(Input for this tutorial came from Robert W. Colby, author of The Encyclopedia of Technical Market Indicators, and the Technical Analysis Institute book, Japanese Candlestick Charts )

Candlestick charts provide a more visual presentation of price action than traditional bar charts and have become the chart of choice for many technical analysts.

One candlestick itself can provide important information about the strength or weakness of the market during a given day or other time period, depending where the close is relative to the open. However, a candlestick pattern usually takes several candlesticks to produce chart formations that give the best signals.

The key in candlestick chart analysis is where a given candle or candlestick formation occurs during the market action. Candlesticks may look identical but have an entirely different meaning after an uptrend than they do after a downtrend.

Because they can be used in analysis in much the same way as bar charts, candlestick charts have quickly become a favorite of traders and analysts since being introduced to the West in 1990. Candlestick analysts have also added a little mystique to candlestick charts by giving various patterns clever names and providing more descriptive characteristics for these patterns than is the case in typical bar chart analysis. Both types of charts have their double tops, inside days, gaps and other formations. But candlestick analysis ascribes more meaning to the candlestick bodies price action between the open and close and to the shadows or tails price action that takes place outside of the open-close range for a period.

Because of their popularity in recent years, you should become acquainted with the nuances and terms of candlestick charts if you aren’t already.

Japanese candlestick chart pattern recognition has been meticulously refined over hundreds of years of actual experience by Japanese traders, becoming a technical tool of great and growing significance around the world in recent years.

Japanese candlestick charts have caught on rapidly in the West since 1991, when Steve Nison published the first book written in the English language on the subject, Japanese Candlestick Charting Techniques: A Contemporary Guide to the Ancient Investment Techniques of the Far East. He added another book a few years later, Beyond Candlesticks: More Japanese Charting Techniques Revealed. In 1992, Greg Morris thoroughly described and quantitatively tested candlestick patterns and found that many were highly accurate in his book, now titled Candlestick Charting Explained. A number of other books have been written on candlestick charts since then.

According to Morris, Japanese candlestick pattern recognition is based on 160 rules that Munehisa Honma developed from 1750 to 1803. Honma owned a great rice field near Sakata, on the west coast of northern Honshu. He traded rice with such expertise that he grew extremely wealthy. His trading rules became known as Sakata’s Method, Sakata’s Law and Honma Constitution. Honma emphasized the importance of trading in harmony with the trend. After a price rise, however, price eventually must fall: it takes more force to cause price to rise than to fall. When there is no trend, stand aside in trading range markets.

East Meets West

Candlestick charts have been adopted quickly and easily in the West because they have many similarities to the long-familiar bar charts. All the long-established Western chart pattern recognition methods can be applied directly without modification to candlestick charts. And most computer programs can construct candlestick charts just as easily as bar charts. When plotting by hand, candlestick charts take just a little more time than a bar chart. The colorful and exotic names and Eastern mystique adds to the appeal of candlestick charts.

Nison believes that candlestick charts can offer signals in advance of traditional Western bar charts: Candlestick charts can reveal a trend change in fewer trading sessions, offering timing advantages. Still, relying on Japanese candlestick charts alone is like leaning your ladder against a cloud, Nison cautions. The major trend is more important than a few candlesticks. Rather than narrowing his focus to any one tool, Nison wisely emphasizes a trading triad, a combination of (1) sound money management discipline, (2) Western technical analysis methods for analyzing trends and patterns and (3) Japanese candlestick chart interpretation.

Three is a recurring number in both Japanese and Western technical interpretation. Contratrend corrections often run for three candlesticks. A narrowing of price range and length of real bodies over three candlesticks signify a loss of momentum and warn of a probable price reversal. Many reversals require three candlesticks or three movements or three failed attempts at trend progress before changing direction.

Like R. N. Elliott, the Japanese independently recognized three impulse waves advancing a wave of larger degree. Also, like Charles Dow and his successors, the Japanese independently recognized three psychological phases of a bull market (skepticism, growing recognition and enthusiasm) and three phases of a bear market (denial, fear and disgust). That traders and technical analysts from opposite sides of the world and working in isolation arrived at similar interpretations might imply that there is something here that is universal and very basic to human behavior.

Constructing Candlestick Charts

Japanese candlestick charts can be drawn for any time period. The most popular time interval to plot is one day, with its obvious and readily available open, close, high and low prices. Short-term traders may choose to plot time intervals measured in minutes. For example, a 30-minute candlestick chart could divide the 6.5 hours of the New York Stock Exchange trading day into 13 intervals, using the first price in each half-hour interval as the open and the last price in each half-hour interval as the close.

Longer-term investors consult weekly candlestick charts, using Monday’s open and Friday’s close to define a weekly candlestick chart’s real body. Monthly candlestick charts are constructed using the first trading day of the month’s open and the last trading day of the month’s close to define the monthly real body.

Japanese candlestick charts are fully compatible with Western charting techniques because they are nearly the same as Western bar charts, except that the range between the opening and closing prices is highlighted and given special emphasis in candlestick chart interpretation. The high and the low price for a period are represented exactly the same way in both Western bar charts and candlestick charts.

The real body is the price range between the period’s open and close. This is drawn as the widest part of the candlestick chart. The real body is either white or black, signifying buying or selling dominance after the open. (Of course, with some of today’s analytical software, you can choose any colors you wish.) The contrasting shading (white or black) helps traders perceive changes in the balance of market forces between buying (white) or selling (black) dominance.

White candlestick: If the close is higher than the open, the real body is white. A white (Yang) candlestick indicates buying dominance after the open.

Black candlestick: If the close is lower than the open, the real body is filled in black. A black (Yin) candlestick indicates selling dominance after the open.

The real body is the most important part of each candlestick. The shade (white or black) and length of the real body reveals whether the bulls or bears are dominant during the main period of trading. A long white real body implies that the bulls are in charge. A long black real body implies that the bears are in charge. Candlesticks with very small real bodies, where the difference between the open and close are relatively tiny compared to normal trading ranges, imply that neither side is currently in charge and, furthermore, that the previous trend may be worn out.

Shadows are the part of the price range that lies outside the real body’s open-to-close price range. Shadows are represented as thin lines extending from the real body to the extreme high and low prices for the period, above and below the real body. The peak of the upper shadow is the high of the period, while the bottom of the lower shadow is the low of the period.

Marubozu lines lack shadows at one or both extremes: The open and/or the close is the extreme high or low price of the period. Major Yang Marubozu lines have the close equal to the extreme high and indicate extreme buying, which is bullish. Major Yin Marubozu lines have the close equal to the extreme low and indicate extreme selling, which is bearish. When the opening is the low, there is buying dominance during the period, which is bullish. When the opening is the high, there is selling dominance during the period, which is bearish.

The length and position of the shadows are meaningful. A tall upper shadow implies that the market rejected higher prices and is heading lower. A long lower shadow implies that the market rejected lower prices and is heading higher. Very long shadows, both upper and lower, are known as high-wave lines. and these indicate that the market has lost its sense of direction. Multiple high-wave lines indicate trend reversal.

Individual candlesticks or candlestick patterns tend to be most useful in helping to spot market reversal tops or bottoms, but they can also provide information as a trend is unfolding. Some candlesticks suggest that bullish and bearish traders may have achieved some kind of balance and the market can’t decide which way to go next, or the candlestick pattern may just be setting up to continue the trend that is already in place. Windows (gaps to Westerners) could indicate either.