"The beginning is most important"
Some cf you may have already heard cf candlecharts. Probably, many more cf you have not. In December 1989, I wrote an introductory article on candlesticks that precipitated an immediate groundswell of interest. It turned out that I was one of the few Americans familiar with this centuries-old Japanese technique. I wrote follow-up articles, gave numerous presentations, taught classes, and was interviewed on television and by newspapers across the country. In early 1990, I wrote a short reference piece for my Chartered Market Technician thesis about candlestick charts. It contained very basic introductory material, but it was the only readily available information on candlestick charts in the United States. This handout became very popular. Within a few months, Merrill Lynch, the publisher of the booklet, received over 10,000 requests.
"Why," I have often asked myself, "has a system which has been around so long almost completely unknown in the West?" Were the Japanese trying to keep it secret? Was it the lack of information in the United States? I don't know the answer, but it has taken years of research to fit all the pieces together. I was fortunate in several ways.
Perhaps my perseverance and serendipity were the unique combination needed that others did not have.
In 1987, I became acquainted with a Japanese broker. One day, while I was with her in her office, she was looking at one of her Japanese stock chart books (Japanese chart books are in candlestick form). She exclaimed, "look, a window." I asked what she was talking about. She told me a window was the same as a gap in Western technicals. She went on to explain that while Western technicians use the expression "filling in the gap" the Japanese would say "closing the window." She then used other expresions like, "doji" and "dark-cloud cover." I was hooked. I spent the next few years exploring, researching, and analyzing anything I could about candlestick charts.
It was not easy. There are scant English publications on the subject. My initial education was with the help of a Japanese broker and through drawing and analyzing candlestick charts on my own. Then, thanks to the Market Technicians Association (MTA) library, I came across a booklet published by the Nippon Technical Analysts Association called Analysis of Stock Price in Japan. It was a Japanese booklet which had been translated into English. Unfortunately, there were just ten pages on interpreting candlestick charts. Nonetheless, I finally had some English candlestick material.
A few months later, I borrowed a book that has had a major influence on my professional life. The MTA office manager, Shelley Lebeck, brought a book entitled The Japanese Chart of Charts by Seiki Shimizu and translated by Greg Nicholson (published by the Tokyo Futures Trading Publishing Co.) back from Japan. It contains about 70 pages on candlestick charts and is written in English. Reading it was like finding an oasis in a desert.
As I discovered, while the book yielded a harvest of information, it took some effort and time to get comfortable with its concepts. They were all so new. I also had to become comfortable with the Japanese terminology. The writing style was sometimes obscure. Part of this might have resulted from the translation. The book was originally written in Japanese about 25 years ago for a Japanese audience. I also found out, when I had my own material translated, that it is dreadfully difficult to translate such a specialized subject from Japanese to English. Nonetheless, I had some written reference material. This book became my "Rosetta Stone."
I carried the book with me for months, reading and rereading, taking copious notes, applying the candlestick methods to the scores of my hand-drawn candlestick charts. I chewed and grinded away at the new ideas and terminology. I was fortunate in another sense. I had the help of the author, Seiki Shimizu, to answer my many questions. Although Mr. Shimizu does not speak English, the translator of the book, Greg Nicholson, graciously acted as our intermediary via fax messages. The Japanese Chart of Charts provided the foundation for the rest of my investigation into candlesticks. Without that book, this book would not have been possible.
In order to continually develop my abilities in candlestick charting techniques, I sought out Japanese candlestick practitioners who would have the time and inclination to speak with me about the subject. I met a Japanese trader, Morihiko Goto who had been using candlestick charts and who was willing to share his valuable time and insights. This was exciting enough! Then he told me that his family had been using candlestick charts for generations! We spent many hours discussing the history and the uses of candlestick charts. He was an invaluable storehouse of knowledge.
I also had an extensive amount of Japanese candlestick literature translated. Obtaining the original Japanese candlestick information was one problem. Getting it translated was another. Based on one estimate there are probably fewer than 400 full-time Japanese-to-English translators in America (this includes part-time translators)' I had to find a translator who could not only translate routine material, but also the highly specialized subject of technical analysis. In this regard I was lucky to have the help of Languages Services Unlimited in New York. The director, Richard Solberg, provided indispensable help to this project. He was a rarity. He was an American fluent in Japanese who understood, and used, technical analysis. Not only did Richard do a wonderful job of translating, but he helped me hunt down and obtain Japanese candlestick literature. Thanks to his help I might have the largest collection of Japanese books on candlesticks in the country. Without Richard this book would have been much less extensive.
Before my introductory article on candlestick charts appeared in late 1989, there were few services offering candlestick charts in the United States. Now a plethora cf services offer these charts. These include:
Commodity Trend Service Charts (North Palm Beach, FL);
CQG (Glenwood Springs, CO);
Ensign Software (Idaho Falls, ID);
FutureSource™ (Lombard, IL); and
Knight Ridder-Commodity Perspective (Chicago, IL).
By the time you read this book, there probably will be additional services providing candlestick charts. Their popularity grows stronger every day. The profusion of services offering the candlestick charts attests to both their popularity and their usefulness.
WHY HAVE CANDLESTICK CHARTING TECHNIQUES CAPTURED THE ATTENTION OF TRADERS AND INVESTORS AROUND THE WORLD?
I have had calls and faxs from around the world requesting more information about candlestick techniques. Why the extensive interest? There are many reasons and a few are:
1. Candlestick charts are flexible. Users run the spectrum from first-time chartists to seasoned professionals. This is because candlestick charts can be used alone or in combination with other technical analysis techniques. A significant advantage attributed to candlestick charting techniques is that these techniques can be used in addition to, not instead of, other technical tools. I am not trying to convince veteran technicians that this system is superior to whatever else they may be using. That is not my claim. My claim is that candlestick charting techniques provide an extra dimension of analysis.
2. Candlestick charting techniques are for the most part unused in the United States. Yet, this technical approach enjoys a centuries-old tradition in the Far East, a tradition which has evolved from centuries of trial and error.
3. Then there are the picturesque terms used to describe the patterns. Would the expression "hanging-man line" spark your interest? This is only one example of how Japanese terminology gives candlesticks a flavor all their own and, once you get a taste, you will not be able to do without them.
4. The Japanese probably know all the Western methods of technical analysis, yet we know almost nothing about theirs. Now it is our turn to benefit from their knowledge. The Japanese use a combination of candlestick charting techniques along with Western technical tools. Why shouldn't we do the same?
5. The primary reason for the widespread attention aroused by candlestick charts is that using them instead of, or in addition to, bar charts is a win-win situation.
As we will see in Chapter 3 on drawing candlestick lines, the same data is required in order to draw the candlestick charts as that which is needed for our bar charts (that is, the open, high, low, and close). This is very significant since it means that any of the technical analysis used with bar charting (such as moving averages, trendlines, Elliott Wave, retracements, and so on) can be employed with candlestick charts. But, and this is the key point, candlestick charts can send signals not available from bar charts. In addition, there are some patterns that may allow you to get the jump on those who use traditional Western charting techniques. By employing candlestick charting instead of bar charting you have the ability to use all the same analyses as you would with bar charting. But candlestick charts provide a unique avenue of analysis not available anywhere else.
WHAT IS IN THIS BOOK?
Part I of the book reveals the basics on constructing, reading, and interpreting over 50 candlestick chart lines and patterns. Part II explains how to meld candlestick charts with Western technical analysis techniques. This is where the true power of candlecharts is manifested. This is how I use them.
I have drawn illustrations of candlestick patterns to assist in the educational process. These illustrations are representative examples only. The drawn exhibits should be viewed in the context that they show certain guidelines and principles. The actual patterns do not have to look exactly as they do in the exhibits in order to provide the reader with a valid signal. This is emphasized throughout the book in the many chart examples. You will see how variations of the patterns can still provide 'mportant clues about the state of the markets.
Thus, there is some subjectivity in deciding whether a certain candlestick formation meets the guidelines for that particular formation, but this subjectivity is no different than that used with other charting techniques. For instance, is a $400 support area in gold considered broken if prices go under $400 intra-day, or do prices have to close under $400? Does a $.10 penetration of $400 substantiate broken support or is a larger penetration needed? You will have to decide these answers based on your trading temperment, your risk adversity, and your market philosophy. Likewise, through text, illustrations and real examples I will provide the general principles and guidelines for recognizing the candlestick formations. But you should not expect the real-world examples to always match their ideal formations.
I believe that the best way to explain how an indicator works is through marketplace examples. Consequently, I have included many such examples. These examples span the entire investment spectrum from futures, fixed-income, equity, London metal markets and foreign exchange markets. Since my background is in the futures markets, most of my charts are from this arena. I also look at the entire time spectrum— from intra-day to daily, weekly, and monthly candlestick charts. For this book, when I describe the candlestick lines and patterns, I will often refer to daily data. For instance, I may say that in order to complete a candlestick pattern the market has to open above the prior day's high. But the same principles will be valid for all time frames.
Two glossaries are at the end of the text. The first includes candlestick terms and the second Western technical terms used in the book. The candlestick glossary includes a visual glossary of all the patterns.
As with any subjective form of technical analysis, there are, at times, variable definitions which will be defined according to the users' experience and background. This is true of some candlestick patterns. Depending on my source of information, these were instances in which I came across different, albeit usually minor, definitions of what constitutes a certain pattern. For example, one Japanese author writes that the open has to be above the prior close in order to complete a dark-cloud cover pattern (see Chapter 4). Other written and oral sources say that, for this pattern, the open should be above the prior high.
In cases where there were different definitions, I chose the rules that increased the probability that the pattern's forecast would be correct. For example, the pattern referred to in the prior paragraph is a reversal signal that appears at tops. Thus, I chose the definition that the market has to open above the prior day's high. It is more bearish if the market opens above the prior day's high and then fails, then it would be if the market just opens above the prior day's close and then failed.
Much of the Japanese material I had translated is less than specific. Part of this might be the result of the Japanese penchant for being vague. The penchant may have its origins in the feudal ages when it was acceptable for a samurai to behead any commoner who did not treat him as expected. The commoner did not always know how a samurai expected him to act or to answer. By being vague, many heads were spared. However, I think the more important reason for the somewhat ambiguous explanations has to do with the fact that technical analysis is more of an art than a science. You should not expect rigid rules with most forms of technical analysis —just guideposts.
Yet, because of this uncertainty, some of the ideas in this book may be swayed by the author's trading philosophy. For instance, if a Japanese author says that a candlestick line has to be "surpassed to signal the next bull move, I equate "surpassed" with "on a close above." That is because, to me, a close is more important than an intra-day move above a candlestick line. Another example of subjectivity: In the Japanese literature many candlestick patterns are described as important at a high-price area or at a low-price area. Obviously what constitutes a "high-price" or "low-price" area is open to interpretation.
As with all charting methods, candlestick chart patterns are subject to the interpretation of the user. This could be viewed as a limitation. Extended experience with candlestick charting in your market specialty will show you which of the patterns, and variations of these patterns, work best. In this sense, subjectivity may not be a liability. As you gain experience in candlestick techniques, you will discover which candlestick combinations work best in your market. This may give you an advantage over those who have not devoted the time and energy in tracking your markets as closely as you have.
As discussed later in the text, drawing the individual candlestick chart lines requires a close. Therefore, you may have to wait for the close to get a valid trading signal. This may mean a market on close order may be needed or you may have to try and anticipate what the close will be and place an order a few minutes prior to the close. You may also prefer to wait for the next day's opening before placing an order.
This aspect may be a problem but there are many technical systems (especially those based on moving averages of closing prices) which require a closing price for a signal. This is why there is often a surge in activity during the final few minutes of a trading session as computerized trading signals, based on closing prices, kick into play. Some technicians consider only a close above resistance a valid buy signal so they have to wait until the close for confirmation. This aspect of waiting for a close is not unique to candlestick charts.
On occasion, I can use the hourly candlestick charts to get a trade signal rather than waiting for the close of that day. For instance, there could be a potentially bullish candlestick pattern on the daily chart. Yet, I would have to wait for the close before the candlestick pattern is completed. If the hourly charts also show a bullish candlestick indicator during that day, I may recommend buying (if the prevalent trend is up) even before the close.
The opening price is also important in the candlestick lines. Equity traders, who do not have access to on-line quote machines, may not be able to get opening prices on stocks in their newspapers. I hope that, as candlestick charts become more common, more newspapers will include openings on individual stocks.
Candlestick charts provide many useful trading signals. They do not, however, provide price targets. There are other methods to forecast targets (such as prior support or resistance levels, retracements, swing objectives, and so on). Some Japanese candlestick practitioners place a trade based on a candlestick signal.and stay with that trade until another candlestick pattern tells them to offset. Candlestick patterns should always be viewed in the context as to what occurred before and in relation to other technical evidence.
With the hundreds of charts throughout this book, do not be surprised if you see patterns that I have missed within charts. There will also be examples cf patterns that, at times, did not work. Candlesticks will not provide an infallible trading tool. They do, however, add a vibrant color to your technical palette.
Candlestick charts allow you to use the same technical devices that you use with bar charts. But the candlestick charts give you signals not available with bar charts. So why use a bar chart? In the near future, candlestick charts may become as standard as the bar chart. In fact, I am going to make a bold prediction: As more technicians become comfortable with candlestick charts, they will no longer use bar charts. I have been a technical analyst for nearly 20 years. And now, after discovering all their benefits, I only use candlestick charts. I still use all the traditional Western technical tools, but the candlesticks have given me a unique perspective into the markets.
Before I delve into the topic of candlestick charts, I will briefly discuss the importance of technical analysis as a separate discipline. For those of you who are new to this topic, the following section is meant to emphasize why technical analysis is so important. It is not an in-depth discussion. If you would like to learn more about the topic, I suggest you read John Murphy's excellent book Technical Analysis of the Futures Markets (The New York Institute of Finance).
If you are already familiar with the benefits of technical analysis, you can skip this section. Do not worry, if you do not read the following section, it will not interfere with later candlestick chart analysis information.
The importance of technical analysis is five-fold. First, while fundamental analysis may provide a gauge of the supply/demand situations, price/earnings ratios, economic statistics, and so forth, there is no psychological component involved in such analysis. Yet the markets are influenced at times, to a major extent, by emotionalism. An ounce of emotion can be worth a pound of facts. As JohnManyard Keynes stated, "there is nothing so disastrous as a rational investment policy in an irrational world."2 Technical analysis provides the only mechanism to measure the "irrational" (emotional) component present in all markets.
Here is an entertaining story about how strongly psychology can affect a market. It is from the book The Afew Gatsbys.3 It takes place at the Chicago Board of Trade.
Soybeans were sharply higher. There was a drought in the Illinois Soybean Belt. And unless it ended soon, there would be a severe shortage cf beans. . . . Suddenly a few drops of water slid down a window. "Look," someone shouted, "rain!". More than 500 pairs of eyes [the traders-editor's note] shifted to the big windows. . . . Then came a steady trickle which turned into a steady downpour. It was raining in downtown Chicago.
Sell. Buy. Buy. Sell. The shouts cascaded from the traders' lips with a roar that matched the thunder outside. And the price of soybeans began to slowly move down. Then the price of soybeans broke like some tropic fever.
It was pouring in Chicago all right, but no one grows soybeans in Chicago. In the heart of the Soybean Belt, some 300 miles south of Chicago the sky was blue, sunny and very dry. But even f it wasn't raining on the soybean fields it was in the heads cf the traders, and that is all that counts [emphasis added]. To the market nothing matters unless the market reacts to it. The game is played with the mind and the emotions [emphasis added].
In order to drive home the point about the importance of mass psychology, think about what happens when you exchange a piece of paper called "money" for some item like food or clothing? Why is that paper, with no intrinsic value, exchanged for something tangible? It is because of a shared psychology. Everyone believes it will be accepted, so it is. Once this shared psychology evaporates, when people stop believing in money, it becomes worthless.
Second, technicals are also an important component of disciplined trading. Discipline helps mitigate the nemesis of all traders, namely, emotion. As soon as you have money in the market, emotionalism is in the driver's seat and rationale and objectivity are merely passengers. f you doubt this, try paper trading. Then try trading with your own funds. You will soon discover how deeply the counterproductive aspects of tension, anticipation, and anxiety alter the way you trade and view the markets—usually in proportion to the funds committed. Technicals can put objectivity back into the drivers seat. They provide a mechanism to set entry and exit points, to set risk/reward ratios, or stop/out levels. By using them, you foster a risk and money management approach to trading.
As touched upon in the previous discussion, the technicals contrib— ute to market objectivity. It is human nature, unfortunately, to see the market as we want to see it, not as it really is. How often does the fol— lowing occur? A trader buys. Immediately the market falls. Does he take a loss. Usually no. Although there is no room for hope in the market, the trader will glean all the fundamentally bullish news he can in order to buoy his hope that the market will turn in his direction. Meanwhile prices continue to descend. Perhaps the market is trying to tell him something. The markets communicate with us. We can monitor these messages by using the technicals. This trader is closing his eyes and ears to the messages being sent by the market.
If this trader stepped back and objectively viewed price activity, he might get a better feel of the market. What if a supposedly bullish story is released and prices do not move up or even fall? That type of price action is sending out volumes of information about the psychology of the market and how one should trade in it.
I believe it was the famous trader Jesse Livermore who expressed the idea that one can see the whole better when one sees it from a distance. Technicals make us step back and get a different and, perhaps, better perspective on the market.
Third, following the technicals is important even if you do not fully believe in their use. This is because, at times, the technicals are the majoi reason for a market move. Since they are a market moving factor, they should be watched.
Fourth, random walk proffers that the market price for one day has no bearing on the price the following day. But this academic view leaves out an important component — people. People remember prices from one day to the next and act accordingly. To wit, peoples' reactions indeed affect price, but price also affects peoples' reactions. Thus, price, itself, is an important component in market analysis. Those who disparage technical analysis forget this last point.
Fifth, and finally, the price action is the most direct and easily acces— sible method of seeing overall supply/demand relationships. There may be fundamental news not known to the general public but you can expect it is already in the price. Those who have advance knowledge of some market moving event will most likely buy or sell until current prices reflect their information. This knowledge, at times, consequently, may be discounted when the event occurs. Thus, current prices should reflect all available information, whether known by the general public or by a select few.
'Hill, Julie Skur. "That's Not What I Said," Business Tokyo, August 1990, pp. 46-47 'Smith, Adam. The Money Game, New York, NY: Random House, 1986, p. 154. 3Tamarkin, Bob. The New Gatsbys, Chicago, IL: Bob Tamarkin, 1985, pp. 122-123.
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