Some say the markets are full of sharks… Some say the markets are just a form of globalised gambling… And some say you have to have lost your mind to even think of taking part in the market… But as far as the Japanese are concerned, the markets are a smorgasbord of opportunity!
The Japanese have been engaging in technical analysis for decades; they created candlestick charts which are used by experts around the world.
The income of the average trader has decreased tremendously relative to what the fathers of technical analysis used to rake in back in the day. There are a number of reasons why this is the case; the introduction of high-frequency trading has made it difficult for the small individual trader to seize the riskless arbitrage profits as the markets have become somewhat “efficient”. The second reason is the fact that technical analysts have been flooded with information and trading tools that traders don’t always use optimally.
Technical analysis tools and indicators have been designed over the years in an attempt to reduce risk and to enable spot-on timing. In trading timing is everything; and so is being on the right side of a trade, traders lose millions every day because they are either on the wrong side of a trade or just timing their trades badly. The ultimate goal is, therefore, to be on the right side of the trade and have immaculate timing.
Japanese candlesticks form part of the basic trader’s tool set. Candlesticks should be used in conjunction with other indicators.
Figure 1 illustrates candlesticks in their simplest form.
Here are some basic bullish and bearish indicators and how they can be interpreted to maximise returns and minimise risk:
Engulfing: On the first day, the market players do not like the security so they are taking a short position but are not too bearish. On day two the market changes and feels positive about the security. There is more demand for the security than there is supply. In the diagram, the real body ‘engulfs’ the other candlestick. Notice that the stick in day two opens below the low and closes above the high of the day one candlestick; this is a very bullish indicator.
Hammer: the low dip indicates that during the day the market sentiment was bearish but towards the end of the day long positions outperformed the short positions to close at a high. This is the point where astute traders will come into the market and grab the security at a low a price because the hammer usually happens when the stop loss orders have been executed thus giving a very low shadow.
Harami: this pattern does not necessarily indicate a bullish pattern but is an indication of a possible change in momentum. The wide range candlestick that closes below the opening price on day one showed a strong bear market but things changed on day two when the real body, though not strong, emerged on day two. This shows that the bottom might have been hit and a slow recovery might be ahead.
Piercing: this pattern indicates that a very strong reversal might be ahead. The majority of positions were short on day one and this was countered by a strong real body on day two. The piercing is somewhat normal for very volatile securities but for less than volatile securities it is a good indicator to go long.
The bearish indicators are nothing out of the ordinary and are just inverted versions of the bull market patterns.
The engulfing and harami are no different from the ones expressed earlier except that they are just in reverse. The shooting star is a bearish version of the hammer while the dark cloud cover is the bearish version of the piercing.
Let us now move our attention to the doji which is probably the most popular candlestick because it normally forms at peaks and troughs of price movements. The price movement for the day illustrated by the doji shows that the security closes at the same price it closed at but still hit a lower low and a higher high. The market seems to be on the fence about the current price direction and a reversal is almost inevitable the next day (The Top 10 Best Candlestick Patterns 2012).
The doji can also come in different forms as illustrated in fig. 4. The long legged doji shows that the market tried higher prices and lower prices but rejected them all. The gravestone shows that market was positive about the security but rejected the high prices at the end of the day due to uncertainty (The Top 10 Best Candlestick Patterns 2012)
Perhaps the most reliable candlesticks indicator is the kicker. It shows abrupt changes in the market usually due to new significant information is also known as a market shock.
The kicker shows a strong trend in one direction which then changes suddenly meaning that not everyone in the market saw it coming. It indicates a strong reversal and in most cases this where the small traders have an advantage over institutional traders who take a longer time to respond to market shocks.
One thing that makes candlesticks so useful is the fact that they give reversal signals earlier other technical indicators.
Finance is an exciting world where the bottom line is everything. Caution is imperative and so is hard work. You have to be eager to learn and be prepared for the worst; candlestick patterns will help you do just that. There is a myriad of other candlestick patterns that might tickle your fancy so do some further reading to help you put things into perspective.
The above covers only basic examples of candlestick analysis; if you find that candlesticks give you the cutting edge in trading decisions, don’t hesitate to research them in further context and detail.
You might not be Japanese but thinking like one could earn you big bucks.
Go get them tiger….
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Northcott, A., 2009. Understanding candlestick formations. Futures: News, Analysis & Strategies for Futures, Options & Derivatives Traders. 38(11):60-62.