Use Japanese Candlesticks to spot trading signals

Technical analysis is the study of how the price of a security changes over time. Technical analysts use 'charts' with price on the y-axis and time on the x-axis to understand and predict the future direction of security prices.

Western technical analysis techniques are generally accepted to have appeared around the late 19th and early 20th centuries with the works of Charles Dow and William P. Hamilton. As the name suggests, Japanese Candlesticks originated in Japan, and were in use around 150 years earlier than the first Western techniques. 

Originally used to trade rice futures, the creation and development of Japanese Candlesticks can be attributed to rice merchant Munehisa Homma (1716-1803). Homma is rumoured to have become the wealthiest man in Japan (and some say the world) due to the use of his pioneering trading methodology.

The principles of Homma's methodology were based around his observations of price action and trading psychology. It is the latter which separates Japanese Candlesticks from more modern Western techniques which simply manipulate price history with mathematical formulas.

Any experienced trader would know that their trading psychology is at least, if not more important than their trading methodology. Homma used his observations of how other traders responded to certain repeating scenarios, to build his Japanese Candlesticks methodology into an effective tool that kept him one step ahead of the emotional masses.
 

We're only going to introduce the Japanese Candlesticks methodology in this article, as it would take us dozens of articles to fully explain it. But, the basis for the creation of a Japanese Candlestick is very simple. A white box, or 'body' is drawn for the period we're analysing if the close of the period is greater than the open of the period. Conversely, a black, filled body is drawn if the close of the period is below the open of the period.

A 'shadow' is drawn as a line protruding from the top or bottom of the body. The length of an upper shadow is the difference between the high of the period and the close of the period if the body of the candle is white, and it is the difference between the high of the period and the open of the period if the body of the candle is black. In a similar fashion, lower shadows are measured as the difference between the open of the period and the low of the period for a white-bodied candle, and as the difference between the close of the period and the low of the period for a black-bodied candle.



There are many dozens of Japanese Candlestick patterns, and they can range from one, two, or up to 7 periods. However, there are two main pattern types to look out for. Continuation patterns, and reversal patterns.

The most basic continuation pattern is a single candle which has a relatively long body (relative to other candles over the medium-term), and very small, or preferably, no shadows. These candles are referred to as 'Marubozu'. Marubozu in Japanese means 'shaven head' and this reflects the fact that the body has little-to-no shadows, and in effect, is therefore 'shaven'.

When a white Marubozu is observed, one should assume that there is significant demand in the market, and therefore the price is more likely to continue higher than it is to move lower. Conversely, when a black Marubozu is observed, one should assume that there is significant supply in the market, and therefore the price is more likely to continue lower than it is to move higher.

The most basic reversal pattern is a single candle which has a long shadow and a very small body. When the shadow is pointing down, the candle resembles a hammer, and therefore variants of this pattern are often referred to as 'hammers'. In 'inverted hammer' for example, has a small body and a long shadow pointing up.

With all hammers, the colour of its body is less relevant than the length of its shadow. The length of a hammer's shadow represents the degree of resistance to a move in the direction of the shadow. Therefore, a long upper shadow represents a resistance to move higher, and logically, it indicates a great deal of excess supply at the prices reached towards the height of the shadow. Conversely, a long lower shadow represents a resistance to move lower, and logically, it indicates a great deal of excess demand at the prices reached towards the depth of the shadow. 

Based upon the above analysis of hammers, Japanese Candlestick proponents believe that long shadows 'point' to areas of excess demand or excess supply in the market. Where a number of shadows coincide, often the experience is that the excess demand/supply will eventually overwhelm price movement and send prices in the opposite direction to the shadows. The subsequent move can be substantial and rapid.
 

One of the key flexibilities of Japanese Candlesticks is the ability to use them on any security over any timeframe. At the heart of the methodology is the analysis of demand and supply, and whether an excess or equilibrium of either is evident in the market. So, philosophically speaking, Japanese Candlesticks can be used for any security whose price is determined by demand and supply, that is, every security in every market anywhere in the world!

Also, the concepts are just as transferable over various timeframes. As long as one can obtain an open, high, low, and closing price for a period, one can draw a Japanese Candlestick for the period. So, we can draw Japanese Candlesticks on 1-minute, 5 minute, hourly, daily, weekly and monthly timeframes and more. Whilst in theory any periodicity is possible, one should always try and match one's timeframe to one's investing style. So, longer term investors should use longer periodicities and vice-versa for shorter term traders. 

Regardless of the period of time a Japanese Candlestick refers to, one thing remains all-important. The user must wait for the close of the candle before assessing its importance and relevance. This is because a decision made intra-candle could be invalidated by the close of the candle. Too many traders have made the mistake of buying upon seen a fantastic Marubozu just after the open, only to see it transform into a bearish inverted hammer by the close. It is a sickening feeling, I can tell you!
 

The benefits of using Japanese Candlesticks are best explained using a case study. Here we will use popular buy now-pay later company Afterpay (APT). It recently fell from its all-time high of $160.05 to under $100 in less than four weeks. We contend, that if one had a firm grasp of Japanese Candlestick techniques, one could have clearly identified the point where the market for Afterpay switched from excess demand to excess supply. In doing so, one could have exited their long position on Afterpay near the high price, and if they wished, switched to shorts with confidence.



Before Candle 1, Afterpay was in a short term downtrend (black candles) within a strong and well established long-term uptrend. Candle 1 (hammer type candle) is an excellent signal that excess demand has returned to the market for Afterpay shares. The low of Candle 1's shadow, $129.01, is now a solid base of demand from which to continue the long term uptrend. Candle 2 (Marubozu type candle) is excellent confirmation of the swing back to excess demand observed at Candle 1. The balance of probability points to higher share prices ahead. Candle 3 is another confirmation of the uptrend.

Candle 4 is a signal that some supply has been found. Far from signalling the end of the uptrend, it is simply a warning sign that sellers are about. We must await confirmation! Candle 5 is a strong signal that the selling was likely temporary, and that the prevailing uptrend is likely to proceed. Candle 6 makes us again wonder if all is well with this uptrend, clearly Candle 4 was not a fluke! We must be attentive for further signals that excess supply sits at the $160.05 level. 

Candle 7 is the second-most pivotal candle on this chart. It shows that attempts to push prices higher are meeting substantial and building supply. The next two candles demonstrate that demand impetus is almost completely depleted. Candles 8 and 9 are very interesting, they probably balance each other out, but together they demonstrate that the days of easy price gains for Afterpay are probably a thing of the past. The upper shadow on Candle 9 is not very convincing for the bulls.

Candle 10 is easily the most pivotal candle on this chart. It confirms the bull's worst fears! The long upper shadow confirms substantial and persistent supply at the $160.05 level. Further, the low close on the session after such a promising start, indicates that buyers have completely lost the ability to control the price. The balance of probability has now significantly swung to lower prices ahead.

Candle 11 confirms what we already knew from Candle 10, but nonetheless it is a telling signal of just how skewed this market has become towards the supply side. Candle 12, that's it, it's all over for the bulls! Look out below!
 

The effectiveness of Japanese Candlesticks are further enhanced when combined with Western technical analysis techniques, in particular, when combined with support and resistance. Check out this article for an in-depth explanation on how to identify support and resistance levels on a chart. 



In the Afterpay case study, the lower peak of Candle 10 compared to the peak at Candle 6 indicates that supply is building. The break of the trough at the low of Candle 8 (on Candle 12) confirms a new downtrend, and the high of Candle 6 as a major peak, that is, a major point of supply moving forward.

Not shown in this chart, but shown in the case studies in our previous article on how to spot support and resistance, is a major support level at $123.40, and another at $105.03. We should be watching the candles intently at each level for signs of possible excess demand which could indicate a potential bounce in the share price.



In our final chart for Afterpay above, we can see that hopes for a substantial support zone around $123.40 were dashed at Candle 1. The best the bulls could do was a close well off the high of the session, and only moderately off the low. A very weak display by the bulls indeed! But, as East meets West, some excess demand at the major support level did materialise, if only for two more trading sessions. The feeble rally was extinguished at Candle 2, a continuation Marubozu, which clearly signalled the resumption of the downtrend. The next target? The next major support level at $105.03.

Indeed, Candle 6 smashes into this next Western major support level. The Eastern methodology confirms for us that significant excess demand did actually exist at this point. We get a nice bounce from the low at $99.38 to as much at $118.48 just after the open of Candle 7. Candle 7 is a live candle however (at the time of taking the snap shot). Therefore, it cannot provide any informational value, and must not be used in our decision making process. We must await the close of the candle to determine whether the current bounce has any longer-term merit.
 

Nearly 300 years after their creation, Japanese Candlesticks are still being used by traders to improve their trading outcomes. Whilst the world has changed unimaginably since the days of the legendary Munehisa Homma, his methodology has easily stood the test of time. This is because it is founded upon the most fundamental concept of finance - the interaction of demand and supply.

Japanese Candlesticks remain the most descriptive technical analysis tool for quickly summarising all of the hopes and fears shared by traders in the market at any point in time. This ensures that they will continue to be used effectively by traders for many years to come.