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CHARTING
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MAXIMUM PROFITS
B.M. DAVIS
COPYRIGHT © 2009
ALL RIGHTS RESERVED
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Candlestick Charting
Candlestick charting was developed by Japanese rice traders over four centuries
ago and could quite possibly be the oldest form of technical analysis. Since
technical analysis is not only predicting probable price moves but also assessing
market psychology, candlestick charting is probably the best tool to give the
trader these answers in the shortest amount of time. Once a trader becomes
familiar with candlestick charting, he or she can get a quick and highly visual
signal because of the story candlesticks tell. Strict adherers to candlestick
methodology take positions based on very short term patterns given by
candlestick tradition. While candlestick charting is relatively unknown, and
therefore unpracticed by the common investor, their use among active traders is
growing. The greatest benefit candlestick charts provide the technical analyst is
the ease of use and interpretation. The same price action, quickly seen using
candlestick charts, may go unnoticed while scrolling through bar charts.
While analysis of chart patterns takes experience and some practice, so too will
candlesticks. However, after learning the basic signals, candlesticks can provide
the novice trader a shorter learning curve and also shorten the learning curve to
chart reading in general. I like using bar charts to find chart patterns, and then
switch to candlesticks for a closer look. Candlestick charts are especially useful
when analyzing areas of consolidation such as triangles and flags for signs of
reversal or continuation. The major signals in candlestick theory are reversal
signals. Some of these signals are considered so strong by serious candlestick
practitioners; they will enter a trade based on its signal alone, without the need
for conformation. Since our trading style is to confirm everything, we won’t act
on the signal alone, although we will pay close attention.
Our goal will be to teach you candlestick methods in their purest form, so we
will alert you to the signals in which no conformation is said to be necessary. We
will also break down each signal, expanding on its psychological implications on
the chart. Our objective will be to not only educate you in the proper use of
candlesticks, but also give plenty of examples of their improper use within a
chart formation or pattern.
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Figure 1
The chart symbols used in candlestick charts are fairly easy to understand.
Candlestick charts get their name from the symbol used to represent the trading
range in which you are charting (daily, weekly etc…), which are called candles.
The candle has a wide area separating the open price from the closing price,
which is called the body, Figure 1. On a trading day where the stocks price closed
higher than its open, the candle will have an unfilled or clear body and on a day
where the stock closes below the open price, the body will be filled (black in the
example above). It’s important to keep in mind that a black candle does not
necessarily mean the stock closed lower than the day before, just lower than the
close. Conversely, a clear candle doesn’t necessarily mean the stock closed higher
than the day before, just higher than the open. On some charting software the
unfilled bodies may be changed to green and the filled bodies to red. Many
charting software also allow the user to change the colors themselves depending
on their preference. The color of the body is not as important as the contrast
between the two different candle types. For the illustrations in this article, we
will use the traditional black and white bodies. On most candles there will be a
thin line extending from the top and bottom of the body. The line extending from
the top of the body represents the distance from the open or close (depending on
the candle) and the high price of the day. Conversely, the line extending from the
bottom of the body represents the distance to the low price. These lines are called
the wicks, along with a variety of other commonly used names, such as whiskers
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or hairs. Since candlestick theory puts its emphasis on the relationship of the
open price, as compared to the closing price, the wicks rarely carry any technical
significance. However, there are a few candles and patterns you will want to pay
close attention to not only the wick, but also to the length of the wick.
The Doji
The Doji is one of the most important signals in Candlestick analysis. A Doji has
the appearance of a cross, with the opening price the same as the close. It
signifies indecision in the market (Figure 2).
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Figure 2
Other variations of the Doji are the Gravestone Doji and the Dragonfly Doji
(Figure 3& 4). The Gravestone Doji shows price action that opens and closed at
the bottom of its daily range, giving the bears a slight upper hand for the day
and can be considered very bearish at a top. The Dragonfly Doji opens and
closed at the top of its daily range and can be considered very bullish.
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Figure 4 – Dragonfly Doji
The psychology behind the Doji shows that buyers and sellers were even for the
day, without one side or the other being able to get the upper hand to move the
price of the stock. In an oversold market the Doji has very bullish implications
and conversely, in an overbought market it has very bearish overtones. All Doji
signals are enhanced by a long daily range, and overbought or oversold market
conditions. Let’s look at a few charts and observe the Doji in different situations.
In September 2003 MSFT bottomed out with a formation that included two Dojis. Notice
the second Doji formed at the end of the first consolidation of the uptrend, just before the
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broke out and made its biggest gain of the new uptrend. Two months later, the uptrend
ended with two more Dojis before gapping down into a new downtrend.
After a fairly good downtrend, NCR ended it with a bottom containing two Dojis. A Doji
doesn’t have to be at the exact bottom, as in this chart to have reversal implications.
Many times indecision shows itself a week or more before a bottom formation is complete.
Hammers
The Hammer, which is similar to the Doji, is a single candle that represents a
possible change in trend direction. Also similar to the Doji, the Hammer has a
few different variations. A hammer has a long daily range compared to the
difference between the closing and opening price. Unlike the Doji, The Hammer
will have either a white or black body, with the white body being somewhat
more bullish or a dark body being slightly more bearish. Below are two
variations of the Hammer candle (Figures 5 & 6)
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Figure 5 – Hammer
The significance of a Hammer is its long wick compared to its open and close. It
depicts either buyers or sellers started the day off moving prices their desired
direction. Once the price went up or down a significant amount, depending
whether the initial pressure was selling or buying, the opposite side got the
upper hand and were able to push prices the other direction showing the
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pressure of the trend was lessoning. On the day of a hammer, the signal will be
improved by higher volume and the length of the prior trend. A Hammer can
have either bullish or bearish overtones depending were it forms. If the trend
was an up trend, the length of the wick warns of selling pressure. Even though
the bulls were able to push prices back to the top of the daily range, the fact that
they had to tells us the trend may be weakening.
Figure 7
On the Dow chart in Figure 7 we can see an example of both a clear and dark
bodied hammer at two different minor bottoms in an uptrend. Also we have an
example of an inverted Hammer during the last week of October, 2003. At this
minor bottom the wick of an inverted hammer shows us that buyers were
starting to step in and with some strength. The clear body tells us that they were
able to hold off the sellers and close the day above its close, even though a dark
bodied inverted Hammer would still have been bullish in this position.
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move and confirming trend direction. Factors that enhance the signals of the long
day would be small wicks and high trading volume for the day. Figure 8 & 9
illustrates an example of a long white candle and a long dark candle.
Figure 8
Figure 9
Figure 10 shows us three examples of long days, two bearish (dark body) and
one bullish (clear body). Notice on each of the days illustrated the volume was
higher than average. The two bearish long days would be considered
confirmation of the established bearish down trend. Conversely, the clear
bodied candle was a big confirmation of a new uptrend.
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Figure 10
Short Days
Short days can obviously be considered the exact opposite of the long day.
Usually a short day is found in an area of price consolidation on the chart. Short
days are typically days with little trading activity, which is sometimes useful in
determining if a consolidation is setting up for a move. Consolidations are
covered more in depth in the chart patterns section of the site. Briefly, when
analyzing consolidation periods on a chart, we look for volume to taper off in a
period of consolidation before a price move. We won’t spend much more time on
this page discussing short days except the example in the chart below in Figure
11.
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Figure 11
Spinning Tops
Figure 12
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Spinning tops a re candles that have a small body compared to the size of the
wicks. For a candle to be defined as a spinning top it must not only have long
wicks, but must have wicks at both ends of the body. Spinning tops may or may
not offer information depending on their place on a stock chart. In a market that
is trending sideways a spinning top can usually be considered neutral. However,
after a big move in price in either direction a spinning top can have the same
reversal implications as the doji, especially if it is accompanied by a spike in
volume or forms within a few days of a doji.
Figure 13
In Figure 13 you can see spinning tops at reversal points in the price of BORL.
Examining this chart will reveal more spinning top candles assuming a more
neutral roll.
Marubozu Variations
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Another candle that separates itself from the pack is the Marubozu and
variations of the Marubozu. While rare, the true Marubozu has a full body with
no wicks and has a markedly longer body than the average daily price range of
the stock being studied. Figure 14 shows an illustration of the Black and White
Marubozu. Notice the lack of wicks; the Black Marubozu opens on its high for
the day and closes on the low. Conversely, the White Marubozu opens on its low
for the day and closes on the high.
Figure 14
The Black Marubozu can be both a very bearish candle when found in a topping
pattern, and a bullish warning candle when found at the end of a long down
trend, cautioning us that selling may be peaking. The White Marubozu on the
other hand rarely proves to be anything other than very bullish, with buying
starting right at the open and continuing throughout the day until the closing
bell.
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Figure 15
Figure 16
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The Opening Marubozu, as seen in the Illustration above (Figure 16) is also more
common than the true Marubozu. The Opening Marubozu is defined exactly
opposite of the Closing Marubozu. The White Opening Marubozu will have its
low price for the day at the open and will close with a wick on the top showing
some selling into the close. The Black Opening Marubozu opens on its high and
will close with a wick showing a little buying into the close.
Figure 17
In Figure 17, I’ve illustrated a Black Marubozu. While the price of VPI continued
to climb a bit after forming this candle, a clear topping pattern emerged soon
afterward as VPI ended its uptrend. In this example, the Black Marubozu was the
first high volume selling day since a new uptrend started in early December,
which would also seen as a warning sign to holders of this stock.
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Figure 18
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Figure 19
Reversal Patterns
Now that we have covered the major one day candles, let's look at reversal
patterns and their implications on market psychology. One of the most powerful
aspects of any type of technical analysis is its ability to gauge the psychology of
any tradable stock or index. Major Candlestick reversal patterns are no different
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and can tell us the psychology in as little as two days, or at least warn the
investor of an impending change. It’s important to remember that a well
established trend will usually not turn on a dime and reverse itself in the
opposite direction. Candlestick reversal signals tell us when the trend is losing
steam. The prices may go higher, but not with the same vigor as they had before.
With so many tradable stocks, the investor can decide to put his funds elsewhere
or ride it out and wait for the next sell signal. The major reversal patterns are as
follows:
• Bearish Engulfing
• Bullish Engulfing
• Hanging Man
• Bullish Piercing
• Dark Cloud
• Harami Pattern
• Shooting Star
• Morning Star
• Evening Star
• Bullish Kicker
• Bearish Kicker
Bearish Engulfing
Figure 2
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Figure 2 illustrates a nice Bearish Engulfing formation in HANS. This candle
engulfed two of the previous days making the signal that much stronger.
Notice also that the second day had a strong increase in volume and the
pattern formed near the resistance of the previous high a few weeks earlier.
While the price of HANS tried to rally during the next week, the Bearish
Engulfing signal forewarned the impending downtrend.
Figure 3
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Bullish Engulfing
Figure 4
The Bullish Engulfing formation (Figure 4) is a very strong two day reversal
signal consisting of a black candle on the first day, with the price gapping down
on the second day and opening lower than the close of the first day. The price
then rallies and the clear candle of the second day closes higher than the first
days opening price, completely engulfing the first days body. A look at the
psychology behind this formation reveals the sellers, or the supply of stock,
dwindling as prices move lower. When the price gaps down on the second day
and buyers start to step in with force, the pattern reveals a change in investor
sentiment from distribution to accumulation. There are a few things we look for
to strengthen the signal:
• · High volume on the second day with low volume on the first.
• · A large body engulfing a small body.
• · Prices heavily oversold, with prices falling faster than the angle of the
trend preceding the formation.
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• · The body of the second day engulfing the body and the wicks of the first
day.
• · The pattern forms on any technical price support area such as, a trend
line, major moving average, or horizontal support.
Figure 5
Figure 5 shows a nice Bullish Engulfing formation starting a rally in BORL that
gained better than %50. Notice the heavy volume on the second day of the
formation and low volume on the first day. Also, the oversold MACD indicator
crossed over its trigger line to validate the new uptrend.
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Figure 6
Figure 6 shows a Bullish Engulfing formation after a gap down in price on the
first day indicating panic selling was beginning to peak. Notice the nice gap
down on the second day and the short wick below the body indicating the last of
the panic selling ended soon after the opening bell and buyers came into the
stock and moved prices higher throughout the day.
Hanging Man
Figure 7
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The Hanging Man formation (Figure 7) gets its name from the patterns unique
appearance it gives on a stock chart of a man hanging at the peak of an uptrend.
The pattern is made up of three candles with the second candle being a hammer
that has gapped up above the preceding candle. On the third day, prices start to
decline below the wick of the hammer of the previous day completing the
formation. When we see this formation we can observe selling coming in on the
day that the hammer forms. After an uptrend, selling comes in after prices gap
up and push prices lower. The buyers are able to regain control and push prices
back up towards the opening price or beyond forming the lower wick and small
body of the hammer. Even though the buyers were still around on the second
day, the initial selling is seen as a warning the trend may be slowing. The third
day’s dark candle is seen as conformation of this warning. There are a few things
we can look for that will make this pattern more significant:
• A long wick at the bottom of the hammer candle indicating how much
selling pressure was present.
• High volume on the second and third day.
• The pattern forms at a point of technical resistance such as a major moving
average, upper trend line, or horizontal resistance.
Figure 8
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In Figure 8 we have an illustration of a Hanging Man formation in TACT that
gave the first warning of an impending downtrend. Notice the overbought
MACD indicator and declining histogram as the pattern formed which also
helped validate the signal.
Figure 9
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Bullish Piercing
Figure 10
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Figure 11
Figure 11 shows a Bullish Piercing formation in the price of FON. Notice the
dramatic change in trend that followed this pattern. Conformation of the Bullish
Piercing pattern is recommended and this chart illustrates a confirmed signal on
the long white candle following the pattern.
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Figure 12
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Dark Cloud Cover
Figure 13
Figure 13 represents a Dark Cloud Cover formation. This two day reversal
formation is made up of a white (or clear) body on the first day, followed by a
dark candle on the second day that gaps up and comes back down into the body
of the first day’s candle. While the Dark Cloud is a strong reversal signal,
conformation is required by the next days candle to determine if it will be used
as a reversal signal. The Dark Cloud pattern forms after a substantial uptrend
has been in place. On the first day’s white candle buying has peaked. The small
number of buyers that are left the next morning cause the price to gap up above
the close of the first day and sellers begin to step in, bringing prices back down
into the body of the first day’s candle. We can watch for a couple of indications
that will help us determine the strength of the Dark Cloud Cover formation:
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• The pattern forms at a major technical resistance such as an upper trend
line or major moving average.
Figure 14
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Figure 15
In Figure 15, we see an example of a Bearish Dark Cloud pattern in the price of
INTV that was confirmed the very next day. Notice the overbought conditions on
the MACD indicator also helping to confirm the signal.
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Harami
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The Harami pattern can be both bullish and bearish. Figure 16 illustrates a
Bearish Harami and a Bullish Harami is seen in Figure 17. Both Harami patterns
are two day reversal signals made up of a long candle on the first day with a
smaller bodied candle on the second day forming within the body of the first
day’s candle. Although the Harami is a strong reversal signal, conformation of
the signal is required. The Bearish Harami reversal signal is seen after a
significant rise in price. With a white candle forming on the first day, the price
gaps down on the second day to open below the close of the first. The price falls
throughout the day, closing lower, but still above previous day’s opening price.
The Bullish Harami reversal signal occurs after a sizeable downtrend. A large
black candle forms on the first day, the price gaps up the next morning as buyers
step in. They are able to move prices higher all day, but not high enough to
overtake the opening price of the previous day’s candle. There are a couple of
things we can watch for to make the Harami pattern stronger:
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Figure 18
A Bearish Harami pattern, in Figure 18, kicks off a significant reversal in the
price of LTD. The signal was confirmed the next day and MACD indicator was in
overbought territory.
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Figure 19
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Shooting Star
Figure 20
• Very long candles on the first and third day of the formation.
• The third day penetrates the first days candle by greater than 50%.
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• The pattern forms at a point of technical resistance such as an upper
trend line, major moving average, or horizontal price resistance.
Figure 21
Figure 21 illustrates a Shooting Star formation in the price of LTD that formed
at horizontal resistance as the price of the stock was channeling sideways.
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Morning Star
Figure 22
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Figure 23
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Figure 24
Figure 24 illustrates a Morning Star formation in the price of LTD that led to
substantial gains during the next two months. Notice the over sold MACD
and the divergent histogram while prices were falling, also validating the
signal.
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Figure 25
Evening Star
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Figure 26
Figure 26 illustrates an Evening Star reversal pattern. The Evening Star is a three
day pattern that consists of a longer than average white (or clear) bodied candle
on the first day, followed by a smaller black or clear candle that gaps up to open
above the close of the first day. The third candle is a longer than average black
(or filled) bodied candle that gaps down to open below the body of the second
candle and trades well into the body of the first candle. While the bodies of all
three candles may not be separated from one another, the trading range of all
three days will trade into one another which are represented by the wicks. After
a substantial uptrend in price, buyers carry prices higher on a very bullish day.
The following day buyers are still strong enough to open the stock above the
close but sellers come into the stock, supply and demand even out, causing a
small bodied candle on the second day. The third and final day of the pattern
reveals the demand for the stock at current prices has dried up and sellers step in
causing an oversupply of stock. Prices plummet throughout the day well into the
body of the first candle, eating up the gains of the last three days. There are a few
things we can look for to strengthen the Evening Star reversal signal:
• High volume on all three days.
• The length of the first and last candle or the formation.
• The distance in which the third candle penetrates the body of the first
day’s candle.
• The length of the uptrend preceding the Evening Star formation.
• The pattern develops at a point of technical resistance such as a major
moving average, upper trend line, or horizontal resistance.
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Figure 27
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Figure 28
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Kicker Signals
Figure 29
Figure 30
Figure 29 & 30 Illustrates the Bullish and Bearish Kicker reversal signal. The
Bullish Kicker is a two day reversal pattern consisting of a dark (or filled) bodied
candle on the first day that should be longer than average. On the second day a
white bodied candle gaps up to open above the close of the first day and also
closes higher than the first day’s open. The Bearish Kicker is also a two day
reversal pattern made up of a longer than average white bodied candle on the
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first day. The second day forms a dark bodied candle that gaps down below the
close and then closes below the open of the first day’s candle. There are a few
criteria we can look for to strengthen the Kicker signal:
• The length of the second day’s candle. z High volume on the second day.
• The distance from the close of the first day to the open of the second day.
• The pattern forms at a point of technical support or resistance such as a
major moving average, trend line, or horizontal support or resistance.
Figure 31
Figure 31 illustrates a huge Bullish Kicker reversal signal in the price of QLGC
that kicked off a very large rally that led to gains of over 200%.
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Figure 32
Figure 32 illustrates a Bearish Kicker in the price of PMCS that led to a 30%
decline in price.
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