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EXAMPLES OF CANDLE PATTERNS

The broad part of the candlestick line in Exhibit 1 is called the real body. The real body represents the range between the session's open and close. If the close of the session is above the open then the real body is white. If the real body is black the close of the session is lower than the open.

The thin lines above and below the real body are the shadows. These are the session's price extremes. The shadow above the real body is called the upper shadow and the peak of the upper shadow is the high of the session. The shadow under the real body is the lower shadow and the bottom of the lower shadow is the session's low.

Candle lines can be drawn for all time-frames, from intra-day to monthly charts. For example, a 60-minute candle line uses the open, high, low and close of that 60-minute period; for a daily chart it would be the open, high, low and close for the day. On a weekly chart the candle would be based on Monday's open, the high and low of the week and Friday's close.

Notice that the candles to the right have no real bodies. These are examples of doji (pronounced doe-gee). A doji is a candle in which the opening and close are the same. Doji represent a market that is in balance between the forces of supply and demand.

While the candlestick line uses the same data as a bar chart, the colour of the candlestick's real body and the length of the candle line's real body and shadows convey an instant x-ray into who's winning the battle between the bulls and the bears.

For instance, when the real body is black, that means the stock closed below its opening price. This gives you an instant picture of a positive or negative close. Those of us who stare at charts for hours at a time find candlesticks are not only easy on the eyes, they convey strong visual signals sometimes missed on bar charts.

The logo of our firm, which is a spinning top, is “ Helping Clients Spot Market Turns Before the Competition ”. This is because one of the most powerful aspects of candle charts is that they will often provide reversal signals not available with traditional bar charting techniques. Let's take a look at this aspect with a “spinning top.”

As mentioned previously, one of the more powerful aspects of candle charts is the quick visual information they relay about the market's heath. For example, a small real body (white or black) indicates a period in which the bulls and bears are more in a tug of war. The Japanese have a nickname for small real bodies - “spinning tops” -  because of their resemblance to the tops we had as children. Such small real bodies give a warning that the market's trend may be losing momentum. As the Japanese phrase it, the "market is losing its breath."

Let's look at an example of how candle charts will often help you preserve capital, a benefit so important in today's volatile environment. In this scenario I will illustrate how a candle chart can help you avoid a potentially losing trade from the long side.

I have two charts below. The chart above is a bar chart . On this chart the stock looks strong since it is making consecutively higher closes. It looks like a stock to buy.

Using the same data as on the bar chart, we now make a candle chart.

Note the different perspective we get with the candle chart than with the bar chart. On the candle chart, in the same circled area, there are a series of small real bodies—which the Japanese call “Spinning Tops”. Small real bodies hint that the prior trend (i.e. the rally) could be losing its breath.

As such, while the bar chart makes it look attractive to buy, the candle chart shows there is indeed a reason for caution about going long – the small real bodies illustrate the bulls are losing force. Thus, by using the candle chart, a trader would likely not buy in the circled area and thus help avoid a losing trade.

This is but one example of how candles shine at helping you preserve capital.

Warren Buffet has two rules:

• Rule 1- Don't lose money.
• Rule 2- Don't forget rule 1.

Candles shine at helping you preserve capital.

The doji is one of the most famous candlestick patterns.

As the real body shrinks we ultimately wind up with a doji. This was shown in the first example. A doji is when the open and close are the same.

The doji indicates a market in complete balance between supply and demand. Since a doji session represents a market at a juncture of indecision, they can often be an early warning that a preceding rally could be losing steam. Indeed, with a doji the Japanese would say, that “the market is tired”. (Keep in mind a close over the doji would “refresh” the market). 

Properly used, candle charts may not only help improve profits, but will assist in preserving capital. They can do this by helping you avoid a potential losing trade or exiting a profitable trade early. The chart above shows an example of this.

This is a chart of the SOX, also known as the Philadelphia Semiconductor Index, which lists the biggest computer memory producers in the world, such as Intel, Texas Instruments and Motorola.

The horizontal line in this chart shows a resistance area near 135. A tall white candle pierces this resistance in early March. But observe what unfolded the next session—the doji. This doji line hinted that the bulls had lost full control of the market (note: it does not mean that the bears have taken control).

This is a classic example of the power of candle charting techniques. Specifically, within one session we were able to see a visual clue via the doji that while the market was maintaining its highs, the doji shouted that the bulls were not in complete control. So while the market looked healthy from the outside, the internals (as shown by the doji) were relaying the fact that this stock was not as healthy as one would think.