BASIC CANDLESTICKS

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BASIC CANDLESTICKS

Different body/shadow combinations have different meanings. Days in which the difference between the open and close prices is great are called Long Days. Likewise, days in which the difference between the open and close price is small, are called Short Days. Remember, we are only talking about the size of the body and no reference is made to the high and/or low prices. (See Figure 12.3.)

Spinning Tops are days in which the candlesticks have small bodies with upper and lower shadows that are of greater length than that of the body. The body color is relatively unimportant in spinning top candlesticks. These candlesticks are considered as days of indecision. (See Figure 12.4.)

Figure 12.3

Figure 12.4 Spinning tops.

When the open price and the close price are equal, they are called Doji lines. Doji candlesticks can have shadows of varying length. When referring to Doji candlesticks, there is some consideration as to whether the open and close price must be exactly equal. This is a time when the prices must be almost equal, especially when dealing with large price movements.

There are different Doji candlesticks that are important. The Longlegged Doji has long upper and lower shadows and reflects considerable indecision on the part of market participants. The Gravestone Doji has only a long upper shadow and no lower shadow. The longer the upper shadow, the more bearish the interpretation. The Dragonfly Doji is the opposite of the Gravestone Doji, the lower shadow is long and there is no upper shadow. It is usually considered quite bullish. (See Figure 12.5.)

Figure 12.5 Doji candlesticks.

The single candlestick lines are essential to Japanese candlestick analysis. You will find that all Japanese candle patterns are made from combinations of these basic candlesticks.

CANDLE PATTERN ANALYSIS

A Japanese candle pattern is a psychological depiction of traders’ mentality at the time. It vividly shows the actions of the traders as time unfolds in the market. The mere fact that humans react consistently during similar situations makes candle pattern analysis work.

A Japanese candle pattern can consist of a single candlestick line or be a combination of multiple lines, normally never more than five. While most candle patterns are used to determine reversal points in the market, there are a few that are used to determine trend continuation. They are referred to as reversal and continuation patterns. Whenever a reversal pattern has bullish implications, an inversely related pattern has bearish meaning. Similarly, whenever a continuation pattern has bullish implications, an opposite pattern gives bearish meaning. When there is a pair of patterns that work in both bullish and bearish situations, they usually have the same name. In a few cases, however, the bullish pattern and its bearish counterpart have completely different names.

Reversal Patterns

A reversal candle pattern is a combination of Japanese candlesticks that normally indicate a reversal of the trend. One serious consideration that must be used to help 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.

This presents one of the age-old problems when analyzing markets: What is the trend? You must determine the trend, before you can utilize Japanese candle patterns effectively. While volumes have been written on the subject of trend determination, the use of a moving average will work quite well with Japanese candle patterns. Once the short term (ten periods or so) trend has been determined, Japanese candle patterns will significantly assist in identifying the reversal of that trend.

Japanese literature consistently refers to approximately forty reversal candle patterns. These vary from single candlestick lines to more complex patterns of up to five candlestick lines. There are many good references on candlesticks, so only a few of the more popular patterns will be discussed here.

Dark Cloud Cover. This is a two day reversal pattern that only has bearish implications. (See Figure 12.6.) This is also one of the times when the pattern’s counterpart exists but has a different name (see Piercing Line). The first day of this pattern is a long white candlestick. This reflects the current trend of the market and helps confirm the uptrend to traders. The next day opens above the high price of the previous day, again adding to the bullishness. However, trading for the rest of the day is lower with a close price at least below the midpoint of the body of the first day. This is a significant blow to the bullish mentality and will force many to exit the market. Since the close price is below the open price on the second day, the body is black. This is the dark cloud referred to in the name.

Piercing Line. The opposite of the Dark Cloud Cover, the Piercing Line, has bullish implications. (See Figure 12.7.) The scenario is quite similar, but opposite. A downtrend is in place, the first candlestick is a long black day which solidifies traders’ confidence in the downtrend. The next day, prices open at a new low and then trade higher all day and close above the midpoint of the first candlestick’s body. This offers a significant change to the downtrend mentality and many will reverse or exit their positions.

Figure 12.6 Dark cloud cover -.

Evening Star and Morning Star. The Evening Star and its cousin, the Morning Star, are two powerful reversal candle patterns. These are both three day patterns that work exceptionally well. The scenario for understanding the change in trader psychology for the Evening Star will be thoroughly discussed here since the opposite can be said for the Morning Star. (See Figures 12.8 and 12.9.)

Figure 12.7 Piercing line +.

Figure 12.8 Evening star -.

Figure 12.9 Morning star +.

The Evening Star is a bearish reversal candle pattern, as its name suggests. The first day of this pattern is a long white candlestick which fully enforces the current uptrend. On the open of the second day, prices gap up above the body of the first day. Trading on this second day is somewhat restricted and the close price is near the open price while remaining above the body of the first day. The body for the second day is small. This type of day following a long day is referred to as a Star pattern. A Star is a small body day that gaps away from a long body day. The third and last day of this pattern opens with a gap below the body of the star and closes lower with the close price below the midpoint of the first day.

The previous explanation was the perfect scenario. Many references will accept as valid, an Evening Star which does not meet each detail exactly. For instance, the third day might not gap down or the close on the third day might not be quite below the midpoint of the first day’s body. These details are subjective when viewing a candlestick chart, but not when using a computer program to automatically identify the patterns. That is because computer programs require explicit instructions to read the candle chart, and don’t allow for subjective interpretation.

Continuation Patterns

Each trading day, a decision needs to be made, whether it is to exit a trade, enter a trade, or remain in a trade. A candle pattern that helps identify the fact that the current trend is going to continue is more valuable than may first appear. It helps answer the question as to whether or not you should remain in a trade. Japanese literature refers to 16 continuation candle patterns. One continuation pattern and its related opposite cousin are particularly good at

trend continuation identification.

Rising and Falling Three Methods. The Rising Three Methods continuation candle pattern is the bullish counterpart to this duo and will be the subject of this scenario building. A bullish continuation pattern can only occur in an uptrend and a bearish continuation pattern can only occur in a downtrend. This restates the required relationship to the trend that is so necessary in candle pattern analysis. (See Figures 12.10 and 12.11.)

Figure 12.10 Rising Three Methods +.

Figure 12.11 Falling Three Methods -.

The first day of the Rising Three Methods pattern is a long white day which fully supports the uptrending market. However, over the course of the next three trading periods, small body days occur which, as a group, trend downward. They all remain within the range of the first day’s long white body and at least two of these three small-bodied days have black bodies. This period of time when the market appears to have gone nowhere is considered by the Japanese as a “period of rest.” On the fifth day of this pattern, another long white day develops which closes at a new high. Prices have finally broken out of the short trading range and the uptrend will continue.

A five day pattern such as the Rising Three Methods requires a lot of detail in its definition. The above scenario is the perfect example of the Rising Three Methods pattern. Flexibility can be applied with some success and this only comes with experience. For example, the three small reaction days could remain within the first day’s high-low range instead of the body’s range. The small reaction days do not always have to be predominantly black. And finally, the concept of the “period of rest” could be expanded to include more than three reaction days. Don’t ignore the Rising and Falling Three Methods pattern; it can give you a feeling of comfort when worrying about protecting profits in a trade.

Using Computers for Candle Pattern Identification

A personal computer with software designed to recognize candle patterns is a great way to remove emotion, especially during a trade. However, there are a couple of things to keep in mind when viewing candlesticks on a computer screen. A computer screen is made up of small light elements called pixels. There are only so many pixels on your computer screen, with the amount based upon the resolution of your video card/monitor combination. If you are viewing price data that has a large range of prices in a short period of time, you may think that you are seeing many Doji days (open and close price are equal) when in fact, you are not. With a large range of prices on the screen, each pixel element will have a price range of its own. A computer software program that identifies patterns based on a mathematical relationship will overcome this visual anomaly. Hopefully, the above explanation will keep you from thinking that your software isn’t working.

FILTERED CANDLE PATTERNS

A revolutionary concept developed by Greg Morris in 1991, called candle pattern filtering, provides a simple method to improve the overall reliability of candle patterns. While the short term trend of the market must be identified before a candle pattern can exist, determination of overbought and oversold markets using traditional technical analysis will enhance a candle pattern’s predictive ability. Concurrently, this technique helps eliminate bad or premature candle patterns.

One must first grasp how a traditional technical indicator responds to price data. In this example, Stochastics %D will be used. The stochastic indicator oscillates between 0 and 100, with 20 being oversold and 80 being overbought. The primary interpretation for this indicator is when %D rises above 80 and then falls below 80, a sell signal has been generated. Similarly, when it drops below 20 and then rises above 20, a buy signal is given. (See Chapter 10 for more on Stochastics.)

Here is what we know about stochastics %D: When it enters the area above 80 or below 20, it will eventually generate a signal. In other words, it is just a matter of time until a signal is given. The area above 80 and below 20 is called the presignal area and represents the area that %D must get to before it can give a trading signal of its own. (See Figure 12.12.)

Figure 12.12

The filtered candle pattern concept uses this presignal area. Candle patterns are considered only when %D is in its presignal area. If a candle pattern occurs when stochastics %D is at, say 65, the pattern is ignored. Also, only reversal candle patterns are considered using this concept.

Candle pattern filtering is not limited to using stochastics %D. Any technical oscillator that you might normally use for analysis can be used to filter candle patterns. Wilder’s RSI, Lambert’s CCI, and Williams’ %R are a few that will work equally as well. (These oscillators are explained in Chapter 10.)

CONCLUSION

Japanese candlestick charting and candle pattern analysis are essential tools for making market timing decisions. One should use Japanese candle patterns in the same manner as any other technical tool or technique; that is, to study

the psychology of market participants. Once you become used to seeing your price charts using candlesticks, you may not want to use bar charts again. Japanese candle patterns, used in conjunction with other technical indicators in the filtering concept, will almost always offer a trading signal prior to using other price-based indicators.

CANDLE PATTERNS

The candle patterns listed below comprise the library that is used to identify candlestick signals. The number in parentheses at the end of each name represents the number of candles that are used to define that particular pattern. The bullish and bearish patterns are divided into two groups signifying either reversal or continuation patterns.

Long White Body (1) Long Black Body (1) Hammer (1) Hanging Man (1) Inverted Hammer (1) Shooting Star (1) Belt Hold (1) Belt Hold (1) Engulfing Pattern (2) Engulfing Pattern (2) Harami (2) Harami (2) Harami Cross (2) Harami Cross (2) Piercing Line (2) Dark Cloud Cover (2) Doji Star (2) Doji Star (2) Meeting Lines (2) Meeting Lines (2) Three White Soldiers (3) Three Black Crows (3) Morning Star (3) Evening Star (3) Morning Doji Star (3) Evening Doji Star (3) Abandoned Baby (3) Abandoned Baby (3) Tri-Star (3) Tri-Star (3) Breakaway (5) Breakaway (5) Three Inside Up (3) Three Inside Down (3) Three Outside Up (3) Three Outside Down (3) Kicking (2) Kicking (2) Unique Three Rivers Bottom (3) Latter Top (5) Three Stars in the South (3) Matching High (2) Concealing Swallow (4) Upside Gap Two Crows (3) Stick Sandwich (3) Identical Three Crows (3)

Bullish Reversals Bearish Reversals

Homing Pigeon (2) Deliberation (3) Ladder Bottom (5) Advance Block (3) Matching Low (2) Two Crows (3)

Separating Lines (2) Separating Lines (2) Rising Three Methods (5) Falling Three Methods (5) Upside Tasuki Gap (3) Downside Tasuki Gap (3) Side by Side White Lines (3) Side by Side White Lines (3) Three Line Strike (4) Three Line Strike (4) On Neck Line (2) On Neck Line (2) In Neck Line (2) In Neck Line (2)

Bullish Continuation Bearish Continuation

Upside Gap Three Methods (3) Downside Gap Three Methods (3)

*This chapter was contributed by Gregory L. Morris.

HISTORICAL BACKGROUND

In 1938, a monograph entitled The Wave Principle was the first published reference to what has come to be known as the Elliott Wave Principle. The monograph was published by Charles J. Collins and was based on the original work presented to him by the founder of the Wave Principle, Ralph Nelson (R.N.) Elliott.

Elliott was very much influenced by the Dow Theory, which has much in common with the Wave Principle. In a 1934 letter to Collins, Elliott mentioned that he had been a subscriber to Robert Rhea’s stock market service and was familiar with Rhea’s book on Dow Theory. Elliott goes on to say that the Wave Principle was “a much needed complement to the Dow Theory.”

In 1946, just two years before his death, Elliott wrote his definitive work on the Wave Principle, Nature’s Law—The Secret of the Universe.

Elliott’s ideas might have faded from memory if A. Hamilton Bolton hadn’t decided in 1953 to publish the Elliott Wave Supplement to the Bank Credit Analyst, which he did annually for 14 years, until his death in 1967. A.J. Frost took over the Elliott Supplements and collaborated with Robert Prechter in 1978 on the Elliott Wave Principle. Most of the diagrams in this chapter are taken from Frost and Prechter’s book. Prechter went a step further and in 1980 published The Major Works of R.N. Elliott, making available the original Elliott writings that had long been out of print.

BASIC TENETS OF THE ELLIOTT WAVE PRINCIPLE

There are three important aspects of wave theory—pattern, ratio, and time in that order of importance. Pattern refers to the wave patterns or formations that comprise the most important element of the theory. Ratio analysis is useful in determining retracement points and price objectives by measuring the relationships between the different waves. Finally, time relationships also exist and can be used to confirm the wave patterns and ratios, but are considered by some Elliotticians to be less reliable in market forecasting.

Elliott Wave Theory was originally applied to the major stock market averages, particularly the Dow Jones Industrial Average. In its most basic form, the theory says that the stock market follows a repetitive rhythm of a five wave advance followed by a three wave decline. Figure 13.1 shows one complete cycle. If you count the waves, you will find that one complete cycle has eight waves—five up and three down. In the advancing portion of the cycle, notice that each of the five waves are numbered. Waves 1, 3, and 5 called impulse waves—are rising waves, while waves 2 and 4 move against the uptrend. Waves 2 and 4 are called corrective waves because they correct waves 1 and 3. After the five wave numbered advance has been completed, a three wave correction begins. The three corrective waves are identified by the letters a, b, c.

Along with the constant form of the various waves, there is the important consideration of degree. There are many different degrees of trend. Elliott, in fact, categorized nine different degrees of trend (or magnitude) ranging from a Grand Supercycle spanning two hundred years to a subminuette degree covering only a few hours. The point to remember is that the basic eight wave cycle remains constant no matter what degree of trend is being studied.

Each wave subdivides into waves of one lesser degree that, in turn, can also be subdivided into waves of even lesser degree. It also follows then that each wave is itself part of the wave of the next higher degree. Figure 13.2 demonstrates these relationships. The largest two waves—1 and 2—can be subdivided into eight lesser waves that, in turn, can be subdivided into 34 even lesser waves. The two largest waves—1 and 2—are only the first two waves in an even larger five wave advance. Wave 3 of that next higher degree is about to begin. The 34 waves in Figure 13.2 are subdivided further to the next smaller degree in Figure 13.3, resulting in 144 waves.

The numbers shown so far 1,2,3,5,8,13,21,34,55,89,144—are not just random numbers. They are part of the Fibonacci number sequence, which forms the mathematical basis for the Elliott Wave Theory. We’ll come back to them a little later. For now, look at Figures 13.1-13.3 and notice a very significant characteristic of the waves. Whether a given wave divides into five waves or three waves is determined by the direction of the next larger wave. For example, in Figure 13.2, waves (1), (3), and (5) subdivide into five waves because the next larger wave of which they are part—wave 1—is an advancing wave. Because waves (2) and (4) are moving against the trend, they subdivide into only three waves. Look more closely at corrective waves (a), (b), and (c), which comprise the larger corrective wave 2. Notice that the two declining waves—(a) and (c)—each break down into five waves. This is because they are moving in the same direction as the next larger wave 2. Wave (b) by contrast only has three waves, because it is moving against the next larger wave 2.

Being able to determine between threes and fives is obviously of tremendous importance in the application of this approach. That information tells the analyst what to expect next. A completed five wave move, for example, usually means that only part of a larger wave has been completed and that there’s more to come (unless it’s a fifth of a fifth). One of the most important rules to remember is that a correction can never take place in five waves. In a bull market, for example, if a five wave decline is seen, this means that it is probably only the first wave of a three wave (a-b-c) decline and that there’s more to come on the downside. In a bear market, a three wave advance should be followed by resumption of the downtrend. A five wave rally would warn of a more substantial move to the upside and might possibly even be the first wave of a new bull trend.