The Power of Japanese Candlestick Charts. Fred K. H. Tam

while a black real body depicts a down-day or weak day, a day where the bears are victorious. The length of the real body measures the strength of the move.

      The Shadow

      The lines above and below the real body are called shadows. The line above the real body is called the upper shadow, and the line below the real body is called the lower shadow. The upper and lower shadows reflect price fluctuations during the session. The high of the upper shadow represents the high price reached during the session while the low of the lower shadow represents the low price reached during the session.

      ■ Construction of a Bar Chart

      Drawing a Western bar chart requires only three elements of price data.

      1. The high

      2. The low

      3. The close

      Sometimes the open is also drawn into the chart, in which case the open will be represented by a slash to the left of the high-low range.

      Comparison between a Candlestick and a Bar Chart

Figure 1.2 and Figure 1.3 show examples of a candle chart and a bar chart for S&P 500 Hourly (2013).

FIGURE 1.2 S&P 500 Hourly (2013) – A candle chart describes the state of players’ psychology much better than a bar chart

FIGURE 1.3 S&P 500 Hourly (2013) – A bar chart is flat and makes it difficult to spot changes in players’ psychology

      CHAPTER 2

      Single Candle Types

      ■ Single Candles

      Reading the single candle marks the beginning of Japanese candlestick analysis. A single candle can represent any trading period, but in my examples that follow, each candle represents a trading day.

      The three purposes of identifying the single candle are:

      1. To understand the players’ psychology behind the formation of the candle.

      2. To investigate the relationship between one candle and the candles that preceded it and from this investigation, interpret any changes to the players’ psychology that arise from the patterns that emerge.

      3. To act by making a decision on whether to buy, hold, or sell through the patterns that emerge.

      Basic Candlestick Formation

      There are three basic candle types:

      1. A white, or empty, candle indicates that the closing price is higher than the opening price for the trading session.

      2. A black, or full, candle indicates that the closing price is lower than the opening price for the trading session.

      3. A doji occurs when the opening and the closing price are equal, or very close to each other.

      The following diagram shows these three basic candle types.

      Size, Location, and Colour

      To interpret the psychology behind the single candle, there are three elements to look for:

      1. Size

      2. Location

      3. Colour

      A large size candle, for example, suggests tremendous strength and power behind the move. A large candle is also indicative of more volatile market conditions.

      Though its large size makes it a very powerful candle, the location of the long candle is important in analysing whether it will be a continuation or reversal pattern. Its interpretation depends on whether it is found at a low price or high price area.

      The colour of the candle is also important in determining whether the bulls or bears are in control on a particular trading day. A white candle denotes that the bulls are in control (also called an up-day) and a black candle denotes that the bears are in control (also called a down-day). The only category of candles where colour is unimportant is the Umbrella Candles. As I go into the various candle types, you will understand how their location, size, and colour play important roles in interpreting the psychology behind a candle or a collection of candles.

      The Long Candle

      A long candle is defined as one where the open and close (real body) are far apart. It has a greater than average price range. Long candles can be white (bullish) or black (bearish) as shown in the previous diagrams.

      A long candle reflects a day with a larger price movement. A long white candle is generally interpreted as a very bullish day and a long black candle is interpreted as a very bearish day.

Though its large size makes it a significant candle, it is important to note the location of this large candle and the candle that follows, as their combinations may signal a reversal pattern (see Figure 2.1).

FIGURE 2.1 Gold Hourly (2012) – Locations of long candles may signal a reversal

      The Short Candle

      A short candle is defined as one where the difference between the open and close (real body) is small. It may or may not have shadows. When there are shadows, their short upper and/or lower shadows have a less than average price range. A short candle reflects a day of narrow price movement. It is generally viewed as an insignificant candle and is indicative of a consolidation or indecisive market. Relatively small volumes accompany their occurrence. Short candles can be either white or black as shown in the preceding diagrams.

      Though its small size makes it an insignificant candle, it is important to note the location of this small candle along with the candles preceding it, as their combination may signal a reversal pattern.

      Exception to the rule: A short candle is normally viewed as an insignificant candle because of its small real body, short shadows, small volume, and a less than average price range. But the exception to this rule is when short candles are a part of an umbrella group (i.e., the Hammer, Hangman, Inverted Hammer, and Shooting Star) or when they have very long upper and lower shadows (called high wave Spinning Tops or doji). If these candles of the umbrella group or high wave Spinning Tops or doji are spotted at the top or bottom of a market trend, they are signals of a market top or bottom. In such a situation the location of these candles will be a more significant factor than their small size.