How eSignal's Candlestick Charts Can Decrease Market Risk

Before I show an example of how eSignal's candle charts can help improve your trading success, I will briefly describe what candle charts are and how you can benefit from using them.

What Are Candlestick Charts?

Japanese candlestick (also called candle) charts, so named because the lines look like candles with their wicks, are Japan's most popular form of technical analysis. Candle charts are more than 100 years old and, as such, are older than western bar charts and point and figure charts. Yet, these charts were unknown to the western world until I revealed them in the 1980s.

The Benefits of Adding Candle Charts to Your Trading Arsenal

Candle charts are easy to understand: Anyone, from the first-time chartist to the seasoned professional, can easily harness the power of candle charts.

Candlestick charting tools will give you a jump on the competition: Many of the candle signals are given in a few sessions, rather than the weeks often needed for a bar chart signal. Thus, candle charts will help you enter and exit the market with better timing.

Candlestick charting tools will help preserve capital: You will discover that the candles shine in helping you preserve capital because they often send out indications that a new high or low may not be sustained.

Candle charting techniques are easily used in conjunction with western charting tools: Because candle charts use the same data as a bar chart, any of the technical analyses used with bar charts (such as moving averages, trend lines, retracements, Bollinger Bands, etc.) can be employed with candle charts.

Candlestick charts can be used to trade stocks, futures -- any market that has an open, high, low and close: They can also be used in all time frames -- from intraday to weekly.

How the Candlestick Lines Are Constructed

The broad part of the candlestick line (as seen in the first graphic above) is called the real body. The real body represents the range between the session's open and close. If the close of the session is above the open, the real body is white (i.e., green in Neovest products). If the real body is black, the close of the session is lower than the open.

The thin lines above and below the real body are the shadows. These are the session's price extremes. The shadow above the real body is called the upper shadow, and the peak of the upper shadow is the high of the session. The shadow under the real body is the lower shadow, and the bottom of the lower shadow is the session's low.

Candle lines can be drawn for all time frames -- from intraday to monthly charts.

Notice that the candles to the right in the first graphic have no real bodies. These are examples of doji (pronounced doe-gee). A doji is a candle on which the opening and close are the same. Doji represent a market that is in balance between the forces of supply and demand.

While the candlestick line uses the same data as a bar chart, the color of the candlestick's real body and the length of the candle line's real body and shadows provide an instant x-ray into who's winning the battle between the bulls and the bears. For instance, when the real body is black, that means the stock closed below its opening price. This gives you an instant picture of a positive or negative close. Those of us who stare at charts for hours at a time find candlesticks are not only easy on the eyes, they also convey strong visual signals sometimes missed on bar charts.

Spinning Tops

The logo of our firm is "Helping Clients Spot Market Turns before the Competition." This is because one of the most powerful aspects of candle charts is that they will often provide reversal signals not available with traditional bar charting techniques. Let's take a look at this aspect with a "spinning top" (as seen in the second graphic to the right).

As mentioned previously, one of more powerful aspects of candle charts is the quick visual information they relay about the market's health. For example, a small real body (white or black) indicates a period in which the bulls and bears are in a tug of war. The Japanese have a nickname for small real bodies -- "spinning tops" -- because of their resemblance to the tops we had as children. Such small real bodies give a warning that the market's trend may be losing momentum. As the Japanese phrase it, the "market is losing its breath."

Let's look at an example of how candle charts will often help you preserve capital, a benefit so important in today's volatile environment. In this scenario, I will illustrate how a candle chart can help you avoid a potentially losing trade from the long side.

I have one chart each in the two screenshots to the right. The first chart is a bar chart. On that chart, on the area circled, the stock looks strong because it is making consecutively higher closes. It looks like a stock to buy.

Using the same data as on the bar chart, we now make a candle chart (the second chart). Note the different perspective we get with the candle chart than with the bar chart. On the candle chart, in the same circled area, there are a series of small real bodies -- those that the Japanese call "spinning tops." Small real bodies hint that the prior trend (i.e., the rally) could be losing its breath.

As such, although the bar chart makes it look attractive to buy, the candle chart shows there is indeed a reason for caution about going long -- the small real bodies illustrate the bulls are losing force. By using the candle chart, a trader would likely not buy in the circled area and, thus, help avoid a losing trade.

This is but one example of how candles shine at helping you preserve capital. Warren Buffet has two rules: Rule 1: Don't lose money. Rule 2: Don't forget Rule 1. Candles shine at helping you preserve capital.

Candles and the Overall Technical Analysis Picture

This is only a basic introduction to candle charts. There are many more patterns, concepts and trading techniques that must be considered. But, even with these basic concepts, you can see how the candles open new and unique doors of analysis.

Remember a basic principle: Candle charting techniques are a tool and not a system. Effective candle charting techniques require, not only an understanding of the candle patterns, but a policy of using sound, coherent trading strategies and tactics. These include using stops, determining the risk and reward aspect of a potential trade, observing where a candle pattern is in relation to the overall trend and monitoring the market's action after a trade is placed. By understanding, and using, these trading principles, you will be in a position to most fully enhance the power of the candles.