Candlesticks Light the Way to Logical Trading

In Understanding Japanese Candlestick Charts, we discuss the history and basics of the art of Japanese candlestick charts. Here we delve into how to analyze candlestick patterns.

Principles behind the art

Before learning how to analyze candlestick charts, we must understand that candlestick patterns, for all intents and purposes, are simply the reactions of traders to the market at any given time. The fact that humans often react en masse to situations allows candlestick chart analysis to work.

Many of the investors who rushed into the dot-com bubble, prior to that time, had never bought a single share in a public company. Volumes at the top broke records and smart money was starting to come out of 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 dot-com flavor of the moment. Like the lemmings, these new players took greed to a level never seen before, and before long they saw the market crash.

JDSU shows long bullish candles in August 1999 to March 2000.

Image by Sabrina Jiang © Investopedia 2021

Let’s take a look at what was a favorite of many investors during that time. This JDS Uniphase presentation on the chart above is a lesson in how to recognize long bullish candles, which were formed when the company’s share price moved from the $ 25 area in late August 1999 to an additional $ 140 in March. 2000. of long green sails that occurred during a seven-month voyage.

Pattern analysis

Traders should remember that a pattern can consist of a single candle, but it can also contain a series of candles over several trading days.

A reversal candle pattern is a number or series of candles that typically 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 the John J. Murphy classic, “Technical Analysis of Financial Markets”:

A serious consideration that should be used to identify bullish or bearish patterns is the market trend that precedes the pattern. You cannot have a bullish reversal pattern in an uptrend. You can have a series of candles that resemble the bullish pattern, but if the trend is up, it is not a bullish Japanese candle pattern. Similarly, you cannot have a bearish reversal candle pattern in a downtrend.

The trader who takes the candlestick charts to the next level will read that there could be as many as 40 or more patterns indicating reversals. One-day reversals form chandeliers like hammers and hanging men. A hammer is an umbrella that appears after a price drop and, according to candle professionals, comes from the action of “hammering” a bottom. If a stock or commodity opens lower and the price falls during the session only to return close to the opening price at the close, professionals call it a hammer.

It is very important to recognize and understand a hanged man. It is an umbrella that develops after a rally. The shadow must be twice as long as the body. Hanged men who appear after a long rally should be noticed and acted upon. If a trading range for the pending day is above the entire trading range of the previous day, a gap day can be indicated.

Let’s look at two charts, one with a hammer and the other with a hanged man. The first graphic from Lucent Technologies and shows a classic hung man. After three days with a rising price, the hanged man appears. The next day, the share price falls by more than 20%. T

A basic hanging man pattern on a Lucent Technologies graphic.

Image by Sabrina Jiang © Investopedia 2021

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 halts the decline, marking the beginning of a run of nine days with the stock price rising $ 11.

A hammer pattern on a Nortel chart in 2001.

Image by Sabrina Jiang © Investopedia 2021

For those of you who wish to explore this area of ​​technical analysis more deeply, check out the books written by Steve Nison. He has written several textbooks that even a beginner can use to better understand candlestick charts.

The bottom line

The fact that humans 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 business decisions, rather than just following the crowd. Remember it’s your moneyinvest it wisely.

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Mark Holland

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