Trading Japanese Candlesticks

Charts may be deaf and mute, yet they still communicate very well. Candlestick formations are the sign language of the market. They frequently tell the trader where U-turns or reversals are and where the market is going.

Most beginner traders prefer learning how to read charts using what is called a Japanese candlestick, which monitors price movement against time. There are three types of charts traders can refer to: a line chart, a bar chart, or a candlestick chart. Until recently, bar charts dominated the financial industry, but now even the world's top traders are using Japanese candlestick charts for the additional information they can provide.

THE HISTORY OF JAPANESE CANDLESTICKS_

The period 1500 to 1600 in Japan was known as Sengoku Jidai, or The Age of War. Military confrontation had become a way of life in that country as feudal lords fought for control of rival territories.

Over a period of 40 years (1534-1582, 16th century), three charismatic generals—Nobunaga Oda, Hideyoshi Toyotumi, and Leyasu Tokagawa— unified Japan. Once somewhat relative peace had been established, several new opportunities for expansion developed.

It was during 1600 that the concept of the Japanese candlestick was being explored, tested, and used in monitoring prices in the rice markets. Because there was no standardized currency, the price of rice became the predominant medium of exchange, or currency. In the late 1600s, the Rice Exchange was formed to regulate trading proceedings. By 1710, there were more than 1,300 rice dealers. Rather than just deal in actual rice, rice coupons were issued, and these became one of the first forms of futures contracts ever traded.

Similar events took place in other parts of the world. There was the Tulip Mania that swept The Netherlands in the early 1600s, which also involved a form of futures contract. During this period, tulips became the standard medium of exchange and became even more valuable than gold there.

The popularity of these Tulip coupons were drawing attention around the world and other countries began to catch on to this effective way of trading. Rice coupons in Japan became significant, with a bale of rice being the standard amount to be traded. By 1749, there were approximately 110,000 bales of rice traded via "empty rice coupons" although it is believed there were only about 30,000 bales in all of Japan. An empty rice coupon became a form of a futures contract—a coupon for rice that may not even be planted or harvested yet. The rice is traded for a specific future date, as if it was grown and going to be delivered to that person on that future date. Today, futures trading is a multibillion dollar industry. In America, most futures trading for commodities occurs in Chicago, at the Chicago Mercantile Exchange, or CME.

But where do Japanese candlesticks fit in? Munehisa Homma was born into a wealthy Japanese farming family in 1724. Homma had an aptitude for business and would eventually become a dominant trader in the Japanese rice market. Although candlesticks were not actually developed by Homma, he studied the psychology of investors and formulated several key trading principles. These concepts evolved into the candlestick charting techniques that we know today.

Candlestick charts were originally plotted painstakingly by hand. This labor-intensive step, as well as the fact that many Japanese traders could not properly communicate or share their trading methods due to language barriers, meant that the use of Japanese candlestick formations could not become widespread until recent times. However, they are now included in the majority of financial charting packages as a standard option and are a key indicator for establishing a method of prices and analyses, alongside the more traditional bar charts and line charts.

HOW TO READ A JAPANESE CANDLESTICK_

Japanese candlestick charts monitor price movement during a certain period of time. As the candlesticks form, they begin to tell a story of the activity in the market, as well as reflect the mood of the market during that time. Candlesticks become the sign language of the market, communicating via certain formations the future potential moves of the market, which is how profits are made—by projecting correctly where the market will go, not where it has been.

Successful traders take the time to study and understand this visual language. Candlestick formations indicate clear buy and sell signals, communicating to the trader when it is time to enter the market or to get out. How well you understand candlestick formations can give you a significant advantage in the market.

Japanese candlesticks formations can provide the trader with the market's first sign of changing direction, a coming U-turn, or a reversal. They will appear in the form of a single candlestick or a combination of more than one candlestick. There are hundreds of formations, yet only a handful of formations carry substantial weight when looking for a good entry point. A good entry point is described as a location where the market goes your way from the beginning. Let us see what a Japanese candlestick looks like and how it forms (see Figure 4-1).

Candlesticks, which are composed of full bodies and wicks, measure price fluctuations within a certain period of time. As prices move up or down from the opening, the body begins to form. If, from the opening price, prices move up and then close higher than the opening, it is a bullish candle. These candlesticks, in this book, will always appear "empty" or "white"—which indicates their bullish nature. If prices begin to fall from the opening price and close lower than the opening, it is a bearish candle. These candlesticks will always appear to be "filled" or "black" in this book—which indicates their Bearish nature. The lines on the north and south sides of the bodies of the candles are called "wicks." They monitor the highest price, or high, and the lowest price, or low, of that time period. For example, you can set your charts to provide you with 5-minute candlesticks, 10-, 15-, or 30-minute candlesticks, even hourly, daily, weekly, monthly, or yearly. Candlesticks monitor price movement against time, providing traders with four key pieces of information for that specific time period: the opening price, the closing price, the highest price reached, and the lowest price reached.

FIGURE 4-1

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