Technical Analysis and Charts: Candlestick Charting
In the eighteenth century, a man in Japan named Munehisa Homma discovered that, although there was a link between price and the supply and demand of rice, the markets were heavily influenced by the emotions of those rice traders. What he came to understand was that when emotions came into play, a vast difference between the value and the price of rice occurred.
This difference between the value and the price can be applied to all the things we trade today as it was to rice in Japan nearly 300 years ago. We saw what happens to the market when affected by the herd mentality. Recently, we observed the market when there was an overwhelming feeling of doom.
The principles established by Homma are the basis for the candlestick chart analysis, which is used to measure market emotions surrounding a company or commodity. A little over two decades ago, the West was introduced to candlestick charting and it grew in popularity and use ever since.
What Do Candlesticks Look Like?
We need to get the basics down first. As in a standard bar chart, there are four elements necessary to construct a candlestick chart, the open, high, low and closing price for a given time period. Below are examples of candlesticks and a definition for each candlestick component:
A candlestick is a visual representation of price movement during a given period. A candlestick chart is a group of candlesticks in chronological order. A candlestick has two parts, the "body" and the "tails." If the body is filled in, the stock price has gone down during that time period, whereby the top of the body is the open price and the bottom of the body is the close.
If the body is not filled in, the stock price has gone up during that time period, whereby the bottom of the body is the open and the top of the body is the close. If the stock price did not change, a horizontal line will represent the body. The "tails," or vertical lines, extending from the body indicate the high and low prices during that time period.
Comparing Candlestick to Bar Charts
A big difference between the bar charts we have commonly used in the West and the Japanese candlestick line is the relationship between opening and closing prices. Like in a line chart, we place more emphasis on the progression of today's closing price from yesterday's close. In Japan, chartists are more interested in the relationship between the closing price and the opening price of same trading day.
In both charts you can see the overall trend of the stock price; however, you can see how much easier looking at the change in body color of the candlestick chart is for interpreting the day-to-day sentiment.
[caption id="attachment_29039" align="alignnone" width="278" caption="(3a)"][/caption]
[caption id="attachment_29040" align="alignnone" width="278" caption="(3b)"][/caption]
The long, dark, filled-in real bodies represent a bearish close (3a), while a long open, light-colored real body represents a bullish close (3b).
Take note that candlestick analysts historically view the open and closing prices as the most important of the day. Look at how much easier it is with candlesticks to determine if the closing price was higher or lower than the opening price.
FYI - Take Notice of Spinning Top Bodies
Here is a phenomenon to look out for because it may help decide where exactly a security is trading. Spinning tops are very small bodies and can be either black or white. This pattern shows a very tight trading range between the open and the close.
If you see this spinning top after a prolonged uptrend, it may suggest that the uptrend is losing steam and a drop may be coming soon. On the other hand, if you find it after a prolonged downtrend, it may represent a price bottom.
I think we all knew, but were kind of unaware of how to track emotions in graph. Investors' emotions can have a major impact on an asset's pricing. Candlesticks give us a greater insight and help investors and traders gauge the emotions surrounding equities and thus make better predictions about where those equities are going.