JAPANESE CANDLESTICK TECHNIQUES

In this technique, the open, high, low and closing prices are charted. The X-axis would represent the days and the Y-axis the prices. These charts depict the demand-supply equation of a scrip.

The candlestick has three parts - the upper shadow, lower shadow and the body. The upper and lower shadows are in the form of a straight line. The top of the upper shadow would represent the high prices of the day and the bottom of the lower shadow, the low of the day. Now, the body would represent the distance from the open to the close. If the open is higher than the close prices, then the body of the candlestick would be shaded and if it is lower than the close prices, then the body of the candlestick would not be shaded. Thus by looking at the shade of the body, an analyst can find out if the day was a bull day or a bear day. It may be noted that the study of the close prices in relation to the open prices is of paramount importance in the study of candlesticks.

INTERPRETATION :

Candlestick technique is one more powerful indicator that can be used along with other technical tools like the oscillators, trendlines, moving averages, etc. to ascertain the probability of a change in the direction of the trend. Apart from combining it with other tools, this technique can be used as a stand alone indicator to effectively trade the market. This means the analyst following the candlestick technique can either enter long or short in a scrip on the basis of the pattern formed on the candlestick chart with an adequate stop loss.

1.2. IMPORTANT TREND REVERSAL PATTERNS :

A trend reversal pattern implies that the prior trend is likely to change. If the prior trend is rising, the trend reversal pattern would indicate that the trend would change to either a flat trend or a falling trend or vice versa. Technically, one can trade the reversal pattern with an adequate stop loss. To cut one's losses and roll one's profits one has to maintain stop loss since no technical tool is perfect.

1.2.1. Hammer and hanging man pattern :

In this pattern, the real body of the candlestick is at the upper end of the trading range and the lower shadow is about twice the distance of the body of the candle. Further there should either be no upper shadow or the upper shadow should be quite small. Here, the candle can be either a bullish or bearish. If this candlestick is seen on the candlestick chart during a down move, it would be called a hammer. Such a pattern has bullish implications, suggesting the possibility of a trend reversal in the offing.

On the other hand, if this candlestick is spotted during an up move, then it would be termed as a hanging man pattern. This patten has bearish implications and suggests the possibility of a reversal of the trend.

The body of the hammer or the hanging man can either be black or white. It is noticed that if the body of the hammer is white, the pattern is all the more bullish. On the other hand, if the body of the hanging man is black, the pattern is all the more bearish.

It may be noted that there are analysts who trade the hanging man or hammer only after getting confirmation on the following day.

1.2.2. Engulfing patterns :

To spot this pattern, one has to study two consecutive candlesticks. These patterns are broadly classified into bullish engulfing and bearish engulfing patterns. The word ‘engulfing’ signifies that the body of the second candlestick would engulf

the body of the first. The first candlestick is usually smaller of the two candlesticks or a doji and the second one is the bigger one that engulfs the first one's body. Further, in the bullish candlestick, the first smaller body would be a black candle and the second larger candlestick should be a white candle. In the bearish engulfing pattern, the first candlestick would be a smaller white candle and the second candle would be a larger black candlestick. A bullish engulfing pattern is significant if it occurs during a downmove and the bearish engulfing pattern is significant if it occurs during an up move. In other words, the engulfing patterns are meaningful if they have a prior trend to reverse.

1.2.3. Dark-cloud cover and the piercing pattern :

The dark-cloud cover and piercing pattern is a variation of the engulfing pattern. Here too, one has to study two consecutive candlesticks to identify this pattern. In this pattern, the candlestick is a white candlestick and the second one, a black candlestick. In this pattern, the second candlestick opens higher than the upper shadow of the first candlestick and then closes well below the opening of the day and well into the body of the first candlestick. Here, the close of the second candle should envelop at least half of the body of the first candlestick. It may be noted that though the second candlestick covers at least half of the first candle, it does not cover the entire body of the first candle. If it were to cover the same body of the first candle, the pattern would become an engulfing pattern and not a dark-cloud cover pattern.

The piercing pattern is the minor image of the dark-cloud pattern. Here, the first candlestick would be a black one and the second candlestick would be a white one. The open of the white candlestick would open below the shadow of the first candlestick and the close of the second candlestick will be well above the low and well into the body of the first candle. Here also, for the pattern to be meaningful, the close of the second candlestick should engulf at least 50% of the body of the first candlestick. In this case also, though the body of the second candlestick engulfs mode than 50% of the body of the first candle-stick, it does not engulf the entire body of the first candlestick, otherwise the pattern would be termed as and engulfing pattern and not a piercing pattern.

It may be noted that like all other reversal pattern, these patterns are also meaningful if they were to occur after a substantial rise or fall in the value of the scrip. In other words, the existence of a prior trend is necessary for these patterns to be significant.

The dark-cloud cover pattern signifies that the bulls are losing control of the market and the bears are gaining control. In such a situation, one can expect the prices to move downwards and hence, sell short with an adequate stop loss.

The piercing pattern would signify that the bears are losing control and the bulls are likely to take charge of the scrip. In such a situation, one can expect the scrip to move upwards and hence, enter long on the occurrence of this pattern, with an adequate stop loss.

1.2.4. Stars :

A star in the Japanese candlestick patterns, usually foretells a reversal in the offing. Very often, the star is accompanied by the formation of a top or a bottom. In order to identify a star, one has to study two successive candlesticks.

The second candlestick would be smaller than the first one and may be in the form of a bullish candle, bearish candle or a Doji candle. In a star formation, the second candle's body is above or below the body of the first one. Analysts are of the opinion that these star patterns should be traded as and when they are confirmed by the price action on the following day.

1.2.4.1 Evening star :

One has to study three consecutive candle sticks before trading this star pattern. The first candlestick would be a bullish candle, the second would be a small bullish or bearish or Doji candlestick and the third would be a bearish candlestick. Here, the second candlestick's body would be above that of the first one's body. The third candlestick would be seen moving downwards and may also display a gap on the candlestick chart. Further, the body of the third candlestick would move well into the body of the first one. This pattern has bearish implications, and suggests the formation of a minor or major top in the making. Traders may go short if this pattern occurs after a substantial rise in the value of the scrib, with an adequate stop loss. It may be noted that the third bearish candle gives the final confirmation for booking profits or going short.

1.2.4.2 Morning Star

In this pattern, there would be a bearish candle, followed by a smaller bullish or bearish or Doji candlestick, followed by another bullish candle. Here also, the bodies of the first two candles would display a gap or in other words they would not overlap. The body of the third candlestick would move well into the body of the first black one. Further, if the third candlestick is seen gaping away from the body of the star, this pattern would be all the more powerful. This pattern has bullish implications and suggests the formation of a minor or major bottom in the making. One may enter long on the occurrence of this pattern, with an adequate stop loss. Again the pattern would be powerful if it were to occur after a substantial fall in value

1.2.5. Doji patterns :

Doji is considered to be neutral candlestick and it indicates indecision. However, if this Doji were to occur within a multicycle pattern or at the top or the bottom, it has specific predictive value. The Doji candle indicates the clashing of the heads between the bulls and the bears and neither of them winning. Doji candlesticks can call the tops and the bottoms during an up move or a downmove. Doji is the most important candlestick and should be carefully watched on the candlestick chart. Doji at the top or bottom levels should be traded only if it is confirmed by the price action on the following days.

1.2.5.1 Long-legged Doji :

In this pattern, the distance between the high and the low is greater than normal, and the open and the close are at the same level. Quite often, this long-legged Doji signifies a turning point in the direction of the trend. In fact, this long- legged Doji can successfully call market tops.

1.2.5.2 Dragon-fly Doji :

This is yet another pattern that signifies the possibility of trend reversal. In this pattern, the open and the close are at the same price and the low of the candle is noticeably lower than the open, high and the close prices of the day.

1.2.5.3 Gravestone Doji :

In this pattern, the open, close and the low prices are at the same level and the high for the day is noticeably higher than the open, close and the low prices for the day. Such a pattern has the potential of predicting a reversal in the direction of the trend. The bearish implications of the Gravestone Doji is directly related to the height of the upper shadow. If this pattern were to occur at the top, it would signify that the market opened at lower levels, moved upwards but could not be sustained at higher levels and hence dipped to the opening level for the day. Here, it signifies that the bulls lost control of the market at higher levels and bears began to force down the prices. This Doji is sometimes also found at market bottoms, but is more commonly seen at market tops.

1.2.5.4 Double Doji :

A double Doji would indicate that a powerful move is likely to follow in the near future. A Doji would, as such refer to indecision, wherein neither the bulls nor the bears are in a position to force the prices. If the double Doji occurs after a substantial rise, and if on the following day, the market moves lower, it is a signal for the analyst to enter short with an adequate stop loss. On the same count, if after a substantial fall or when the market is in the oversold zone, one finds the occurrence of the double Doji and if on the following day, the market moves upwards, analyst can enter long with an adequate stop loss.

1.2.6. Harami patterns :

Harami means pregnant in Japanese. The Harami pattern usually signifies a decrease in the momentum of the scrip. This pattern has also been referred to as a reversal pattern. It is not a powerful reversal pattern like the engulfing pattern, star pattern etc. but nonetheless, it is a reversal pattern which signifies that a brake has been applied to the market momentum, from where the market can reverse direction. In this pattern, there are two candlesticks. The first one is a normal one and the second is a smaller one, whose body is within the first candlestick. It is generally noticed that is Harami pattern is more powerful if the two candles are of opposite colours. The smaller the size of the body of the second candlestick, the more potent the pattern.

If in a Harami pattern the second candle is a Doji then it is called Harami cross. The Harami cross is more powerful than the Harami pattern. Harami cross is quite powerful in calling the tops during the up move.