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Saturday, April 7, 2012

How candlestick analysis of stock prices works

Anatomy of a stock chart candlestick
Candlestick analysis helps traders make financial decisions
Candlestick analysis tracks price movements to confirm trends

Candlestick charting is a kind of financial analysis used in what is known as technical analysis. Technical analysis of financial securities interprets charted or graphed price movements, patterns and trends of a financial product to help improve the results of financial activities such as stock trading. In candlestick analysis the candlestick chart or graph is the tool for  analysis, but the analysis of that chart is what provides financial utility. Moreover, as a form of technical analysis, candlestick charting reflects financial influences such as market psychology via product price patterns instead of the evaluating the product itself.

The history of candlestick charting


In the book 'Trading Applications of Japanese Candlestick Charting' by Gary Wagner and Bradley Matheny, the origins of candlestick charting are said to date back to the seventeenth century creation of an honorary samurai and futures trader named Sokyu Homma. According to Wagner and Matheny, Homma's candlestick patterns indicated commodity price direction when a series of three candlesticks in either an upward or downward pattern occur as 'gaps' in the opposite direction.

Patterns like those developed by Sokyu Homma are determined using candlestick charting through evaluation of key variables in a financial product's price including its opening price, highest price, lowest price and closing price. These price movements are represented as a pattern or series of chronological units such as a single day, with each unit graphed as a single rectangle or line known as a candlestick. The video below further explains the history and purpose of candlestick charting.


Interpretation of price patterns


The appearance of candlesticks and wicks provide a lot of information about a financial product's price patterns for the period of time it is measuring. Essential aspects of the candlesticks are their color, length and the length of the 'wicks' or lines at the top and bottom of the candlestick's body. These candlesticks can vary in length and position on a candlestick chart depending on how the price of a particular price such as company price per share moves in a given time period. The top and bottom of the candlestick's body symbolize the opening and closing prices, and the top and bottom of the wicks represent the highest and lowest values reached during a trading period.

When a candlestick is black or red, a product's price has closed lower than its price when it opened at the beginning of trading. If the product's price closes higher than the opening price, the body of the candle is green or white. Long candlesticks and wicks represent a larger range of price movement than shorter candlesticks where the bottom wicks indicate the lowest price of the trading period and the top wick show the highest price. Sometimes no candlestick body is formed at all and this is called a 'doji'. Also per Wagner and Bradley, a Doji represents a trading period in which the opening price and closing price were very similar.

Price evaluation and forecasting


Once the appearance and location of a candlestick is understood, it is then interpreted for price evaluation and forecasting purposes. This is done by analyzing the form of the candles and their relationship to other candlesticks on the chart. For example, a series of black candlesticks each positioned lower than the next indicates a negative price trend such as a 'bearish hook reversal' and may mean confidence in a stock or commodity has been lost. Furthermore, if the majority of candlesticks on a chart are black with a visible downward trend, this can indicate a long term trend such as a market correction. A market correction is when a price moves lower to correct overly optimistic speculation regarding a specific product's value.

There are several candlestick chart patterns which a chartist is ideally familiar with. These patterns also have names such as 'spinning top', and 'marubozu' which help the chartist quickly interpret their meaning based on previous interpretations of the candlestick pattern. To illustrate, according to Minyanville Media Inc, an Emmy Award Winning business information provider, a 'spinning top' can serve as an indicator a price reversal is about to take place. Candlestick charting analysis, like most financial analysis in general is not definitive proof of where a financial product's price is heading. However, candlestick charts can serve as indicators of market indecisiveness, conviction and momentum; all of which in and of themselves influence the price of financial products.

Image attribution: Ticmarc, Public Domain