Candlestick charts were developed in Japan in the eighteenth century. Munehisa Homma developed these charting principles to amass a huge fortune trading rice coupons. Homma used candlestick techniques to trade unconventionally as a warrior; he had a ruthless ability to seize opportunity and take action, due in part to candlestick conviction. Eventually Homma won the honorary title of Samurai because of his demonstrated mastery.*
Many credit Steve Nison, author of the groundbreaking book, Japanese Candlestick Charting Techniques, with introducing candlestick charts to the United States in the 1980s. In his book, Steve provides a comprehensive, easy-to-understand guide to reading and applying candlestick charts.
Japanese candlestick charting techniques provide a fun, simple, and extremely effective means for charting stocks. Once you become familiar with candlestick charts, you'll have a difficult time looking at bar charts. Candlesticks provide a fresh, powerful dimension for traders and charting enthusiasts.
Candlestick charts display a stock's price action in a multidimensional view, utilizing color and symmetry. Candlesticks allow the viewer to take into account the important opening price, as well as the high, low, and close.
Japanese candlesticks utilize the opening price, the closing price, the high price, and the low price to form a pattern. Each candlestick has a body and a wick. The color of the body reflects the relationship between the opening and the closing price, and is one of the most important characteristics.
A white body is formed when the closing price is above the opening price. White bodies are bullish, illustrating that the bulls won the battle for the day. A black body is formed when the closing price is lower than the opening price. Black bodies are bearish, illustrating that the bears won the day's battle. The wick or shadow is the high or low range outside of the body.
Candlestick charts produce potent reversal patterns as well as valid continuation patterns. When combined with Western charting techniques, candlestick charts provide a potent one-two combination for increased decision-making leverage.
*Nison, Steve. Japanese Candlestick Charting Techniques. Simon & Schuster, 1991.
To view this image, please refer to the print version of this book
Figure 14-1 Candlestick Construction the opening price
The opening price is the starting gate in candlestick trend analysis, and is more important than the previous night's close. A lot can change between the previous day's close and the current day's opening. By using the opening price as the starting point for the color of the candle, candlesticks place more emphasis on the here-and-now aspect of the market.
The opening price is especially important for market makers, because it is often determined by the emotional extreme reflected in nonprofessional order flow. (See Chapters 6 and 21 on the opening price signal and gaps.) Because of this emotional extreme, the opening price is often close to the high or low of a stock's price action for the day. Market makers who have buy or sell orders that have accumulated from the night before and from the early morning dictate the market's opening. These orders are usually the product of novice investors or panicky traders who are acting on old news from the previous night or from the early morning.
Market makers enjoy a unique advantage at the opening, because they have an inside look as to the real demand or supply for a stock. Specialists or market makers gap a stock on the opening when they have one-sided order flow affecting the supply-demand relationship.
If the markup or markdown is due to small order flow with no institutional demand behind it, market makers may deem it to be artificial and will often sell or "fade" the opening. This means taking a position on the opposite side of the gap. (See Chapter 21 on artificial gaps.) For example, if a stock is marked up 2 points on non-institutional order flow, market makers may short the stock on the opening for their own inventory. The same holds true if the stock is marked down on noninstitutional order flow, in which case market makers would buy it for their own inventory.
New York Stock Exchange specialists are the sole proprietors of the order flow for their stocks, so they have single-handed control of the opening price. Market makers on the NASDAQ have to compete with one another for order flow, so they do not have a complete picture for the pre-opening demand. In many instances the opening price is close to the high or low point of the day because it was dictated by the emotional capitulation of amateur players at the opening bell.
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