Option Investor

Charting Fundamentals: Candlestick Basics

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A new reader asked about the methods we use to evaluate stocks for the OW portfolio. One of the more popular techniques for assessing historical price patterns is the "candlestick" chart and we utilize them because they are beneficial to all types of investors and are relatively simple to interpret. In addition, the study of candlestick patterns can be used alone or in combination with other types of charting to provide clues about future price trends.

The most significant difference in candlesticks is the manner in which an issue's open, high, low, and close alters the look of the individual chart. This unique and exciting visual depiction is often described as an enhanced, three dimensional bar-chart. The similarities between these two common systems are numerous, but the major difference is that candlestick charts can convey signals not available from simple bar charts. In fact, there are a number of patterns that provide much better entry signals than more traditional charting techniques. Drawing a daily bar chart requires an opening price along with a high, low, and close. The same data is used to construct a candlestick chart but the final result is much more revealing. The thick part of the candlestick line is called the "real body." It represents the range between that session's opening and closing prices. When the real body is filled-in (or black), the close of the session was lower than the open. When the real body is empty (or white), the closing price was higher than that of the open. The thin lines above and below the body are called the "shadows." The shadows reflect the high and low price extremes during the day's trading. The top of the upper shadow denotes the high of the session while the bottom of the lower shadow is the low of the session. In most cases, the real body is the essential price movement whereas the shadows are generally considered less relevant fluctuations in price.

The chart above illustrates some common candlestick lines. The long, black candlesticks reflect a bearish period in which the market opened near its high and closed near its low. In contrast, the open bodies represent bullish periods. Candlesticks with short bodies (spinning tops) are generally neutral indications of the closely fought battle between buyers and sellers. Lines with horizontal bars instead of real bodies are called doji's. A doji occurs when the issue opens and closes at or very near the same price (although the lengths of the shadows can vary). Some technicians also refer to the candlesticks as yin and yang lines. The yin line, referred to as "in-sen" in Japan, is simply another name for the black candlestick. The yang line or "yo-sen" is the Japanese term for the white candlestick.

As with most forms of technical analysis, the key premise is that past price behavior can be used to forecast future trends. The wonderful feature of candlestick charting is most traders can easily discern price tendencies or patterns that would have been difficult or impossible to identify by more conventional means. As with any system, these signals should always be viewed with regard to other indications from the instrument being evaluated. With dedication and commitment, you will discover which patterns work best for your style of trading and the market in which you participate. In the next arcticle, we will help you begin that process and investors who are interested in learning more about candlestick charting in the interim should consider Steve Nison's classic book, "Japanese Candlestick Charting Techniques," available in your local library.

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