You’d be hard-pressed to find someone who’s more enthusiastic about candlestick charting than yours truly. I can go on and on about the advantages that candlesticks afford. If you want to read more of my gushing about the many great advantages of candlestick charting, turn to Chapter 2, but here are my top three reasons:
Two of the best features of candlestick charting in general are visual appeal and readability. You can glance at a candlestick chart and quickly gain an understanding of what’s going on with the price of a security. You can also tell whether sellers or buyers have dominated a given day and get a sense of how the price is trending.
Even after reading up on the most rudimentary candlestick basics, you can easily spot the opening and closing price for a security on a candlestick chart. These price levels can be very important areas of support and resistance from day to day, and knowing where they are can be extremely helpful, especially for short-term traders.
Candlesticks aren’t just pretty faces. Candlestick charts also feature specific patterns that you can identify and use to decide when it’s time to buy, sell, or wait on a trade or investment. These patterns can be a real boon to your work with securities, and you can combine them with other technical indicators for even more reliable results.
Understanding Candlestick Components
You can’t trade and invest effectively by using candlestick charts unless you understand candlestick patterns, and you may have a very hard time understanding those patterns if you aren’t familiar with basic candlestick construction. Candlestick charting starts with the knowledge of what it takes to make a candlestick and how changes in that basic information affect a candlestick’s appearance and what it means. For starters, you need to know what goes into creating a candlestick’s wick (the thin vertical line) and its candle (the thick part in the middle).
The following four pieces of information are combined to create a candlestick:
Price on the open: The price at which a security opens in a given period is the first piece of information used in creating a candlestick. Depending on whether the security’s performance is bullish or bearish, the opening price corresponds to either the bottom edge of a candlestick’s candle or the top edge. Candlesticks that represent bullish price action appear white on a chart in this book but green in many charting packages, and candlesticks that represent bearish price action appear black or red when color is available.
High price: The highest price that a security reaches during a given period corresponds to the top of a candlestick’s wick. If a security opens at a certain price and then trades consistently lower than that price throughout the period, there won’t be any wick above the candle.
Low price: The lowest price that a security reaches during a period corresponds to the bottom of a candlestick’s wick. If the price action for that period is extremely bullish, and prices trade higher than the open, there won’t be any wick below the candle.
Price on the close: When a security finishes trading during a given period, its closing price is the last piece of information used to create a candlestick. Depending on the security’s performance during that period, the closing price can correspond to either the top edge of a candlestick’s candle (if the period was bullish) or the bottom edge (if the period was bearish).
As a true candlestick devotee, I believe that you can gain far more insight into a period’s trading by looking at a candlestick than you can by looking at another type of charting tool. Want proof? Take a look at Figure 1-1.
FIGURE 1-1: Bullish and bearish candlesticks side by side.
You can tell right away that the up day has a white candle and the down day has a black candle. That simple difference alone clearly reveals the nature of the price action that took place during that period. In the case of the candlestick with the black candle, there was more selling pressure than desire to buy. And the candlestick with the white candle indicates that there was more buying pressure than desire to sell.
Why are these details so important? Candlestick charts quickly clue you in on the type of buying and selling that’s been going on during a given period and where it may occur again. In many cases, the buyers continue to buy and the sellers continue to sell during subsequent periods or when the price reaches a level that spurred them to action in the past.
For more information on candlestick construction, see Chapter 3.
Working with Candlestick Patterns
The components of a candlestick may be the bones of candlestick charting, but candlestick patterns are the heart and soul. Patterns appear on candlestick charts as simple, single-stick occurrences or complex, multistick formations, and many types of patterns can tell you what may be in store for a security that you’ve had your eye on for trading or investing. Knowing what may lie ahead can be the difference between a profitable trade and a flop.
Simple patterns
Some candlestick patterns are very simple: A single candlestick on a chart can serve as a candlestick pattern. A single candlestick that signifies time to buy or sell is very appealing to traders who are just starting to work with candlestick charts, because after you understand the basics of candlestick construction, you can immediately start identifying simple patterns and using them to make more-informed trading decisions. Turn to Chapters 5 and 6 for several great examples of how just one candlestick can tell you what a security’s price is going to do in the immediate future.
I also consider double-stick candlestick patterns as simple patterns, and you can explore several varieties in Chapters 7 and 8.
Complex patterns
When a candlestick pattern includes three periods’ worth of price action (three candlesticks), I consider it to be a complex pattern. Many complex candlestick patterns require specific price activity over the course of three days for the pattern to be considered valid, and I discuss a range of them in Chapters 9 and 10.
Complex candlestick patterns can be frustrating at times, because you may watch with anticipation as a pattern develops nicely for the first two days only to fizzle out on the third.