Using Candle Charts to Spot the Early
Turning Signals – The Basics
By S t ev e N is on, CMT
What are Candlestick Charts?
Candle charts are Japan’s most popular, and oldest, form of technical
analysis. They are older than point and figure and bar charts. Amazingly,
candlestick charting techniques, used for generations in the Far East, were
unknown to the West until I revealed them in my first book Japanese Candlestick
Charting Techniques back in 1991 B.C (Before Candles).
Japanese candlestick (also called candle) charts, so named because the lines
look like candles with their wicks, are Japan’s most popular form of technical
analysis. Candle charts are over 1,000 years old and as such are older than Western
bar charts and point and figure charts. Yet, amazingly, these charts were unknown
to the Western world until recently. Candle trading techniques have now become
one of the most discussed forms of technical analysis around the world. Almost
every technical analysis software package and Internet charting service now has
candle charts. This attests to their popularity and usefulness.
This article is a very basic introduction to candle charting techniques. But
even with the primary candle signals discussed, you will discover how candles
open avenues of analysis not available anywhere else. My goal here is to provide a
sense of the potential that the candles can offer.
What are the Benefits of Candle Charts?
Candle charts are easy to understand: Anyone, from the first-time chartist
to the seasoned professional can easily harness the power of candle charts. This
is because, as will be shown later, the same data that is required to draw the
candlestick chart is the same as that needed for the bar chart (the high, low, open,
and close).
Candlestick charting tools will give you a jump on the competition: Candle
charts not only show the trend of the move, as does a bar chart, but unlike bar
charts, candle charts also show the force underpinning the move. In addition, many
of the candle signals are given in a few sessions, rather than the weeks often needed
for a bar chart signal. Thus, candle charts will help you enter and exit the market
with better timing.
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Steve Nison, CMT
Candlestick charting tools will help preserve capital: In this volatile
environment, capital preservation is just as important as capital accumulation. You
will discover that the candles shine in helping you preserve capital since they often
send out indications that a new high or low may not be sustained.
Candle charting techniques are easily joined with Western
charting tools: Because candle charts use the same data as a bar chart, it means
that any of the technical analyses used with bar charts (such as moving averages,
trend lines, retracements, Bollinger Bands, etc.) can be employed with candle
charts. However, candle charts can send signals not available with bar charts.
Candlestick charts can be used in stocks, futures, and any market that has an
open, high, low, and close. And they can be used in all time frames—from intraday
to weekly.
CONSTRUCTING T HE CANDLESTICK LINES
The broad part of the candlestick line in Exhibit 1 is called the real body. The real
body represents the range between
the session’s open and close. If the
close of the session is above the
open, then the real body is white. If
the real body is black, the close of
the session is lower than the open.
The thin lines above and below the
real body are the shadows. These
are the session’s price extremes.
The shadow above the real body is
called the upper shadow and the
peak of the upper shadow is the
high of the session. The shadow
under the real body is the lower
shadow and the bottom of the lower
shadow is the session’s low.
Candle lines can be drawn for all time frames, from intraday to monthly
charts. For example, a 60-minute candle line uses the open, high, low and close of
that 60-minute period; for a daily chart it would be the open, high, low and close
for the day. On a weekly chart the candle would be based on Monday’s open, the
high and low of the week, and Friday’s close.
Notice that the candles to the right in Exhibit 1 have no real bodies. These are
examples of doji (pronounced doe-gee). A doji is a candle in which the opening and
close are the same. Doji represent a market that is in balance between the forces
of supply and demand. We will look more at the doji in one of the chart examples
below.
While the candlestick line uses the same data as a bar chart, the color of the
Exhibit 1
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Using Candle Charts to Spot the Early Turning Signals—The Basics
candlestick’s real body and the
length of the candle line’s real body
and shadows convey an instant
x-ray into who’s winning the battle
between the bulls and the bears.
For instance, when the real body is
black, that means the stock closed
below its opening price. This gives
you an instant picture of a positive
or negative close. Those of us who
stare at charts for hours at a time
find candlesticks are not only easy
on the eyes, they convey strong
visual signals sometimes missed on
bar charts.
Spinning Tops
The logo of our firm is “Helping Clients Spot Market Turns Before the
Competition.” This is because one of the most powerful aspects of
candle charts is that they will often provide reversal signals not
available with traditional bar charting techniques. Let’s take a
look at this aspect with a “spinning top.”
As mentioned previously, one of the more powerful aspects of candle charts
is the quick visual information they relay about the market’s heath. For example,
a small real body (white or black) indicates a period in which the bulls and bears
are more in a tug of war. The Japanese have a nickname for small real bodies –
“spinning tops,” because of their resemblance to the tops we had as children. Such
small real bodies give a warning that the market’s trend may be losing momentum.
As the Japanese phrase it, the “market is losing its breath.” A spinning top is
illustrated in Exhibit 2.
Let’s look at an example of how candle charts will often help you preserve
capital, a benefit so important in today’s volatile environment. In this scenario I
will illustrate how a candle chart can help you avoid a potentially losing trade from
the long side.
I have two charts below. The left chart (Exhibit 3) is a bar chart. On chart 3,
on the area circled, the stock looks strong since it is making consecutively higher
closes. It looks like a stock to buy.
Using the same data as on the bar chart, we now make a candle chart (Exhibit
4). Note the different perspective we get with the candle chart than with the bar
chart. On the candle chart, in the same circled area, there are a series of small real
bodies – which the Japanese call “Spinning Tops.” Small real bodies hint that the
prior trend (i.e. the rally) could be losing its breath.
As such, while the bar chart makes it look attractive to buy, the candle chart
shows there is indeed a reason for caution about going long – the small real bodies
illustrate the bulls are losing force. Thus, by using the candle chart, a trader would
Exhibit 2
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Steve Nison, CMT
likely not buy in the circled area and thus help avoid a losing trade.
This is but one example of how candles can help you preserve
capital. Warren Buffet has two rules: Rule 1 – Don’t lose money. Rule 2 – Don’t
forget rule 1. Candles shine at helping you preserve capital.
Doji
As the real body shrinks we ultimately wind up with a doji. As shown on the
right side of Exhibit 1, a doji is when the open and close are the same.
The doji indicates a market in complete balance between supply and demand.
Since a doji session represents a market at a juncture of indecision, they can often
be an early warning that a preceding rally could be losing steam. Indeed, with a
doji the Japanese would say, “the market is tired.” (Keep in mind a close over the
doji would “refresh” the market.)
Properly used, candle charts may not only help improve profits, but will assist
in preserving capital. They can do this by helping you avoid a potential losing trade
or exiting a profitable trade early.
Exhibit 5 shows an example of the latter. The horizontal line in Exhibit 5
shows a resistance area near 135. A tall white candle pierces this resistance in
early March. But observe what unfolded the next session – the doji. This doji line
hinted the bulls had lost full control of the market (note: it does not mean that the
bears have taken control). This is a classic example of the power of candle charting
techniques. Specifically, within one session we were able to see a visual clue via the
doji that while the market was maintaining its highs, the doji shouted that the bulls
were not in complete control. So while the market looked healthy from the outside,
the internals (as shown by the doji) were relaying the fact that this stock was not as
healthy as one would think.
Exhibit 3 Exhibit 4
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Using Candle Charts to Spot the Early Turning Signals—The Basics
The Hammer
We now look at a specific type of candle line that has a very long lower shadow
called a hammer (Exhibit 6). So called because the market is trying to hammer out
a base. The criteria for the hammer are:
1. The real body is at the upper end of the trading range.
2. The color of the real body can be black or white.
3. A bullish long lower shadow that is at least twice the height of the real body.
4. It should have no, or a very short, upper shadow.
The hammer reflects the market insights obtained from a candle chart –
specifically, the hammer’s extended lower shadow shows that the market rejected
lower price levels to close at, or near, the highs of the session. From my experience,
most times when there is a hammer the market may not immediately move up, but
may rally slightly, or trade laterally, and then, after expanding on a base, then rally.
If the market closes under the lows of the hammer, longs should be reconsidered.
Candle charts can be used in all time frames – from intra-day, day to weekly.
In the intra-day chart (Exhibit 7), there are two back-to-back hammers (denoted
by the arrow). These dual hammers took on extra significance since they confirmed
a support level shown by the dashed line.
This is a classic example of the power and
the ease with which one can combine the
insights of candle charts (the hammers) with
classic western trading signals (the support
line) to increase the likelihood of a market
turn. This synergy of candle charts and
western technical tools should provide a
powerful weapon in your trading arsenal.
Exhibit 5 Exhibit 6
Exhibit 7
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Steve Nison, CMT
Engulfing Patterns
An engulfing pattern is a two-candle
pattern. A bearish engulfing pattern
(shown on the right in Exhibit 8) is
formed when, during a rally a black real
body wraps around a white real body. A
bullish engulfing pattern (on the right in
Exhibit 8) is completed when, during a
descent, a white real body envelopes the
prior black real body.
The engulfing pattern is illustrative
of how the candles can help provide
greater understanding into the behavior
of the markets. For example, a bullish
engulfing pattern reflects how the bulls
have wrested control of the market from
the bears. A bearish engulfing pattern
shows how a superior force of supply has
overwhelmed the bulls. The Japanese
will say, for instance, that with a bearish
engulfing pattern that “the bulls are
immobilized.”
Exhibit 9 shows how a bullish
engulfing pattern in early October called
a reversal for IBM. This bullish engulfing
pattern was especially potent because
it reinforced a support area set by a hammer. Once again this underscores the
increased likelihood of a turn if there is more than one signal confirming supportin
this case, we had a hammer and a bullish engulfing pattern.
Candles and the Overall Picture
Remember a basic principle: candle charting techniques are a tool and not a
system. Effective candle charting techniques require not only an understanding of
the candle patterns, but a policy of using sound, coherent trading strategies and
tactics. These include using stops, determining the risk and reward aspect of a
potential trade, observing where a candle pattern is in relation to the overall trend,
and monitoring the market’s action after a trade is placed. By understanding, and
using, these trading principles, you will be in a position to most fully enhance the
power of the candles.
Exhibit 8
Exhibit 9
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Using Candle Charts to Spot the Early Turning Signals—The Basics
This is only a basic introduction to candle charts. There are many more
patterns, concepts, and trading techniques that must first be considered. But even
with these basic concepts, you can see how the candles open new and unique doors
of analysis.
May the candles light your path to profits!
Steve Nison, CMT, was the first to reveal candlestick charts to the Western world and is the
acknowledged leading authority on the topic. In addition he has over 30 years experience with
Western indicators so his trading strategies combines the best of the East and West. He is founder and
President of CANDLECHARTS.COM which provides educational products services to institutions
and private traders. He is the author of Japanese Candlestick Charting Techniquesand Beyond
Candlesticks. Steve’s work has been highlighted in financial media around the world, including the
Wall Street Journal, Institutional Investor, Worth Magazine, and Barron’s. To learn how to spot the
early market reversals and to sign up for his free trading videos visit www.candlecharts.com.
