In 1988 I attended a Market Technician’s Association (MTA) meeting in Phoenix at the Camelback Inn. There were two wonderful highlights that occurred at that meeting: one was an introduction to Japanese candle pattern analysis/charting, and the other was meeting Ian McAvity who published Deliberations newsletter for over 40 years and remains a great friend. Ian, you can relax because the remainder of this article will be about Japanese candlestick analysis, even though stories about you would be quite entertaining.
At the conference there was a large contingent of Japanese traders present and they presented their charting techniques. It was the first time I had ever heard of “Hi Ashi,” which is what the Japanese call their candlestick chart. I was working with N-Squared Computing then and we decided to create a charting product using Japanese candle patterns with automatic recognition capability. I traveled to Japan and stayed with Takehiro Hikita who was an active red bean and rice trader in Yokohama. I knew Hikita-san for years as he was a devoted customer of N-Squared Computing. He was intent on teaching me the art of candlesticks and also helping to translate most of the books that were available in Japan. Hikita-san was often fond of saying, “Dance with the Trend.” And now you know where this blog's name came from.
After we launched our DOS-based CandlePower software that automatically identified patterns, a publisher called and said I should write a book on the subject. I said, “I didn’t have time: He said, “it would probably sell a lot of the software.” I said “send a contract.” The book became a giant research project for me. It is in its 3rd edition with a huge amount of updated statistics and data. I think it has been a great seller for 25 years because I wasn’t trying to sell candlesticks, I was trying to provide reasonable and honest research on them. In the book I often tell readers what is just crap and what seems to work.
This series of articles on candlesticks will NOT cover the basics of the subject for two reasons: One, I wrote a book about the subject 25 years ago and it still sells well, and two; I want to point out many of the misunderstandings that I see from others in regard to candlesticks. The following are “need to know” information pieces that I have put together in the last 25 years after giving numerous lectures and presentation on candlestick analysis. If you think I have become opinionated over this time, you are correct. However, I always keep in mind that when dealing with an art form such as this, one should never speak in absolutes. Also, if you do not know anything about “candlesticks,” I strongly suggest you learn the basics as most of this series will not mean much to you. Personally, I suggest starting with my book Candlestick Charting Explained or the study guide Candlestick Charting Explained Workbook, or check out StockCharts.com’s excellent ChartSchool. As always, if you want to ask a question via the Comments, I will answer them periodically. I cannot answer them every day because I might be on the golf course.
Why are single-day candle patterns not recommended for trading?
Every day the market sends a message. Here is what I say about single day candlesticks: They are not candle patterns in that they allow you to see the evolution of trader psychology through multiple days like you can with more complex (multiple day) candle patterns. I also say single candlesticks still send a message that should neither be traded, nor ignored.
Can you use candle patterns on intraday or weekly data?
Of course you can, however, I don’t recommend it. The Japanese were adamant about the period of time between the close of one day and the open of the next day as being critically important to the psychological evolution of traders in developing the pattern. With intraday charts, that time period is just the next data tick, not a lot of time to develop a thought. Weekly truly voids the concept as the open is Monday’s open, the close is Friday’s close, the high is the high for the week (could occur on any day), and the low is the low for the week (again, it could occur on any day of the week). In fact, the open, high, and low could all occur on Monday, with the close on Friday. The trading activity for the last 4 days of the week would not be seen in a weekly candlestick. However, as with any art form, if it works for you, use it.
What do you use for Trend Determination?
A future article in this series.
What mistakes do I see the most in the analysis of candle patterns?
Let’s begin with a question! If you find a bullish reversal candle pattern, what does that mean? First it is supposedly reversing something, right? What is it reversing? It is reversing the preceding trend. Second, if it is bullish reversal, wouldn’t the preceding trend have to be down or bearish? Yes, and many tend to ignore this critical element in pattern identification. Pattern analysis in isolation is poor analysis.
What about Pattern Identification?
A future article in this series.
How reliable are the patterns?
A future article in this series.
Price based support and resistance
You will find that when candle patterns occur near support or resistance levels that are price based they will generally work better than when they are not. Price based means the support and resistance lines are horizontal. This works well because investors and traders all have a strong tendency to anchor on prices, whether from when they bought or when they sold.
The ideal candle pattern and variations which are acceptable.
There are many sketches of the candle patterns included in my book. This is to show you the “ideal” pattern. One rarely finds the ideal pattern in real life and trading, but you must have some feel for what it should look like. You can then see how the pattern identified by a software program can vary from the ideal. In developing the software to identify candle patterns I kept the parameters fairly tight on the identification engine, as the closer they are to ideal, the better then generally are. However, you cannot have the identification parameters too tight or there would be very few candle patterns appear.
Do you have any statistics on candle patterns?
Do I ever! A future article(s) in this series.
Why there are more reversal patterns than continuation patterns.
I think it should be obvious that identifying the beginning and end of a trend is more important for trading than the identification of a trend that is continuing. While the continuation patterns should not be ignored, they rarely offer a trading opportunity, more of a sign of confirmation that the trend is still in place. However, if you did not take a position in the early stage of the trend, the continuation would be a second opportunity to place a trade.
Why there are more bullish reversals than bearish reversals.
If you have ever studied long term charts of the markets or stocks, you can quickly see that when they are developing tops, they are usually long drawn out affairs (distribution), the decision making of selling is more difficult for most investors. However, at bottoms, the emotions are quicker and bottoms tend to be more sharp and defined. This is why there are more bullish reversal patterns than bearish reversal patterns.
How do Candle Patterns perform?
A future article in this series.
Do you recommend any additional methods to use with candle patterns?
A future article in this series.
There are many books out now on candle patterns and most software programs have candlestick charting capability. However, very few have the correct (original Japanese) methodology. My original book discussed ONLY the candle patterns that came from original Japanese literature, with two exceptions. The Three Outside and Three Inside patterns were created when I was at N-Squared Computing to enhance the Engulfing and Harami patterns. They do that quite well, but please realize they are NOT real Japanese candle patterns. I made them up – period.
Below are examples. The first two days of the Outside patterns is an Engulfing pattern. The first two days of the Inside patterns is a Harami pattern.
Three Outside Up
Three Outside Down
Three Inside Up
Three Inside Down
I find it amusing that in most books on candlesticks, the Three Outside and Three Inside patterns are generally included as if they are actual Japanese candle patterns. Hey, I know exactly where they found them. I think only Steve Nison and I did any original research, the rest obtained their basic knowledge from us. That statement may or may not be true, but is my opinion. So if you see these Outside and Inside patterns elsewhere without a source, be sure to thank them for me.
For additional study I humbly recommend you refer to the 3rd edition of my book, “Candlestick Charting Explained,” published by McGraw-Hill. I cover all of the patterns, the single day patterns, multiple day patterns, and many others that were created to fill holes in the Japanese literature. I finally decided to include all of the known patterns, many of which are not from the Japanese literature. The book was first published in 1992 and on its 3rd edition (2006) with a vast amount of statistics. In 2011, I wrote an accompanying Workbook called Candlestick Charting Explained Workbook (catchy title isn’t it?) which offers some new material and many study questions. Finally, this series will have a few other articles interspersed so that you aren't over candlesticked.
Dance with the Trend,
Greg Morris
