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Candlestick Charting

Candlestick charting originates from Japan, where it was used from the 17th century to examine patterns in the price of rice. Candlestick charting has come a long way since then and is now part of the mainstream technical analysis toolkit. Reading candlesticks is an attempt to understand the collective emotions that drive the financial markets every day.

Candlesticks are formed using the open, high, low and close of a stock or other security. If the close is above the open, then a hollow candlestick (an up day) is drawn. If the close is below the open, then a filled candlestick (a down day) is drawn.

The hollow or filled portion of the candlestick is called the body (also referred to as the "real body"). The long thin lines above and below the body represent the high/low range and are called shadows (also referred to as wicks and tails). The high is marked by the top of the upper shadow and the low by the bottom of the lower shadow.

Engulfing Patterns

There are numerous candlestick patterns, all with wonderful names and visual set ups. For a more comprehensive overview we suggest you read Steve Nison’s excellent book on the subject. In this short article we’ll cover our favourite patterns, the ‘Bullish Engulfing’ (+BE) and ‘Bearish Engulfing’ (-BE) patterns.

An engulfing pattern occurs when a candlestick with a large body literally engulfs the body of the preceding candlestick. Ideally the engulfing candlestick will be a different colour to the preceding one, signalling a change in trend. A Bullish engulfing will signal the reversal of a down trend and follow a negative candlestick. A Bearish engulfing is simply the opposite of this.

 
The theory behind the formation is that after a trend in one direction, the second large candlestick begins to form when residual pressure causes the security to open above or below the previous open/close. However, the new market direction is revealed as buyers/ sellers step in after this opening gap and begin to drive prices up/ down. Towards the end of the period, this change in direction is so intense that prices move to engulf the previous open/close as well.

Good volume is an indication of the strength of the push the engulfing pattern will give to a new trend. The pattern is also strongest when the engulfing occurs after a marked trend in one direction. In the example above note the ‘V’ that is formed by the immediate reversal of the previous trend. Finally ensure you wait until the candle has closed before identifying it as an engulfing pattern.