Why I Use Japanese Candlestick Charts

Here is your basic construction of a Japanese Candlestick. When the candle is hollow, the close is above the opening price and when the candle is filled (or melted), the close is below the open. This goes for any period in question, whether you're looking at a daily candlestick, weekly candlestick or even intraday like a 30-minute or 65 minute period.

The construction is rather simple but the candle always tells a story. The shadow, or "wick", above and below the real body represent the intra-period highs and lows. The real body defines the prices between the open and the close. If the candlestick is hollow and the close is towards the upper end of the candlestick, the bulls were clearly in control during that particular period. If a candlestick is filled and the close is towards the lower end of the candlestick, the bears were in control during that period. You don't get this sort of quick visual when you're using bar charts, and especially not when you're using line charts.

The candlesticks up top are you basic candlesticks with uniform colors: black and white. Personally, I prefer to take the visual benefits of Japanese Candlesticks one step further. If the closing price of the candlestick in question is above the prior period's closing price, I want a green candle. If the closing price of the current candle is below the prior period's close, I want a red candle. This red/green combination is often seen in other kinds of charts as well.

Something also worth noting is that you can have a hollow red candlestick and you can also have a filled green candlestick. Remember, whether the candle is hollow or filled has nothing to do with the previous closing price. This is determined by the open and close of the candlestick itself, regardless of where it is relative to the prior period. The color is determined by where the current close is compared with the previous close. Here is an example of a hollow red candlestick. In this case, prices gapped down below the prior close, rallied throughout the period, but closed below the prior period's close. Hollow but red:

We can see the opposite scenario as well. In this example, prices gapped up well above the prior period's close, sold off throughout the period, but still managed to close above the prior period's close. Green but filled (or melted):There are many types of candlesticks with all different shapes and sizes. Not all of them need to have well-defined real bodies like this. In many cases, in fact, they don't even have a real body. These are what we refer to as a Doji. A Doji is when there is movement intra-period, higher and/or lower, but the close is at or near the opening price. Here is an example of a Long-legged Doji where prices rallied well above the opening price, sold off well below that price, but ultimately closed right where it opened. These can be red or green, depending on the prior period's close. They represent indecision and can often be found at turning points:

There are two other common types of Doji's: the Dragon Fly Doji (also called a "Hammer" if it comes after a downtrend) and the Gravestone Doji (also called a "Shooting Star" if it comes after an uptrend)"Each candlestick or, in many cases, groups of candlesticks, have names that they have been given over time. The way I see it, it's not the names themselves that matter, but more so the implications of the candles that matters most.

From Steven Nison:

Technical Analysis is the only way to measure the emotional component of the market. We know that many times an ounce of emotion can be worth a pound of facts. How else to explain a sudden shift in the market without a change in the fundamentals?

A fascinating attribute to candle charts is that the names of the candle patterns are a colorful mechanism describing the emotional health of the market at the time these patterns are formed. After hearing the expression, “dark-cloud cover,” would you think the market is in an emotionally healthy state? Of course not! This is a bearish pattern and the name clearly conveys the unhealthy state of the market.

Many of these candlesticks have funny names like Abandoned Baby or Hanging Man, but again, it's the implications of the candlesticks or groups of candlesticks and in what environment they appear that we want to pay attention to. The names themselves, in my opinion, are less important.

Earlier I mentioned using a 65-minute candle. There is a good reason why it is important to use a candlestick that completes an entire period. For daily, weekly or even monthly candlesticks, this is created naturally. When looking intraday, however, you want your candlesticks to all be equal periods. In the U.S. Stock market, there are normally 390 minutes in each day. So you can look at 39 10-minute periods, for example. Or you can analyze 13 30-minute periods. But if you want to look at hourly charts, you will only have 6.5 candlesticks. Therefore to have an equivalent timeframe across the board, each day in the stock market would consist of 6 65-minute candlesticks. To quote my friend Brian Shannon:

Look at the picture below and ask yourself ‘which one doesn’t belong?’  It is not a trick question… the lone apple is clearly different than the 6 oranges in the picture.

So here is the simple solution.  Either switch your chart to a 65 minute timeframe so you have six candles of equal length each day (390/65 = 6.0) or further reduce your timeframe down to 30 minutes of data.  With 30 minute data periods each day will have 13 individual candles of equal length.

I want to make something clear about candlesticks: they are not the end all be all of technical analysis. In fact, in many cases I don't use them at all. For example, once a week I run through all of my charts: commodities, forex, stocks, U.S. Indexes and Sectors, International Indexes, ETFs, etc with just bar charts. I take out my momentum oscillator, I remove any moving averages and just look at weekly and daily bar charts. It's amazing how much you can see when you get everything else the hell out of the way. When you just want to visualize the changes in equilibrium between supply and demand, the ultimate Keep It Simple Stupid (K.I.S.S.), OHLC Bar Charts work great (Open-High-Low-Close).

Also, when doing ratio analysis, I also prefer not to use Japanese Candlesticks. There are many reasons why, but mostly because we are analyzing one security relative to another over time. Since I use this for trend recognition, a line chart connecting closing prices (weekly or daily) is more than enough for me. Also, the reason we use candlesticks is because they tell a much better story visually than other types of charts. But in the case of ratio analysis, I don't need the intra-period story. I'm just looking for trends. In fact, when looking at ratios between two ETFs, let's say, one might open before another one, so the "story" being told by the candle is probably being driven by incorrect information. So with ratios, I always use line charts.

For day-to-day charting, however, Candlesticks do the trick for me. I think they tell a great story that you might miss when using other types of charts. I think all of them, bars, lines and candles, have a place in my process as well as many other technicians whose work I respect. They each play a role and I guess it's all about knowing when to use which ones depending on what your goal is at that particular moment.

I hope this gives you some insight as to why and when I choose to use Japanese Candlestick Charts. To see this type of analysis in real time, Click Here to join us in a more official capacity as a Member of Allstarcharts.com

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