Candlestick Analysis: Lighting the Markets
Steve Nison is a busy man. Ever since his first book “Japanese Candlestick Charting Techniques” was published in 1991 he has run his own advisory business, which gives trade recommendations to institutional investors and [[hedge fund]]s. He is also one of the most respected teachers on trading the financial markets, and his seminars are always a sell-out wherever he goes. Since the publication of his first book he has written another two best sellers on Candlestick analysis. His first book is affectionately known as the “modern-day bible” of trading.
Tom Hougaard caught up with Steve Nison during a quiet day in the market.
Tom Hougaard: How did it all start?
Steve Nison: 30 years ago I worked for a commodity broker and advisory service. All my work was based around fundamental analysis. Today it is hard to imagine that all investment decisions 30 years ago were based on fundamental research. I knew nothing about technical analysis before I started working in this business and while I studied for my MBA we were not taught anything about charts.
The president of the company however was well frequented with the use of charting. During our meetings with our clients I realised that he used technical analysis to derive his trading recommendations, but he explained the recommendations using fundamental analysis. 30 years ago technical analysis was considered somewhat of a black art that no one with respect for themselves would use.
As John Maynard Keynes said: it is extremely dangerous to have a rational investment policy in an irrational world. I think the president of the company knew better than anyone at the time how to integrate technical analysis into fundamental research.
I started studying everything I could find on technical analysis. Back then we used bar charts and line charts to display price action, and it wasn't until I met another commodity broker some 15 years later that I discovered Japanese Candlestick charts.
In 1987 I met a Japanese broker, and while I was in her office discussing the markets she used an expression describing chart patterns that I had never heard before. She used Candlesticks on her own charts, which is the Japanese tradition, and I really got hooked on this tool immediately.
Unfortunately there was no material written in English whatsoever to aid me, and the next 3 years was spent not only translating books but also making it understandable to Western society. That meant spending a lot of time reading about and coming to understand the philosophy of the East, including the principles of Yin and Yang. I ended up learning a whole lot more than just a charting tool.
Technical analysis is the only way to measure the emotional component of the market. We know that many times an ounce of emotion can be worth a pound of facts. How else to explain the sudden shift in the market without a change in the fundamentals?
A fascinating attribute to candle charts is that the names of the candle patterns are a colourful mechanism describing the emotional health of the market at the time these patterns are formed. If you heard the expression “dark-cloud cover,” would you think the market is in a healthy emotional state? Of course not! This is a bearish pattern and as the name suggest there is darkness over the market.
TH: Did you begin to apply your new-found knowledge immediately?
SN: At the time I worked at Hutton as a commodity advisor. No-one knew I was using Candlestick charts to derive buy and sell signals, and I was extremely successful in my analysis. This fuelled my desire to learn more and more. I had good help from some fine Japanese traders who had used Candles all their trading life. One such trader was Morihiko Goto who told me that his family had used this form of charting for generations.
The Japanese stock market started back in 1870 but rice trading had been around for long before that. Charting the fluctuations of rice prices on the Osaka Exchange probably took place more than 100 years before the opening of the stock market. It is hard to pin down exactly when Candlestick charts came to life.
TH: Has Eastern philosophy permeated itself into the terminology of Candlesticks?
SN: The Eastern philosophy of Yin and Yang is at the very base of Japanese Candlestick charting. Yang is bullish and Yin is bearish. The Japanese have a saying that states that when Yang reaches an extreme, we have stillness. The stillness gives rise to Yin.
This has given rise to a candle pattern called an Evening Star. The Japanese have used their understanding of psychology in the candle patterns. The Evening Star is a bullish candle, which is represented by the tall white candle. The next candle is a small real body, which shows that the market has moving momentum or shows stillness, which is then followed by the tall black candle, which is the reversal or the Yin.
Many Japanese Candlestick patterns have their origin in the Japanese warrior society and use military analogies, such as 3 White Soldiers. So although the interpretation of the price action in the market is an art of it own, the Japanese Candlesticks have deep roots in the philosophy of the East.
Back in the 1920's technical analysts in the US began writing about the chart pattern we now know as the Head and Shoulder pattern. This particular pattern consists of 3 rallies of which the middle rally is the longest. However, the same pattern is discussed in material dating back much earlier, but it was called the 3 Buddhas pattern. You will often find 3 statues sitting next to each other in the East. The middle Buddha is the biggest and next to it on either side are two small Buddhas.
TH: Can Candle charts be applied to any market in any time-frame?
SN: The Japanese have a saying, which answers that question: The song of a bird is the same everywhere.
Candles can be used on all time frames. 90% of people who attend my seminars are swing traders. I define a swing trader as someone whose trading time-frame ranges from intra-day to up to 3 weeks. Therefore we focus the seminar work on the hourly and the daily chart.
Our institutional clients often want us to focus on the longer-term charts and we use the weekly candle charts for this purpose. Candlestick analysis is a tool more than a method. I teach traders in the big banks around the world how to read the charts using candles and the use of proper risk management through the use of the candle formations.
All of the candle formations have got an inbuilt money management parameter, in that if a certain pattern is forming in the market, the trader will know what will invalidate this particular pattern. He or she can then put his stop loss at this particular exit point.
TH: What are the advantages of candles over bar charts and line charts?
SN: Candlesticks are superior to bar charts in virtually every conceivable way. Candles will spot reversals before bar charts do. The very nature of the candles is that it will warn you of impending reversals before the reversal has even taken place.
Candles offer razor sharp entry to the market and if you use candles with traditional Western technical analysis you gain a real edge. I call it confluence of technical indicators and I teach this extensively in my seminars. If you for example combine candle pattern with, for example, volume thrusts you get a much better signal than if you use volume alone.
An example of this could be the bullish engulfing pattern, where you have a black candle followed by a white candle. This is a reversal pattern, and I will become bullish if the volume is declining on the black candle and increases on the white candle. This shows me the bulls are in control and I can initiate long positions accordingly.
Another added advantage of candle charts is the colours of the actual candle bars. Visually the candle charts will give the trader an instant indication of the bullish or bearish forces at play. Bar charts will not readily give you this.
At the end of my seminars I always ask the delegates if they will ever go back and look at bar charts. So far I have never had anyone raise his or her hands.