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Basics of Candlestick Charting, Part 1

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Candlestick charts need better PR. The patterns have strange, off-putting names. When a candlestick enthusiast mentions a unique three river bottom, three stars in the south or three black crows pattern, non-aficionados must be grimacing as if they'd eaten something sour. Nothing about those names sounds analytical, mathematical or clear cut. This article sets out to erase that bad impression given candlestick charting by those names. 

About the only negative to candlestick charts are those names. A candlestick chart offers all the same information offered by a regular bar chart, plus some. 

Annotated Daily Intel Bar Chart, through 5/31:

Candlestick charts don't require the same close study to determine when closes are higher than opens.

Annotated Daily Intel Candlestick Chart, Through 5/31:

Even if traders learn nothing more about candlesticks than the information included in those annotations, that's enough to make candlesticks worth including on charts. The trader loses nothing from the switchover, and visual clues offer a quicker assessment. No reading glasses are required to study those notches, either. Lots of white candles and few red ones: an uptrend is strong. Lots of red candles and few white ones: a downtrend is strong. A mixture: markets are range-bound or choppy. 

Intel's May rally was a strong one, as evidenced by the lack of a single red candle until May 31. Many candles were tall white candles. Long candles with small or nonexistent candle shadows indicate a large-range day during which either bulls or bears held sway, and INTC bulls were holding sway during much of May. There was no balancing of strength on the days when prices produced those tall white candles.

Other information can be obtained from that chart with almost as much ease. Most traders understand that even in the strongest trend, markets sometimes need a breather. We know the axiom that small-range days tend to follow large-range ones. It shouldn't be surprising that during INTC's May climb, those tall white candles were sometimes followed by small-bodied ones. 

Small-bodied candles indicate that bulls and bears remained evenly matched during a particular session. Neither could sustain prices far from the open. That can be typical of measured accumulation or distribution that often takes place after a strong move, but such days also offer an opportunity for bulls or bears to turn the tables. Times when bulls and bears are more evenly matched can be times of vulnerability to a reversal. Their appearance alerts traders to pay attention, but those candles don't promise a reversal. 

Small-bodied candles with upper or lower shadows or both gain even more significance. When those shadows appear, particularly if they're long shadows, either bulls or bears have temporarily overcome the other side. Those shadows indicate that either bulls or bears or both, in the case of both upper and lower shadows, were able to push prices a certain direction for a period of time, but weren't able to maintain prices where they wanted them. That gives traders important information.

A small-bodied candle occurring at the top of a strong climb or the bottom of a strong decline indicates at least a temporary waning of bullish or bearish strength. If a candle shadow reached above or below such a candle, the potential for a reversal might be stronger. Such small-bodied candles occurred at the bottom of April's swing low, before INTC reversed and climbed.

Annotated Daily Chart of INTC, through April 6:

Those two small-bodied candles indicated the potential for a reversal, potential made even stronger since they were produced at support. All such potential reversals must be confirmed, however. INTC's gap higher on the third day provided that confirmation.

The second of the small-bodied candles at the bottom of INTC's April swing low opened and closed at almost the same level. If the open and close had been the same, the candle would have had no real body. This would have been a doji, a term often mentioned when candlestick charts are discussed. In addition to sometimes serving as a reversal signal, doji (the word used for both a single candle of this type and plural ones) can also serve as resistance or support when another swing high or low tests it. 

A small-bodied candle in the middle of a consolidation zone offers little information: it just corroborates the sense that neither bulls nor bears yet hold primacy. That's what the consolidation was showing anyway. 

Shadows can be important whether or not the candle body is small. Beginning on May 31, INTC continued producing tall candles, but those candles sported tall upper shadows, too. Bulls couldn't maintain the breakouts to new highs. They didn't have enough strength. 

On June 2, prices punched to a new swing high, but then dropped back with a red candle body produced. Those upper candles had been warning of waning bullish strength and the next day saw follow-through. By the end of that week, the weekly candle had produced a near-doji, a small-bodied candle with both upper and lower shadows. Since then, INTC has been consolidating, with Friday's candle a red one turning down, falling from top to bottom of the consolidation pattern. The weekly candle was a red one, with this week's candle and the previous two looking a bit like a three-candle patterns known as an evening-star pattern. That pattern and others will be discussed in future articles. What's important for this article on the basics is that as early as a week ago, the candlesticks warned that INTC needed to consolidate or pull back.

These basics of candlestick charting provide enough information to gain a quick impression from candlestick charts, but these charts offer more information. The next article on candlestick charting will discuss some specialized single and multiple candlestick formations. Those who don't want to wait might try a book on candlestick theory, with Steve Nison's JAPANESE CANDLESTICK CHARTING TECHNIQUES an often-quoted favorite and Greg Morris' CANDLESTICK CHARTING EXPLAINED another possibility.

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