Japanese Candlestick Trading Explained

Applied to financial markets first by Charles Dow in early 1900, and popularized by Steve Nison in the late 1980's, Japanese candlestick trading is a proven method of forecasting markets.

First invented by Homma Munehisa, a Japanese rice trader, Japanese Candlesticks were designed to give rice traders a simple open, high, low, close view of the markets. Due to the incredible ease and accuracy of monitoring the markets, Japanese traders began studying their usefulness in forecasting future market movements.

Why Use Candlestick patterns

The major benefit of Candlestick signals is that they are very easy to learn and identify. You do not need to learn formulas. You do not have to do extensive fundamental analysis. A Japanese Candlestick reversal signal is a visual identification of a change in investor sentiment. Of the 50 or 60 Candlestick signals, there are 10 major signals that occur at the reversals the majority of the time.

Traders can master Japanese candlestick analysis by focusing on the 10 major signals. A complete understanding of how the signals are formed, and the underlying market forces and psychology can provide traders tremendous predictive powers.

Based on hundreds of years of use within actual markets, the 10 major signals have been proven time an again in real markets. Logically speaking, if the patterns didn't work, Japanese traders wouldn't still be using them today!

Single Stick Candlestick Formations

Each candlestick can tell you much about the forces acting on the market that day. The Japanese quickly began to identify and name these individual patterns:

1. White candlestick - signals uptrend movement (those occur in different lengths; the longer the body, the more significant the price increase)

2. Black candlestick - signals downtrend movement (those occur in different lengths; the longer the body, the more significant the price decrease)

3. Long lower shadow - bullish signal (the lower wick must be at least the body's size; the longer the lower wick, the more reliable the signal)

4. Long upper shadow - bearish signal (the upper wick must be at least the body's size; the longer the upper wick, the more reliable the signal)

5. Hammer - a bullish pattern during a downtrend (long lower wick and small or no body); Shaven head - a bullish pattern during a downtrend & a bearish pattern during an uptrend (no upper wick); Hanging man - bearish pattern during an uptrend (long lower wick, small or no body; wick has the multiple length of the body.

6. Inverted hammer - signals bottom reversal, however confirmation must be obtained from next trade (may be either a white or black body); Shaven bottom - signaling bottom reversal, however confirmation must be obtained from next trade (no lower wick); Shooting star - a bearish pattern during an uptrend (small body, long upper wick, small or no lower wick)

7. Spinning top white - neutral pattern, meaningful in combination with other candlestick patterns

8. Spinning top black - neutral pattern, meaningful in combination with other candlestick patterns

9. Doji - neutral pattern, meaningful in combination with other candlestick patterns

10. Long legged doji - signals a top reversal

11. Dragonfly doji - signals trend reversal (no upper wick, long lower wick)

12. Gravestone doji - signals trend reversal (no lower wick, long upper wick)

13. Marubozu white - dominant bullish trades, continued bullish trend (no upper, no lower wick)

14. Marubozu black - dominant bearish trades, continued bearish trend (no upper, no lower wick)

Exmples of Major, Complex Japanese Candlestick Patterns

Harami - "Pregnant Woman", or "Body Within", the Harami is a 2 candlestick trend reversal formation

Tasuki Gap - "A sash that holds up one's sleeve", that Tasuki gap is a 3 candlestick formation that confirms the continuation of the existing trend.

Engulfing Pattern - A two candlestick reversal pattern in which the second candle, known as the DAKI ("embracing line") engulfs (body is larger and is both higher and lower than the previous candlesticks body) the previous candlestick.

Piercing Pattern - A two candlestick, bullish reversal pattern. The first candle is black, a continuation of the existing trend. The second candle is formed by opening below the low of the previous day. It closes more than midway up the black candle, near or at the high for the day

Dark Cloud Cover - A bearish reversal pattern comprised of two candlesticks. The body of the first candle is white and the body of the second candle is black. The black day opens higher, above the trading range of the previous day. The price closes below the 50% level of the white body.

Star Patterns - A symmetrical, reversal candlestick pattern. The bullish pattern, known as the Morning Star, is a three day signal consists of a long black body, usually one produced of the fear induced at the bottom of a long decline. The following day gaps down. However, the magnitude of the trading range remains small for the day. This produces an indecision type - day. The third day is a white candle day. The white candle represents the fact that the bulls have now stepped in and seized control. The optimal Morning Star signal would have a gap before and after the star day.