Candlestick Analysis

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  Introduction

  One of the interesting and effective methods of analysis is candlestick analysis or in other words analysis of combinations of Japanese candlesticks. Let me remind You the main principles of candlestick charting.

  Japanese Candles (Candlesticks) constructed by analogy with bar's chart. The most common candlesticks are based on daily charts. This is because the method to create and use it to analyze this very period. All the psychological background of this method of technical analysis is based on a ratio of prices at the opening and closing of the same trading day, as well as the closing price of the previous day and the opening of the next.

  A candlestick differs from the bar in shape. In the interval between the opening and closing prices to draw a rectangle, called the body of a candlestick. Vertical sticks top and bottom of a body called the "shadows", which show the maximum and minimum prices at this time interval, respectively. The body of a candlestick is painted over in different ways depending on the relative position of the opening and closing prices. In world practice, adopted the following method - if the bar was closed at the highest level compared with the price discovery, then white, if the bar closed lower than the open, the body of a candle is painted over in black.

  To change the type of the chart on the candlesticks you can use the button panel "Charts" (see fig. 2), toolbar Alt +2 or menu command of the menu "Charts -> Japanese candlesticks" .

  

  Figure 1. Candlestick chart created in MetaTrader 4

  

  Figure 2. Toolbar "Charts"

  The main principle of the analysis of combinations of Japanese candlesticks is to find the standard patterns (or continue to turn the trends), and interpreting them we may predict quite accurately further price behavior.

  It must be remembered that the existence of a pattern points only to the fact that the old trend is likely over. This means that the market can move both in the Flat, and in the opposite direction of the previous trend. Because after 'flat' initial trend may resume, the model turns performing in fact only a function of road signs that say: "Attention. The trend is in the process of change". Since the existence of a pattern does not guarantee the beginning of a new, oppositely directed trends, therefore, open a new position for a turn signal should only occur if the signal is consistent with the direction of a global trend. And it is possible and necessary to close positions according to the reversal patterns.

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  Hammer and hanging man – reversal patterns

  

  Figure 1. Reversal patterns: hammer and hanging man

  "Hammer" (in Japanese "takuri" this word means something like "an attempt to determine the bottom by foot") is a candle with a small body and a long lower shadow that occurs after a downtrend. If a "hammer" appears it is a strong signal that bears are loosing control over the market (Figure 2).

  "Hanging man" — is a candle with a small body and a long lower shadow that occurs after an uptrend. A "hanging man" signals the end of the uptrend. (Figure 3).

  • Three main features of a "hammer" and a "hanging man" (figure 1)
  • The body is in the upper part of the price range. The color of the body is of no importance.
  • The lower shadow is at least twice as long as the body.
  • The candlestick doesn’t have the upper shadow or it is very short.

  

  Figure 2. A hammer on the chart of USDJPY

  Factors that strengthen patterns "hammer" and "hanging man":

  • The longer the lower shadow is, the shorter the upper shadow is and the smaller the body is the higher the potential of a "hammer" or a "hanging man" is.
  • Though bodies of these candles can be both white and black, but the bullish nature of a "hammer" with a white body and the bearish nature of a "hanging man" with a black body are more pronounced. The white body of a "hammer" means that in spite оf the fact that at the beginning of the bar prices were declining by the end of the period bulls managed to increase the closing price up to the highest price of the bar. It indicates that the bulls are strengthening. The black body of a hanging man means that price failed to return to the opening level which is a sign that the bears are strengthening.

  Confirming signals for a "hanging man":

  • The following bar opens lower than the body of the "hanging man".The more downward the price gap between the body of the "hanging man" and the opening price of the following bar is the higher probability that the "hanging man" will form a high is.
  • The following bar is a black candlestick with the closing price lower than the closing price on the day when the "hanging man" appeared.

  Confirming signals for a "hammer" are similar (with accuracy to the reversal).

  One serious consideration that must be used to identify a "hammer" or a "hanging man" is the trend of the market preceding the pattern (downward or upward correspondingly). Also it should be taken into consideration that a "hanging man" forms near the high of the preceding candle and a "hammer" forms near the low of the preceding candle.

  

  Figure 3. A hanging man on the hourly chart of USDCAD

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  Bullish and bearish engulfing patterns

  Three criteria of bullish and bearish engulfing pattern (Figure 1):

  • There must be a pronounced upward or downward trend (even a short-term one) on the market.
  • The body of the second candlestick engulfs the body of the previous candlestick (shadows may not be engulfed).
  • The second body must be of the opposite color and be white in case of a bullish signal and black in case of a bearish signal.

  

  Figure 1. Bullish and bearish engulfing pattern

  There is an exception for the third criterion: when the body of the first candlestick is so small that this candlestick is comparable to a doji (or is a doji). I.e. after a durable downward trend a tiny white body is eclipsed by a very large white body. And in case of an upward trend a tiny black body is engulfed by a very large black body of the second following candlestick.

  

  Figure 2. Example of the pattern

  Factors that strengthen the signal of bullish and bearish engulfing pattern:

  The first candlestick has a very small body while the second candlestick has a very large body. The previous trend is weakening and the new trend is gaining momentum.
  If the pattern appears after a durable or impetuous trend. If a trend lasts for a long time all potential buyers (sellers) have already entered into positions and no new participants are expected. I.e. the trend will complete. Quick price movement "stretches" the market and make traders lock-in profits, closing positions.
  A bigger trading volume corresponds to the second candlestick. This is a sign of the trend’s blow off.
  The second candlestick engulfs several bodies.

  

  Figure 3. Example of the pattern

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  Dark-cloud cover

  

  Figure 1. Dark cloud cover

  Criteria of the "dark-cloud cover" pattern (Figure 1):

  • The pattern consists of two candles that occur after an uptrend (or near the upper border of the trading range).
  • The first candle is white with a strong body. On the next bar the opening price exceeds the high of the preceding bar but the bar closes near the low and overshadows considerable part of the white body of the preceding candle. The lower the closing price of the black candle is the higher probability the top will form. It is considered that the closing price of the black candle must overshadow more than 50% of the body of the white candle.

  Let’s try to explain what is happening in the framework of the "dark-cloud cover" pattern. At first the market rises (the white candle). The following candle opens higher than the maximum of the white candle — the bulls are exultant. They seem to have full control over the situation but the price increase stops. The bears are starting to gain control over the situation and the candle closes near its lows, overshadowing most part of the white candle. The bulls are starting to panic as their positions went into the red. The bears receive a target for a stop-loss (the highest price of the second (black) candle of the pattern).

  

  Figure 2. Example of the pattern

  Factors strengthening the "dark-cloud cover" pattern:

  • The more the black candle covers the body of the white candle the stronger the pattern is.
  • If during a long-lasting uptrend a white candle with a long body and without shadows appears and on the next day a black candle with a long body and without shadows appears it is said that "a black day with a truncated top and bottom" has come.
  • If the second candle of the pattern opens higher than an important resistance level but then the price falls below this level it means the bulls can’t control the market and there is a high probability a top will form.
  • If the second bar is accompanied by a larger trading volume than the first one it indicates the uptrend has spent its force.
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  Piercing pattern – a bottom reversal signal

  The dark cloud cover and piercing candles are like bookends (refer to Figure 1).

  Criteria of the "piercing pattern":

  • The Piercing Pattern is composed of a two-candle formation in a downtrending market.
  • The body of the first candle is black; the body of the second candle is white and long.
  • The second day opens considerably lower than the trading of the prior day and the white candle closes more than halfway up the black candle.

  

  Figure 1. Example of the pattern

  Signal Enhancements:

  • The higher the white candle closes into the black candle, the stronger the reversal.
  • If the second candle of the pattern opens below an important support level but then the price closes above this level it means the bears can’t control the market and there is a high probability that a bottom will form.
  • If the second bar is accompanied by a larger trade volume than the first bar it indicates the downtrend has spent its force.
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  Morning star – a bottom reversal signal

  

  Figure 1. Reversal patterns

  A star is a candle with a small body that forms a price gap with the preceding candle that has a big body (Figure 1). A gap between bodies is essential (shadows can intercross). The color of the star is of no importance. If a star is a doji it is called a doji star.

  Any star especially a doji star indicates the trend is about to reverse. A small body means that the fight between bulls and bears has come to a deadlock.

  Stars feature in four reversal patterns: evening star, morning star, doji star, falling star. In all the patterns the body of the star can be of any color.

  "Morning star" — a bottom reversal pattern. It consists of three candlesticks - a long-bodied black candle extending the current downtrend, a short middle candle that gapped down on the open, and a long-bodied white candle that gapped up on the open and closed above the midpoint of the body of the first day. (Figure 2).

  

  Figure 2. Example of a reversal pattern

  On the black candle the price plunges — the bears have the control over the market. Then a small-bodied candle appears — the bears are loosing conviction. When a strong white body appears it means the bulls seize control. The optimal Morning Star signal would have a gap before and after the star day. Though the second gap occurs rarely it doesn’t diminish the significance of the pattern. The main criterion of significance is the magnitude, that the third day comes up into the black candle of the first day.

  Sometimes it happens that the pattern has not one but several stars.

  Signal Enhancements of the "morning star" pattern:

  • A gap after the star day.
  • The magnitude, that the third day comes up into the black candle of the first day, indicates the strength of the reversal.
  • Small trading volume on the first candle and big volume on the third candle.
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  Evening star – a top reversal signal

  "Evening star" — is exactly the opposite of the Morning Star signal. "Evening star" is a top reversal signal. It consists of three candlesticks - a long-bodied white candle extending the current uptrend, a short middle candle that gapped up on the open, and a long-bodied black candle that should close at least halfway down the white candle. (Figure 1).

  

  Figure 1. Reversal patterns

  On the white candle the price surges — the bulls have the control over the market. Then a small-bodied candle appears — the bulls are loosing conviction. When a strong black body appears it means the bears seize control. The optimal Evening Star signal would have a gap before and after the star day. Though the second gap occurs rarely it doesn’t diminish the significance of the pattern. The main criterion of significance is the magnitude, that the third day comes down into the white candle of the first day.

  Sometimes it the pattern may consist of more than one star.

  

  Figure 2. Example of a reversal pattern

  Signal Enhancements of the "Evening star" pattern:

  • A gap after the star day.
  • The magnitude, that the third day comes down into the white candle of the first day, indicates the strength of the reversal.
  • Small trading volume on the first candle and big volume on the third candle.
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  Evening doji star and morning doji star – strong reversal signals

  If the star is a doji (a candle formed when the open and the close occur at the same level or very close to the same level, i.e. it has no body), the "morning doji star" and "evening doji star" form, that are more convincing reversal signals (Figure 1).

  

  Figure 1. Reversal patterns

  The "Abandoned baby" pattern (refer to Figure 1) forms if:

  • The star is a doji,
  • there is a gap between the doji and the first candle, the shadows mustn’t intercross,
  • there is a gap between the doji and the third candle, the shadows mustn’t intercross as well.

  The "abandoned baby" pattern is a more convincing reversal signal than the "evening doji star" and "morning doji star".

  Signal Enhancements of the patterns considered earlier:

  • The more the body of the third candle overshadows the body of the first candle the more forceful the pattern.
  • Small volume on the first candle and large volume on the third candle.
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  The Shooting Star and the Inverted Hammer

  The "shooting star" and "inverted hammer" patterns (Figure 1) don’t belong to strong reversal patterns.

  
  

  

  Figure 1.

  The criteria of the shooting star and inverted hammer patterns:

  • The real body is small and is at the lower end of the trading range. The color of the body is not important.
    
  • The upper shadow is long.
    
  • There should be no lower shadow or a very small lower shadow.
    
  • The real body of an ideal "shooting star" / "inverted hammer" forms a gap against the real body of the preceding candle but this gap isn’t essential.
    

  

  Figure 2. Example of the pattern

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  The Harami – a reversal pattern

  The previous reversal patterns are relatively strong signals of the trend reversal. The Harami pattern is an "intermediate strength" trend change signal. As a rule when this pattern appears it indicates the market is turning flat.

  The harami pattern — that is "pregnant" in Japanese — is a candle with a small real body that appears within the larger real body of the preceding candle (Figure 1). The first candle is like a mother and the second candle the child that emerges from its belly.

  

  Figure 1. Harami - a reversal pattern

  If candles in the engulfing pattern must be of the different colors in the harami it isn’t essential. The second candle must have a small body and the first candle must have a very large real body. The body of the second candle must be within the body of the first candle. The sizes and relative positions of the shadows are not important. The smaller the second body the higher the potential of a reversal occurring.

  If the second candle of the pattern is a doji it is called the harami cross (sometimes it is also called — petrifying pattern). Such a pattern is more siginificant as it contains an "omnipotent" doji.

  

  Figure 2. Example of the harami pattern

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  Continuation patterns: gaps

  In the world of Japanese candlesticks, there are a number of bullish and bearish continuation patterns. The Japanese insight is, "there are times to buy, times to sell, and times to rest." Most continuation patterns suggest a trend is exhibiting a temporary diversion in behavior and will eventually continue on its existing trend.

  A "gap" is a price void i.e. the situation when the minimum price of the current bar is higher than the maximum price of the preceding candle, or when the maximum price of the current candle is lower than the minimum price of the preceding candle. To "close the gap" means to fill the price void.

  A position should be open in the direction shown by the "gap".

  Later "gaps" become resistance and support areas. If during a retracement the "gap" is closed but the pressure of the trend’s rivals doesn’t decrease it will lead to the reversal of the trend.

  As a rule after the appearance of a price void prices return to the "gap", and this is a good moment to open a position. Stop Loss orders should be placed under (above) the gap in case of an open buy (sell) position.

  "Gaps" after standstill areas deserve special attention.

  The rules of "gaps" analysis:

  • If after the appearance of a "gap" eight-ten rising highs (falling lows) are registered and correction doesn’t start it will start in the nearest future. The Japanese say about such market: "The stomach is 80% full"
  • If a "gap" hasn’t closed during three bars the market will go in the direction of the "gap".
  • After the appearance of three gaps up (down) the top (bottom) should be expected. If after the third gap a reversal pattern occurs the probability the trend will end is higher.
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  The Upward- and Downward-Gap Tasuki

  The "Upward-Gap Tasuki" — is a continuation pattern when after a white candle that forms a &quotgap" up a black candle appears — a retracement to the "gap". The opening price of the black candle is within the real body of the white candle while the closing price is lower (Figure 1). It is recommended to buy at the closing price of the black candle. Stop Loss order is placed under the "gap".

  

  Figure 1. Upward- and Downward-Gap Tasuki

  The "Downward-Gap Tasuki" — a continuation pattern when after a black candle that forms a "gap" down a white candle appears — a retracement to the "gap". The opening price of the white candle is within the real body of the black candle while the closing price is higher (Figure 1). It is recommended to buy at the closing price of the white candle. Stop Loss order is placed under the "gap".

  The real bodies of the both candles in the "tasuki gap" pattern must be approximately equal in size. These patterns are relatively rare on the FOREX market.

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  High-price and Low-price Gapping Plays

  If after a rapid rise the price reaches the resistance level and stops and several candles with small real bodies appear, and then a gap up occurs such a pattern is called "High-price Gapping Plays" (Figure 1). The appearance of this pattern indicates that the bullish trend has resumed and one can open a long position.

  

  Figure 1. High-price and Low-price Gapping Plays

  If after a rapid fall the price reaches the support level and stops and several candles with small real bodies appear, and then a gap down occurs the pattern is called "Low-price Gapping Plays" (refer to Figure 2). The appearance of this pattern indicates that the bearish trend has resumed and one can open a short position.

  

  Figure 2. Low-price Gapping Plays

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  Doji: at the tops, after a long white candle, Rickshaw Man, Gravestone Doji, three stars

  

  Figure 1. Types of doji: Gravestone Doji and Long-legged Rickshaw Man

  The Doji signal is a candle formed when the open and the close occur at the same level or very close to the same level (Figure 1). The appearance of a Doji is one of the most revealing reversal signals. Doji signals are important only on the markets where they are met rarely. That’s why it isn’t recommended to look for doji signals on the charts with the period less than 15 minutes, as on such chart you may find a great number of doji signals.

  A stronger signal has the appearance of a doji on the top. But at the bottom of the market very often "magic" power of the doji to reverse the market is lost.

  The appearance of a doji after a large white candle is a very serious reason for the bulls to take notice.

  The appearance of the "Rickshaw Man" or "Gravestone Doji" patterns after the uptrend almost doesn’t give the uptrend any chance of further price rise. Almost always the appearance of these candles leads to the price fall.

  After the appearance of a doji on the chart the opening/closing level of the doji will serve as the support/resistance level.

  The "three stars" pattern is met very rare but this is a very important reversal pattern. The "three stars" pattern is formed by three doji candles the medium of which is the doji star. (Figure 2).

  

  Figure 2. Reversal pattern