In Understanding Basic Candlestick Charts we looked at the history and the basics of the art of Japanese candlestick charting. Here we look deeper into how to analyze candlestick patterns.
Principles Behind the Art
Before learning how to analyze candlestick charts, we need to understand that candle patterns, for all intents and purposes, are merely traders' reactions to the market at a given time. The fact that human beings often react en masse to situations allows candlestick chart analysis to work.
Many of the investors who rushed into the dotcom bubble had, before that time, never bought a single share in a public company. The volumes at the top were record breaking and the smart money was starting to leave the stock market. Hundreds of thousands of new investors, armed with computers and new online trading accounts, were sitting at their desks buying and selling the dotcom flavor of the moment. Like lemmings, these new players took greed to a level never seen before, and, before long, they saw the market crash around their feet.
JDSU shows long bulling candles in August 1999 to March 2000. Source: TradeStation
Let's have a look at what was a favorite of many investors during that time. This presentation of JDS Uniphase on the chart above is a lesson in how to recognize long bullish candles, which formed as the company's stock price moved from the $25 area in late August 1999 to an outstanding $140 plus in March 2000. Just look at the number of long green candles that occurred during a seven-month ride.
Traders must remember that a pattern may consist of only one candlestick but could also contain a number or series of candlesticks over a number of trading days.
A reversal candle pattern is a number or series of candlesticks that normally show a trend reversal in a stock or commodity being analyzed. However, determining trends can be very difficult. Perhaps this is best explained by Gregory L. Morris in the chapter he wrote for John J. Murphy's classic, "Technical Analysis of the Financial Markets":
One serious consideration that must be used to identify patterns as being either bullish or bearish is the trend of the market preceding the pattern. You cannot have a bullish reversal pattern in an uptrend. You can have a series of candlesticks that resemble the bullish pattern, but if the trend is up it is not a bullish Japanese candle pattern. Likewise, you cannot have a bearish reversal candle pattern in a downtrend.
The trader who takes Japanese candlestick charting to the next level will read that there could be as many as 40 or more patterns that will indicate reversals. One-day reversals form candlesticks such as hammers and hanging men. A hammer is an umbrella that appears after a price decline and, according to candlestick pros, comes from the action of "hammering" out a bottom. If a stock or commodity opens down and the price drops throughout the session only to come back near the opening price at close, the pros call this a hammer.
A hanging man is very important to recognize and understand. It is an umbrella that develops after a rally. The shadow should be twice as long as the body. Hanging men that appear after a long rally should be noted and acted upon. If a trading range for the hanging day is above the entire trading range of the previous day, a gap day may be indicated.
Let's look at two charts, one with a hammer and the other with a hanging man. The first charts Lucent Technologies and shows a classic hanging man. After three days a rising price, the hanging man appears. On the following day, the stock price drops by more than 20%. The second chart shows a hammer from a period in 2001 when Nortel Networks was trading in the $55-$70 range. The hammer appears after two days of declining prices and effectively stops the slide, marking the beginning of a nine-day run with the stock price moving up $11.
A basic hanging man pattern in a chart of Lucent Technologies. Source: TradeStation
A hammer pattern in a chart of Nortel in 2001. Source: TradeStation
For those of you who would like to explore this area of technical analysis more deeply, check out books written by Steve Nison. He has written a number of textbooks that even a novice can use to better understand candlestick charting.
The Bottom Line
The fact that human beings often react en masse to situations is what allows candlestick chart analysis to work. By understanding what these patterns are telling you, you can learn to make optimal trading decisions, rather than just following the crowd. Remember it's your money—invest it wisely.