Japanese candlestick charts are the champion and choice of both professional and amateur chartists. They were developed in the seventeenth century by the Japanese to calculate price changes in rice and were brought to this country and made famous by Steve Nison, a Chartered Market Technician (CMT) and expert in technical analysis.
The Japanese candlestick is often compared to a lesser known chart analyst tool known that is growing in popularity: the western line, or OHLC, which is short for Open, High, Low and Close. It is constructed by using the same data as Japanese candlesticks but displays it differently.
Ask anyone who favors the Japanese candlestick what they think of western line and their feelings are often of derision. Some have called the western line a cheap imitation of the Japanese candlestick. In this article, we'll look at the strengths and weaknesses of these two techniques and attempt to determine which comes out on top.
If you look at any charting software program or a free charting program available on the web, their ability to use candlesticks is built in. Japanese candlesticks have become the favored tool for quickly analyzing the movement or potential trend changes in a security. This should be no surprise to anyone who has ever used them. (To learn more about this type of chart, see The Art Of Candlestick Charting.)
Their simplicity and wealth of available information makes them fairly easy to understand, even for amateur chartists. Although they might be simple, they are still a very powerful and valuable price analysis tool. A Japanese candlestick, which we'll refer to simply as a "candlestick", is made up of some standard components. The most important component in the formation of any candlestick is data that contains an open, high, low and close for a chosen time period. Without these, there can be no candlesticks.
For the ease of this example we'll focus on candlesticks that are black and white (or blank and filled in). Some charting programs will have them colored in red or green. The blank or filled-in portion of the candlestick is called the body; you will also hear it referred to as the real body. The next thing you will see are thin lines coming out from the top and bottom of the body. These lines are called shadows and will show you the high and low of the time period chosen. The line coming out of the top will show you the high of the session and the one coming from the bottom will show you the low.
So why are they either blank or filled in you may ask? If you have a body that is blank, this means that the security has closed higher than its opening price. The top of the body is the closing price and the bottom is the starting point or the opening price. If, however, you have a body that is filled in (usually you will see it filled in red if your software displays candlesticks in color) this shows that the security's closing price is lower than its opening price. The very nature of candlestick charts allows the chart reader to easily spot a change in trend or strength and weakness over a given period.
You might have noted that both the western line and Japanese candlesticks use the same important data points. This is true, but the western line will appear different from the candlestick. The western line is made up of two main parts - just like the Japanese candlestick. The western line will display a vertical bar and two small horizontal lines. The vertical bar shows you the high and low of the session. There is one line that is on the right side of the vertical bar as well as one on the left side. The horizontal line on the left side represents the opening price, while the horizontal line on the right side shows you the closing price. There are no fancy colors and these bars and lines are always black, so they are not as pleasing to the eye as the Japanese candlesticks are.
Head to Head
The major difference between candlesticks and western line is in the way they display opening and closing prices. It is dissimilar due to the emphasis on the difference of the next days or previous day's close and open. The OHLC emphasizes the difference in the closing and opening price of that one session. The candlestick places all the emphasis on the closing price in relation to the previous day's closing price. When they are placed side by side using the same stock and time frame, it is much easier to spot the trends and reversals on a chart using Japanese candlesticks than with the western line. Practically speaking, there is no question that the candlestick is more popular than the western line chart.
Let's dig a bit deeper. While looks and ease of readability are important factors, there is also another factor to consider: The western line makes the chart reader focus more on looking for significant signs that there may be a pattern developing, which requires further investigation before making a move. This investigation can lead to more extensive research before pulling the trigger on making a trade. You would be inclined to think that a rush to judgment is usually found among amateurs, but this is certainly not always the case. The strength of the OHLC chart is that it will make the trader stop and really analyze his or her next move.
In the following two examples you'll notice that the time frames are the same but the stocks are different.
Let's look at the Google (Nasdaq:GOOG) example starting September 6, 2007. Google fell and the candle is red, which means it finished down for the day. The next day, it finished higher, but there was not a lot of strength. On Monday September 10, Google finished lower. You might be inclined, at first glance, to close the position without doing any further investigation. Of course, we can see that this was not a top but rather the beginning of a bullish pattern that would see the price rocket higher.
Now look at the same time frame on the western line example in Figure 2 below: there is no rush to immediately say that there is a top. Instead, the very nature of the western line forces you to look at it more closely. Is there a pattern forming there? The western line will force the trader to further investigate the move.
For a different example, we've chosen to take a look at International Business Machines Corp. (NYSE:IBM). Let's analyze first the candlestick chart of IBM in Figure 3. Starting with the September 13 trading day and looking ahead, is there a possible pattern developing? For the trained eye, it kind of looks like an inverse head and shoulders. Looking at the western line in Figure 4, it is a little easier to see. You can immediately see that one of the shoulders could have possibly formed on September 10. Here is another case in which the western line would have alerted you to a possible pattern developing.
Clearly, both the western line and candlestick patterns have merit. The nature of trading and chart reading happens to be very subjective. It is natural that using a certain chart style will depend on the individual trader. The objective of this article was to introduce western line charts to traders that may not have seen them before. Western line, while clearly not as popular as candlesticks, does have its place in the modern trader's arsenal of trading weapons.
The western line's strength lies in making the analyst look at the difference in day-to-day closing prices that will make you study the chart. Making you step back while investigating a possible developing pattern is not a bad thing at all. Deciding to only use one over the other is probably not the best answer. While not as visually appealing as the Japanese candlesticks, you should consider giving the western line a try. If you use a web-based charting program, you should have two tabs opened. One tab can be the Japanese candlestick and the other should have the western line. And remember to use the same time frame to ensure that your analysis is effective.
For more on charting, see Analyzing Chart Patterns.