Chapter 4
IN THIS CHAPTER
Introducing candlesticks
Making candlesticks colorful
Putting together a candlestick chart
Using candlesticks for decision making
Candlestick charts provide users a graphic way to display price movement throughout the day on a daily chart. This type of display first became popular in Japan and today is one of the most popular charts in North America, especially for stock traders who need information for shorter periods of time, such as hourly or daily.
In this chapter, we break down the parts and colors of a candlestick chart, explain how to create one, and show you how to use one to make investing decisions.
You can see an example of a candlestick chart in Figure 4-1. Each bar represents the price of Apple Inc. for a specific day.
Notice the closing price of Apple Inc. on May 3 was lower than on May 2, but the candle is still hollow. The filling of the candle doesn’t reflect the change from the day before. It may coincidentally reflect the direction from the previous close. The hollow or filled candle style is a subtle change that makes the individual candles for each day stand out more than other displays we discuss in this book.
The following sections go into more detail on the parts of a candlestick chart.
When looking at the body of the candlestick, pay close attention to the components as well as the shapes of the candles.
Each candle body has several components, which you can see in Figure 4-2. These components provide various pieces of information:
The body of the candle tells you whether the market improved or fell during the day. Its appearance gives you a feel for the price action throughout the day. You can visualize these differences in the candlestick shapes shown in Figure 4-3:
The size of each shadow shows you how far the price moved away from the two key times of the day, the open and the close. You can see the differences in shadows in Figure 4-4. The shadows, or wicks, mean different things on a hollow body of the candle:
As we note in the preceding section, the size of each wick shows you how far the price moved away from the two key times of the day, the open and the close. The shadows mean different things on a filled body of the candle. Shadow differences on filled candles are shown in Figure 4-5:
When the stock market opens in the morning, the opening price may not be the same as the previous day’s close. News about the company, the related industry, or other news in politics may have come out after the market closed on the previous day, causing a gap between the previous day’s close and the open the next day. The candlestick chart style does not try to connect the price points together. An example of this can be found on the Apache (APA) chart (refer to Figure 4-5) on April 27. On a candlestick chart these are called windows rather than gaps.
Introducing color on a candlestick chart is a method of quickly comparing the current candle’s price to yesterday’s closing price. The software uses the difference between a close higher than the day before or lower than the day before. For example, choosing one color that will show a close higher than the day before highlights an up day. Using a second color for a day when the market closes lower than the day before highlights a down day.
The majority of the time, the information from the hollow or filled candlestick coincides with the color code of the day:
You can see two distinguishing candles that show up when you use color to view the candles. Their unique qualities show up best on a color candlestick chart, but you can see the difference in the shading on a monochrome chart as well:
Examples of these two unique candles are shown in Figure 4-6. The candles of interest are on March 8 and March 22. These candles show up infrequently but represent important information:
It does not always work out, but these unique candles sometimes mark turns in the market or important inflection points in the market. In the Citigroup example in Figure 4-6, they marked a short-term high on March 8 and very close to a short-term low on March 22. You can see other instances on the chart where these unique candles had no short-term influence.
You can set up your own chart with the price displayed using candlesticks. In this section we show you how to create a candlestick chart on www.stockcharts.com
. To get started, go to stockcharts.com/freecharts/
, enter the stock symbol you’re interested in seeing under “Create a SharpChart,” and click Go.
In the Chart Attributes area, you can create a candlestick chart by selecting Candlesticks in the Type drop-down menu. StockCharts.com
defaults to a candlestick chart type for new visitors to the website. After selecting Candlesticks, you will need to click Update if the chart was in a different display format. You can see the tool for Chart Attributes in Figure 4-7.
After changing some of the selections, click the Update button to show your changes on the chart. This action doesn’t save the chart style that you create, but it does let you experiment with the settings. Members can save the chart style as a default. In Parts 3 and 4, we introduce all the possible options for creating your own chart style, and in Chapter 17, we show you how to build a customized candlestick chart.
Candlestick charts are primarily for short-term trading decisions; longer-term traders or investors tend to use candlestick charts to pick entry and exit points. It is important to understand when candles matter most in stock buying and selling decisions; you also need to become familiar with some of the most common patterns. This section introduces those critical decision-making points.
Candlesticks are built based on intraday price movements, so daily candlesticks aren’t typically used with long time horizons of a year or more. For shorter-term trading opportunities, though, candlesticks can be helpful. The following sections discuss short-term signs you may interpret from individual candles and candle groups.
Candlestick signals typically have a life of five to ten candles. In Figures 4-3 and 4-4, the bullish examples show up more often in the direction of the uptrend. As you might expect, it is easier to find hollow candles with a small top shadow in an uptrend. In Figure 4-5, the bearish candles are plentiful in a downtrend. It is easier to find filled candles with small bottom shadows in a downtrend.
Individual candles may not be very reliable to trade with, but looking at candles collectively can be helpful. Looking across a few months of candles gives you more information, and trading in the direction of the trend is usually more profitable.
When a stock is in an uptrend, more hollow candles are present. When a break in a trend line occurs, you may experience heavy selling. On most charts, if you can draw a multi-month trend line, the candle that closes below the trend line is usually a big filled candle. (See Chapter 9 for more about trend lines.) An example of a trend line break on Consolidated Edison (ED) is shown in Figure 4-8.
Pairing two or more candles can be a little more valuable to confirm a pattern within a trending market. How is that done? The first candle sets a bullish or bearish expectation for the next day, and the next day, investors watch to see whether the move based on the directional bias starts to happen. If it does, they investigate buying the stock on that basis and go through a process to decide.
Technical analysis tools work better when stocks are trending. A stock moving sideways for years is hard to profit from. However, a stock moving sideways for a month or so also allows you the opportunity to buy near recent lows. The term for a stock with price action moving sideways is consolidating. Consolidating happens when the price of a stock stays between two price levels and moves sideways. The stock shown in Figure 4-8 consolidated for three months between $67 and $73.
Conversely, a sustainable move above a previous consolidation range will usually need to be a larger hollow candle. The thinking behind the candle size is that if the price moves above a consolidation area, the new buyer has to be willing to pay more for the stock than at any time in the consolidation period. If only a few new buyers are willing to buy into the stock at a higher level, the chart is most likely to fall back into the consolidation range. Rarely are timid moves above a consolidation zone the best ones to buy.
Candlesticks carry a lot of information. Understanding candlestick patterns can be very beneficial to see a change in trend or typical price action that supports a move in the direction of the main trend.
In Figure 4-8, the period from February 26 to March 2 is a great example of seeing a bullish signal on a candlestick chart. First of all, the intermediate trend was up but had consolidated in a small range between $66 and $70 for about a month. After moving down hard on February 27 to the previous low of February 17, the next two candles got very small, showing a loss of downside selling pressure.
On March 2, the stock fell hard after the market opening, but by the end of the day the price had recovered above the previous close and above the open to create a long shadow under the first hollow candle. This shape of candle is a bullish candlestick called a hammer and is often seen at the bottom of a countertrend move. This is exactly what you would look for to end a downward move. When March 3 had similar price action (another hammer) and closed higher, this was very strong price action. The stock continued higher for most of March.