Japanese Candlestick Patterns – What are the patterns telling us?

Origins

A candlestick chart is a form of hybrid bar/line graph primarily used to show equity price movements over time. This chart form was originally devised by a legendary Japanese rice trader named Homma Munehisa in the early 18th century. Homma used his charts to develop insights into market psychology, which in turn allowed him to amass a considerable fortune in the rice market and eventually rise to the rank of Samurai. Today candlestick charts are used extensively by currency, equity, and options traders engaged in technical analysis.

The Basics

A candlestick line consists of a body, which is a black or white rectangle, and optional upper and lower shadow lines, called the wick. The body indicates the opening and closing prices of a stock. If the opening price was lower than the closing price (the stock went up), the body is white. If the stock went down, the body is black. The wick indicates the highest and lowest prices during the day’s trading (the intra-day high and low).

A candlestick chart thus conveys five pieces of information for each day’s trading and is considerably more informative than a simple line or bar graph of closing prices. Candlesticks do not necessarily have both a body and a wick. If prices were completely flat for the day, the candlestick will have neither and appear simply as a horizontal line.

Basic Patterns

The shape of individual candlesticks is considered by proponents of technical analysis to convey insights into the market trends. There are over a dozen named individual candlestick shapes, each of which has different implications for the next day’s trading. For example, a "Marubozu White" candlestick, a white body with no wick indicating that the opening and closing prices were also the day’s low and high, implies a strong bullish trend. More ominously, a "Gravestone Doji" candlestick, a long wick with a horizontal line at the bottom indicating that the price opened and closed at the day’s low, is the harbinger of a market top, suggesting that it is time to sell.

Complex Patterns

More complex patterns can be observed by comparing the candlesticks for two or more adjacent trading days. For example, a "Bullish Engulfing Pattern" consists of a short black bodied candlestick (indicating a moderate decline) followed by a taller white candlestick, where the body starts below and ends above that of the black candlestick. In financial terms, prices on the second day open lower than the first day’s close and end higher than the first days open. As the name suggests, a "Bullish Engulfing Pattern" is a strongly bullish signal which suggests that it is time to buy.

Does It Work?

Colorful nomenclature such as ‘Gravestone Doji’ and ‘Bullish Engulfing Pattern’ might lead us to consider that Japanese Candlestick Analysis is more superstition than science. Believers in the Efficient Market Hypothesis would certainly dismiss candlesticks of all nationalities and in fact all other forms of technical analysis. However, this would be a mistake. Advances in Behavioral Economics have created renewed interest technical analysis techniques, such as candlestick analysis.

The great insight of Behavioral Economics is that markets are made up of people who do not necessarily act in the way that traditional economic models suggest they should. In other words, at least in the short term, markets are driven by human psychology. This being the case, it is not unreasonable to suggest that the movement of prices yesterday and today will influence the way prices move tomorrow, which is the underlying logic behind candlestick analysis.

It is important to note that this reasoning applies strictly in the short term. In the long term, economic fundamentals swamp trader psychology. However, as a short term trading strategy, candlestick analysis and other technical analysis methods do have some academic backing.

Interestingly, the more traders buy into candlestick analysis, the more powerful a technique it becomes. For example, if a significant portion of traders involved the gold market observe a ‘Gravestone Doji’ in gold prices (indicating a market top) and act accordingly, it becomes very likely that gold prices will decline the next day. In effect, the ‘Gravestone Doji’ will be something of a self fulfilling prophecy. For this reason, the mere fact that Japanese Candlestick Analysis is a widely used technique is evidence that it is a potentially lucrative trading system.