most candlestick signals are continuation signals.

2. Candle charts provide a. early reversal signals.

b. hints of a false breakout.

c. hints that the momentum may be changing.

d. All of the above.

3. Which of the following Western technical tools can be used on a candle chart?

Moving average b. Volume c. Oscillators

4. In candlestick trading, when we talk about a break of resistance on a dally chart, we mean a. a close above a resistance area.

b. an lntraday break above resistance by at least 1%.

c. an lntraday break above resistance by at least (1. a close above the prior session's real body.

3. A box range in Japanese temilnology Is the same as a Western a. triangular trading range.

r>. ascending triangle, c. lateral trading range, c. bull flag

6. Which is false? Candle charts are best used a. as a stand-alone tool. t>. on dally charts.

c. on weekly charts.

\nsivers lor Chapter One. Section Three:

Basic Market Strategies

1. h. Tills is a rn^|or advantage of candle charts. They often send out reversal signals in as few as one. two, or three sessions. Some continuation signals exist, but most of the candlestick signals show bottom or top reversals.

2. d. Among the m^jor advantages of candle charts Is that we can use individual candle lines, or combinations of candle lines (called candlestick patterns), to obtain reversal signals in as little as one, two, or three sessions. We can also use the shape of the candle line to see If a breakout Is likely to be sustainable. For example, a small real body or dojl at a new high could give us a little clue that the bulls are not In complete control, and the rally may not be sustainable. We also use spinning tops to gauge whether the market's trend might be in the process of changing.

3. d. One of the most powerful aspects of candle charts is that because they use the same data as bar charts (i.e.. the open. high. low. and close), all Western bar charting techniques (Le., moving averages, volume, and so on) can be used on candle charts.

4. a. To most effectively confirm a break above resistance, I most often recommend a close above a resistance area Conversely, to confirm a break of support. I like to see a close under a support area.

5. c. A box range is the same as a lateral or consolidated trading environment. in Western technicals. The name Is derived from the fact that such price action resembles a box.

6. a. CandlesUck charting tools are most potent when combined with other technical tools, such as trend lines, moving averages, and volume.

chapter two

Lessons From The Intelligent Investor

Lessons From The Intelligent Investor

If you're like a lot of people watching the recession unfold, you have likely started to look at your finances under a microscope. Perhaps you have started saving the annual savings rate by people has started to recover a bit.

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