21 Candlesticks U Should Know
21 Candlesticks U Should Know
21 Candlesticks U Should Know
CANDLESTICKS
EVERY TRADER
SHOULD KNOW
Dr. Melvin Pasternak
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21 CANDLESTICKS EVERY TRADER SHOULD KNOW BY NAME
By: Dr. Melvin Pasternak
OUTLINE
I INTRODUCTION
Candles Anticipate, Indicators Follow,
Trendlines Confirm
How To Read A Candlestick Chart
Bar vs. Candlestick Charts
Optimism and Pessimism as Shown by Candles
INTRODUCTION
If you are already familiar with the basics of candlesticks, you can
skim this section. If you have seen candles on the web, but have
not studied them in some detail, then you'll now be given the
background you need to use candles.
Below are a three month bar chart and a three month candlestick
chart for IBM. See if you can spot any differences in the "data
series."
Hard to spot the difference? That's because there isn't any. Both
the bar chart and the candlestick chart contain exactly the same
information, only it's presented to the trader in different form.
Both the bar chart and the candle chart contain the same data:
the high for the period (the day), the low, the open and the close.
In a candlestick chart, however, the names are changed. The
difference between the open and the close is called the real
body. The amount the stock went higher beyond the real body is
called the upper shadow. The amount it went lower is called
the lower shadow. If the candle is clear or white it means the
opening was lower than the high and the stock went up. If the
candle is colored then the stock went down. This information is
shown below:
With a bar chart you need to mentally fill in the price action.
You need to say to yourself, "The left tick says that's where it
opened, the right tick where it closed. Now I see. It was an
up day." With a candlestick chart it is done for you. You can
spend your energy on analysis, not figuring out what happened
with the price.
2. With candles you can spot trends more quickly by looking for
whether the candles are clear or colored. Within a period of
trend, you can easily tell what a stock did in a specific period.
The good news is these are reversal signatures and are apt to
occur again. Your ability to recognize them could lead to large
trading gains. First, I will explain the candlesticks, then apply
this theory to analysis of the graph. The candles are pointed
out on the Dow chart below.
BULLISH ENGULFING.
THE HAMMER.
This hammer marks a reversal off a bottom or off an important
support level. On the day of the hammer, prices decline. They
hit bottom and then rebound sharply making up all the ground
– and sometimes more – compared to where the sell-off
started. The candle shows that the buyers have seized control.
A bullish candlestick on the following day confirms this
analysis.
THE DOJI.
If you were to learn only one candle by name, this would have
to be the one. A "common" doji, as I call it, is shaped like a
cross. A doji has no real body. What it says is that there is a
stalemate between supply and demand. It is a time when the
optimist and pessimist, amateur and professional are all in
agreement. This market equilibrium argues against a strong
uptrend or downtrend continuing, so a doji often marks a
reversal day.
During the period the chart pictures, the Dow Jones Industrial
Average went sideways in a broad trading range between
10000 and 11000. I have placed only one moving average on
the chart, the 50-day. A 50-day moving average describes the
Intermediate trend and when it moves sideways like it does
here, you can also be sure it describes a market in a sideways
consolidation pattern.
From 10075 the Dow advanced over the next month to a peak
just below 10600. For almost a month, in what must have
seemed like an eternity for traders, the Dow vacillated in an
excruciatingly narrow range between 10400 and 10600. When
it finally got beyond resistance at 10600, it formed three doji-
like candles in a row. (The candles are doji-like since they
have very small real bodies). These dojis showed that the
bulls and bears were at a stalemate. After a lengthy uptrend
they indicated that the bulls lacked the buying power to move
the market higher. Not surprisingly a strong sell-off ensued.
The decline ended well above 10000 this time finding a bottom
at 10175. The candle which formed here can be interpreted as
a hammer, despite the very small upper shadow. The hammer
candle occurred after the Dow had found support near 10250
for several days.
All in all, there are about 100 candles patterns the trader can
become familiar with. Of these, 21 candles recur frequently
enough and are significant enough that the trader should be
able to spot them by name. Knowing their names allows you
to spot them more easily and assess their implications. When
faced with the need for a quick decision during the heat of
trading, the trader who can name these 21 candles has a
distinct advantage over one who can't.
21 CANDLES EVERY TRADER SHOULD KNOW BY NAME
As significant as the doji is, one should not take action on the
doji alone. Always wait for the next candlestick to take trading
action. That does not necessarily mean, however, that you
need to wait the entire next day. A large gap down, after a doji
that climaxed a sustained uptrend, should normally provide a
safe shorting opportunity. The best entry time for a short trade
would be early in the day after the doji.
The chart of the Disk Drive Index ($DDX) shows three of the
four dojis just described and gives some guidance as to how to
effectively interpret this candle depending on where it occurs in
a trend. The Disk Drive Index consists of 11 stocks in the
computer storage and hard drive businesses. This index's
performance therefore usually correlates highly with the
Nasdaq Composite. In March, the $DDX hit a peak of 125.06
and then a prolonged sell-off in conjunction with the overall
market in general and tech stocks in particular. Also, note,
how in early May, the $DDX traded sideways for several days,
finding support or buying interest at the mid-97 level with
resistance or selling pressure near the psychological barrier of
100.
Finally, the buyers were able to overwhelm the sellers and the
$DDX pierced 100. Note on this day, the four-day moving
average penetrated the nine-The 4-day moving average day
and both began to slope upward. That pattern suggested an
uptrend was beginning. The four-day moving average going
above the nine is a bullish moving average crossover. While I
wouldn't trade on this very short-term signal in isolation, it
provides a useful confirmation that the immediate trend is up.
In the two days after the dojis appeared, the $DDX struggled
to move higher without much success. On the second day, the
candle turned dark showing selling pressure. Note also that
the four-day moving average penetrated down through the
nine-day, the first time this had happened since the uptrend
began in early May.
How can you tell the two candles apart? The hangman candle,
so named because it looks like a person who has been
executed with legs swinging beneath, always occurs after an
extended uptrend. The hangman occurs because traders,
seeing a sell-off in the shares, rush in to snap up the stock at
bargain prices. To their dismay they subsequently find they
could have bought the stock at much cheaper levels. The
hangman looks like this:
On the day of the dark cloud cover, the stock opens above
the previous day's high. For a true dark cloud cover to
emerge, therefore, the stock should gap above the upper
shadow of the previous white "capping" candle. At the
opening bell on this trading day, it seems like the uptrend
will continue.
As the day wears on, however, the bears wrest control. On
the dark cloud cover day, the stock closes at least halfway
into the previous white "capping" candle. The larger the
penetration of the previous candle (that is, the closer this
candle is to being a bearish engulfing), the more powerful
the signal. Traders should pay particular attention to a dark
cloud cover candle if it occurs at an important resistance
area and if the end-of-day volume is strong. Below you will
find an example of a Dark Cloud Cover candle:
The dark cloud cover and piercing candles are like bookends.
Whereas the dark cloud cover warns that an uptrend might
be coming to an end and is thus a signal to take profits on
long trades, a piercing candle intimates that a downtrend
may be about to reverse and shorts should be covered.
On the piercing day, the candle comes back into and closes
at least halfway into the real body of day one. If it does
not come at least halfway back, then the candle is not a
piercing candle and needs to be called by a different name.
(The candle is "on-neck" if it closes at day one's low, "in-
neck" if it closes slightly back into day one's real body, and
"thrusting" if it closes substantially into the real body, but
less than halfway.) In addition, the second day's candle
cannot totally make up the ground lost in day one, otherwise
it would be a bullish engulfing.
The star communicates that the bulls and bears are involved
in a tug of war, yet neither side is winning. After a sustained
uptrend, those who want to take profits have come into
balance with those eager to buy the stock. A large upper
shadow indicates that the stock could not sustain its probe
into new high ground. A potential reversal has been
signaled.
Always look carefully at the next day's candle -- the one that
follows the harami candle. Sometimes harami merely
signifies that the stock is entering a period of consolidation
(the shares will trade sideways). If, however, the stock
you're examining rallies the day after the harami candle
takes place, then there is an increased likelihood that the
shares have put in a Minor bottom.
Note that the lower shadows on three black crows are small,
or in some cases even nonexistent. Although three black
crows is a complete pattern in and of itself, traders should
always be alert to what happens on the fourth day after the
pattern is formed. Since there has been intense selling
throughout the pattern, the stock may be overextended to
the downside. However, if the stock continues its negative
pattern on the fourth day, then it is likely that the issue is
going much lower.
The chart of Macromedia (MACR) was taken during the
period the stock was acquired by Adobe Systems. During
this time, MACR advanced from a late April low of $32.68 to
an early June peak of $44.67. MACR then began to weaken,
but found support just above the $42.50 level. Note the
large black candle about 10 days into the decline. The lower
shadow probed the $40 area, a key level of round number
support.
Several days later, the first of the three black crows formed
just above $40. The second crow broke decisively through
the $40 level and the third crow took the shares down
toward $38. By this time, MACR had fallen almost $4 in
three days and on a very short term basis was substantially
oversold. Oversold conditions may be relieved by a stock
going either up or sideways and in this case MACR went
laterally for the next four days. Eventually, the shares
tested $35 before finding a short-term bottom.
Note how the biotechs went from one end of the Bollinger
band to the other and stochastics from oversold to
overbought. The three white soldiers had consumed a lot of
buying power! After that the biotechs went sideways for
most of the month resolving the overbought condition. .
The next day EAT gapped up on news that the company was
boosting both its quarterly and full year earnings outlook.
The stock opened at $39.25, backed off to $38.65 and
closed over round number resistance at $40. A continuation
gap typically takes place approximately half-way through the
move. If you add the prior move of $3.76 to the low of the
gap day, $38.65, the target becomes $42.41. The stock hit
$42.40 several trading days later!
A CONCLUDING CHALLENGE