The Visual Investor: How to Spot Market Trends, Second Edition By John J. Murphy Copyright by John J. Murphy. APPENDIX B Japanese Candlesticks Japanese candlestick charts, discussed in Chapter 3, are an alternative to the more traditional bar chart. Considered to be the oldest form of charting in the world, Japanese candlesticks were introduced to the western world by Steve Nison in his book Japanese Candlestick Charting Techniques (Prentice Hall, ). Many traders find candlesticks more visually attractive than bar charts and believe that candlesticks include more valuable price information. Figure B. compares the two forms of charting and shows how the candlestick is constructed. Both charts use the same four pieces of daily information the open, the high, the low, and the close. (All of the figures in this Appendix are taken from the Introduction to Candlesticks, which is included in the StockCharts.com ChartSchool). On the candlestick, the difference between the high and low (the range) is marked by a thin line which is called the shadow. The difference between the open and close is marked by a box which is called the body. The upper part of Figure B. shows a white body and a black body. A white body is formed when the day s closing price is higher than the open (which is considered bullish). A black body is formed when the day s closing price is lower than the open (which is considered bearish). While the color of the box is important, so is its size. Figure B. shows long versus short bodies. Generally speaking, the longer the body (box), the more intense is the buying or selling pressure. Conversely, short candlesticks indicate little price movement and consolidation. Long white candlesticks show strong buying pressure. The longer the white candlestick is, the further the close is above the opening 5
6 THE VISUAL INVESTOR Candlestick Formation Upper shadow Real body Lower shadow High Close Open Low Upper shadow Real body Lower shadow High Open Close Low Candlestick Chart Bar Chart 5 Apr 5 6 May 7 4 Jun 7 7.5 7.5 7. 6.75 6.5 6.5 6. 5.75 5.5 5.5 5. 4.75 4.5 4.5 4. 7.5 7.5 7. 6.75 6.5 6.5 6. 5.75 5.5 5.5 5. 4.75 4.5 4.5 4. FIGURE B. Candlestick Formation, Candlestick Chart, and Bar Chart.
Appendix B: Japanese Candlesticks 7 Long versus Short Bodies Generally speaking, the longer the body is, the more intense the buying or selling pressure. Conversely, short candlesticks indicate little price movement and represent consolidation. Long versus Short FIGURE B. Long versus short bodies. price. This indicates that prices advanced significantly from open to close and buyers were aggressive. While long white candlesticks are generally bullish, much depends on their position within the broader technical picture. In other words, where the candlestick signals take place within the trend of the market and how other technical indicators look at the time should be taken into consideration. Most of the technical indicators described in this book can be applied to candlesticks. CANDLESTICK PATTERNS Candlesticks combine to form price patterns. The Candlestick Pattern Dictionary in Figure B.3 lists 3 different candlestick patterns divided into continuation or reversal patterns (see Figure B.3). Most candlestick patterns encompass two or three days of price action. When used in conjunction with other technical criteria, candlestick patterns can help pinpoint shortterm turning points in a market. Figure B.3 shows samples of a few candlestick patterns with esoteric sounding names such as Abandoned Baby, Dark Cloud, Doji, Engulfing Pattern, and Evening Star. Let s take a closer look at one of them.
8 THE VISUAL INVESTOR Candlestick Pattern Dictionary Abandoned Baby: A rare reversal pattern characterized by a gap followed by a Doji, which is then followed by another gap in the opposite direction. The shadows on the Doji must completely gap below or above the shadows of the first and third day. Dark Cloud Cover: A bearish reversal pattern that continues the uptrend with a long white body. The next day opens at a new high then closes below the midpoint of the body of the first day. Doji: Doji form when a security s open and close are virtually equal. The length of the upper and lower shadows can vary, and the resulting candlestick looks like, either, a cross, inverted cross, or plus sign. Doji convey a sense of indecision or tug-of-war between buyers and sellers. Prices move above and below the opening level during the session, but close at or near the opening level. Downside Tasuki Gap: A continuation pattern with a long, black body followed by another black body that has gapped below the first one. The third day is white and opens within the body of the second day, then closes in the gap between the first two days, but does not close the gap. Dragonfly Doji: A Doji where the open and close price are at the high of the day. Like other Doji days, this one normally appears at market turning points. Engulfing Pattern: A reversal pattern that can be bearish or bullish, depending upon whether it appears at the end of an uptrend (bearish engulfing pattern) or a downtrend (bullish engulfing pattern). The first day is characterized by a small body, followed by a day whose body completely engulfs the previous day s body. Evening Doji Star: A three-day bearish reversal pattern similar to the Evening Star. The uptrend continues with a large white body. The next day opens higher, trades in a small range, then closes at its open (Doji). The next day closes below the midpoint of the body of the first day. Evening Star: A bearish reversal pattern that continues an uptrend with a long white body day followed by a gapped up small body day, then a down close with the close below midpoint of the first day. Falling Three Methods: A bearish continuation pattern. A long black body is followed by three small body days, each fully contained within the range of the high and low of the first day. The fifth day closes at a new low. Gravestone Doji: A Doji line that develops when the Doji is at, or very near, the low of the day. FIGURE B.3 Candlestick Pattern Dictionary. BULLISH ENGULFING PATTERN Figure B.4 shows an example of the Bullish Engulfing Pattern. This bullish pattern consists of two candlesticks, the first black and the second white. The size of the black candlestick isn t that important. The second candlestick, however, should be a long white candlestick which should totally engulf the body of the first black candlestick. The circles in Figure B.4 show two examples of that happening. If that short-term upside reversal takes place in an area of chart support (like a previous low, a trendline, or a moving average), it takes on even more significance. Heavier upside volume also adds to the significance of the pattern. The Bullish Engulfing Pattern is similar to a well-known bar chart pattern which forms when a lower close one day is followed up an upside reversal the following day. The upside reversal day takes place when a market opens lower and closes higher the day after a market decline. The wider the price range on the up day, and the heavier the trading volume, the more bullish it becomes.
Appendix B: Japanese Candlesticks FIGURE B.4 Bullish Engulfing Pattern. Candlestick Patterns Nasdaq NYSE Bullish Reversal Patterns: Bullish Engulfing Piercing Line Morning Star Bullish Harami Three White Soldiers Bearish Reversal Patterns: Bearish Engulfing Dark Cloud Cover Evening Star Bearish Harami Three Black Crows Continuation Patterns: Rising Three Methods Falling Three Methods Single-Candle Patterns: Dragonfly Doji Gravestone Doji Hammer Shooting Star Filled Black Candles Hollow Red Candles Equities AMEX TSE CDNX Total 85 3 6 7 4 3 4 4 3 7 4 7 8 4 8 64 3 3 34 5 8 4 4 38 3 6 3 7 7 7 5 8 4 6 4 46 37 FIGURE B.5 Candlestick Patterns.
3 THE VISUAL INVESTOR STOCK SCAN CANDLESTICK PATTERNS In case you need some help locating candlestick patterns (and you probably will), the StockCharts.com Stock Scans page includes a Candlestick Patterns section. Figure B.5 shows what it looks like. Each day, that section lists stocks (and ETFs) that have formed any one of 8 of the more popular candlestick patterns. (Mutual funds don t have candlesticks since they have only one closing price for the day). The patterns are broken down into Bullish Reversal Patterns, Bearish Reversal Patterns, Continuation Patterns, and Single-Day Patterns. Once you click on a stock (or ETF), you ll be shown its candlestick chart along with several technical indicators. That will enable you to determine if its overall chart situation looks promising. As useful as candlesticks are, they should never be used in a vacuum. The best way to use them is to combine them with western charting techniques. That will give you the best of the East and the West. RECOMMENDED READING This explanation is meant as a brief introduction to candlestick charts. You ll find a lot more information on how to use them in the StockCharts.com ChartSchool. Another excellent source of information is Steven Nison s Japanese Candlestick Charting Techniques, which is now in its second, revised edition. Another excellent book on that subject is Candlestick Charting Explained: Timeless Techniques for Trading Stocks and Futures (McGraw-Hill, ) by Gregory L. Morris. Morris developed the candlestick scans that are used by StockCharts.com. Both books are available on that site s Online Bookstore.