21 CANDLESTICKS EVERY TRADER SHOULD KNOW
21
CANDLESTICKS
EVERY TRADER
SHOULD KNOW
Dr. Melvin Pasternak
Working Title: 21 Candlesticks Every Trader
Should Know
Author:
Dr. Melvin Pasternak
Publisher:
Marketplace Books
Release Date: January 2006
Format:
Paperback
Pages:
approx. 120 pages
Retail Price:
$19.95
UNRELEASED
MANUSCRIPT
21 CANDLESTICKS EVERY TRADER SHOULD KNOW BY NAME
By: Dr. Melvin Pasternak
OUTLI N E
I
II
III
INTRODUCTION
Candles Anticipate, Indicators Follow,
Trendlines Confirm
How To Read A Candlestick Chart
Bar vs. Candlestick Charts
Optimism and Pessimism as Shown by Candles
Advantages of Candle vs. Bar Charts
Candles Anticipate Short Term Reversals
Why Candlesticks Work
"The Rule of Two"
Candles in Action: Dow Jones Analysis
Summary
21 CANDLES EVERY TRADER SHOULD
KNOW BY NAME
Candles 1-4: The Four Dojis Show Stocks That
Have Stalled
Candles 5-6: Hammer and Hangman
Candlesticks Signal Key Reversals
Candles 7-8: Bullish and Bearish Engulfing
Candles Spot Key Trend Changes Before They
Take Place
Candle 9: Dark Cloud Cover Warns of
Impending Market Tops
Candle 10: The Piercing Candle Is a Potent
Reversal Signal
Candles 11-12: The Three Candle Evening and
Morning Star Patterns Signal Major Reversals
Candle 13: The Shooting Star Can Wound
Candle 14: The Inverted Hammer Indicates The
Shorts May Be Ready To Cover
Candle 15: The Harami is "Pregnant" With
Possibilities
Candle 16: The "Full" Marubozu Is a Candle
Without Shadows
Candles 17-18 High Wave and Spinning Top
Express Doubt and Confusion
Candle 19: The Ominous Call of Three Black
Crows
Gaps From a Japanese Candlestick Viewpoint
The Four Types of Gaps: Common,
Continuation, Breakaway and Exhaustion
Candlestick Theory on Gaps
IV
Synthesis of Western Wisdom and Eastern
Insight
A Concluding Challenge
About the Author
I NTRODUCTI ON
Candlest icks are one of t he m ost powerful t echnical analysis t ools
in t he t rader's t oolkit . While candlest ick chart s dat es back t o
Japan in t he 1700's, t his form of chart ing did not becom e popular
in t he w est ern w orld unt il t he early 1990's. Since t hat t im e, t hey
have becom e t he default m ode of chart ing for serious t echnical
analyst s replacing t he open- high- low- close bar chart .
There has been a great deal of cogent inform at ion published on
candlest ick chart ing bot h in book form and on t he worldwide web.
Many of t he works, however, are encyclopedic in nat ure. There
are perhaps 100 individual candlest icks and candle pat t erns t hat
are present ed, a daunt ing am ount of inform at ion for a t rader t o
learn.
I n t his book I have select ed 21 candles t hat I believe every t rader
should know by nam e. These are t he candles t hat in m y
experience occur m ost frequent ly and have t he great est
relevance for m aking t rading decisions. Just as knowing t he
nam e of a person helps you im m ediat ely recognize t hem on a
crowded st reet , so being able t o nam e t he candlest ick allows you
t o pick it out of a chart pat t ern. Being able t o nam e it allows you
t o appreciat e it s t echnical im plicat ions and increases t he accuracy
of your predict ions.
I n m y t rading, I t ry t o int egrat e candlest ick analysis, m oving
averages, Bollinger bands, price pat t erns ( such as t riangles) and
indicat ors such as st ochast ics or CCI t o reach decisions. I find
t he m ore inform at ion w hich is int egrat ed, t he m ore likely t he
decision is t o be correct . I n t his book, I have chosen t o com bine
m oving averages, Bollinger bands and t wo indicat ors, st ochast ics,
and CCI on various chart s. As w e discuss individual candlest icks
or candle pat t erns, I int egrat e t hese t ools int o t he discussion.
Hopefully, you w ill not only learn how t o recognize candles from
t his book, but also appreciat e how you can com bine t hem wit h
t he t radit ional t ools of t echnical analysis.
I n t his book m y focus is on Minor t rend reversals, t he kind of
reversal of m ost int erest t o a t rader. The Minor t rend t ypically
last s 5 t o 15 days alt hough on occasion, I have seen it st ret ch out
t o about 30 t rading days. These sam e candle principles work
equally as well, however, on 5 m inut e or weekly chart s. I t is
sim ply a m at t er of adapt ing t his inform at ion t o t he t im e fram e
you are t rading in.
CAN D LESTI CKS AN TI CI PATE, I N D I CATORS FOLLOW ,
TREN D LI N ES CON FI RM
I call candlest icks an " ant icipat ory" indicat or. You haven't com e
across t his w ording before, since it is m y own t erm inology. An
ant icipat ory indicat or gives a signal in advance of m uch ot her
m arket act ion - - in ot her words it is a leading indicat or of m arket
act ivit y.
Mom ent um indicat ors such as CCI or st ochast ics are also
ant icipat ory since usually m om ent um precedes price. Typically,
however, even rapidly m oving m om ent um indicat ors such as CCI
lag t he candle signal by a day or t wo. When you receive a candle
signal followed by a m om ent um signal such as st ochast ics w hich
com m unicat es t he sam e m essage, it is likely t hat in com binat ion
t hey are accurat ely predict ing what will happen wit h a st ock.
On t he ot her hand, t he break of a t rendline or a m oving average
crossover is w hat I call a " confirm ing" signal. I t usually occurs
days lat er t han t he peak or bot t om of price and m uch aft er t he
candlest ick and indicat or signal.
Depending on your t rading st yle, you can act on t he ant icipat ory
signal. However, if you prefer t o be caut ious and wait for m ore
evidence, candlest icks ant icipat e a change in t rend and put you
on t he alert t hat a reversal m ay be im m inent .
H OW TO READ A CAN D LESTI CK CH ART
I f you are already fam iliar wit h t he basics of candlest icks, you can
skim t his sect ion. I f you have seen candles on t he web, but have
not st udied t hem in som e det ail, t hen you'll now be given t he
background you need t o use candles.
Candles m ay be creat ed for any " period" of chart —m ont hly,
weekly, hourly, or even one m inut e. When I discuss candles in
t his book, I will use daily chart exam ples, but be aware t hat you
can creat e candle chart s for virt ually any period.
BAR VS. CAN D LESTI CK CH ARTS
Below are a t hree m ont h bar chart and a t hree m ont h candlest ick
chart for I BM. See if you can spot any differences in t he " dat a
series."
Hard t o spot t he difference? That 's because t here isn't any. Bot h
t he bar chart and t he candlest ick chart cont ain exact ly t he sam e
inform at ion, only it 's present ed t o t he t rader in different form .
Bot h t he bar chart and t he candle chart cont ain t he sam e dat a:
t he high for t he period ( t he day) , t he low, t he open and t he close.
I n a candlest ick chart , however, t he nam es are changed. The
difference bet ween t he open and t he close is called t he r e a l
body. The am ount t he st ock w ent higher beyond t he real body is
called t he u ppe r sh a dow . The am ount it went lower is called
t he low e r sh a dow . I f t he candle is clear or whit e it m eans t he
opening was low er t han t he high and t he st ock went up. I f t he
candle is colored t hen t he st ock went down. This inform at ion is
shown below:
OPTI M I SM AN D PESSI M I SM AS SH OW N BY CAN D LES
Here is an idea about candlest icks t hat helps m e bet t er use t hem
and w hich I haven't seen in books or on t he web.
I t is generally acknowledged t hat t he opening of t he t rading day
is dom inat ed by am at eurs. The close, on t he ot her hand, is
dom inat ed by professional t raders. The low of t he day, one
m ight say, is set by t he pessim ist s - - t hey believed t he m arket
was going lower and sold at t he bot t om . The high of t he day is
set by t he opt im ist s. They were willing t o pay t op price but were
incorrect in t heir analysis, at least in t he short t erm .
I ndividual candlest icks m ay be underst ood by com bining t his
concept wit h t he candle chart . I will use only t w o exam ples, but
you m ight want t o experim ent wit h t his idea yourself.
Shaven Bot t om / Shaven Head. The shaven bot t om / shaven t op
candle depict s a day in w hich t he m arket opened at t he low and
closed at t he high. I t is a day on which t he am at eurs are also t he
pessim ist s. They sell early and t heir shares are gobbled up by
eager buyers. By t he end of t he day t he opt im ist s and
professionals close t he st ock sharply higher. This bullish candle
frequent ly predict s a higher open on t he next day.
Shaven Head/ Shaven Bot t om . This candle is t he opposit e of t he
one j ust described. Depict ed here is a day when t he am at eurs
are t he opt im ist s. They buy at t he t op of t he day, only t o wat ch
prices st eadily decline. By t he end of t rading, prices have
declined sharply and t he professional pessim ist s are in cont rol of
t he m arket . The opening t he next day is oft en lower.
Candles can be m ade m ore sense of by reasoning t hem out in
t his way. Part icularly when you see a candle wit h a large real
body, ask yourself who w on t he bat t le of t he day, t he opt im ist s or
t he pessim ist s, t he am at eurs or t he professionals. This quest ion
will oft en provide you wit h an im port ant clue t o subsequent
t rading act ion.
AD VAN TAGES OF CAN D LE VS. BAR CH ARTS
There are t hree m aj or advant ages of candlest ick chart s
com pared t o bar chart s.
1. Candlest ick chart s are m uch m ore " visually im m ediat e" t han
bar chart s. Once you get used t o t he candle chart , it is m uch
easier t o see what has happened for a specific period be it a
day, a w eek an hour or one m inut e.
Wit h a bar chart you need t o m ent ally fill in t he price act ion.
You need t o say t o yourself, " The left t ick says t hat 's w here it
opened, t he right t ick where it closed. Now I see. I t was an
up day." Wit h a candlest ick chart it is done for you. You can
spend your energy on analysis, not figuring out what happened
wit h t he price.
2. Wit h candles you can spot t rends m ore quickly by looking for
whet her t he candles are clear or colored. Wit hin a period of
t rend, you can easily t ell what a st ock did in a specific period.
The candle m akes it easier t o spot " large range" days. A large
candlest ick suggest s som et hing " dram at ic" happened on t hat
t rading day. A sm all range day suggest s t here m ay be relat ive
consensus on t he share price. When I spot a large range day,
I check t he volum e for t hat day as well. Was volum e unusual?
Was it say 50% higher t han norm al? I f so, it is very likely t hat
t he large range day m ay set t he t one for m any days aft erward.
3. Most im port ant , candles are vit al for spot t ing reversals. These
reversals are usually short t erm - - precisely t he kind t he t rader
is looking for.
When t radit ional t echnical analysis t alks about reversals,
usually it is referring t o form at ions t hat occur over long periods
of t im e. Typical reversal pat t erns are t he double t op and head
and shoulders. By definit ion, t hese involve sm art m oney
dist ribut ing t heir shares t o naive t raders and norm ally occur
over weeks or even m ont hs.
Candlest icks, however, are able t o accurat ely pick up on t he
changes in t rend which occur at t he end of each short t erm
swing in t he m arket . I f you pay m et iculous at t ent ion t o t hem ,
t hey oft en warn you of im pending changes.
CAN D LES AN TI CI PATE SH ORT TERM REVERSALS
The m essage of candlest icks is m ost pow erful w hen t he
m arket s are at an ext rem e, t hat is when t hey are overbought
or oversold. I define overbought as a m arket w hich has gone
up t oo far t oo fast . Most of t he buyers are in and t he sellers
are eager t o nail down profit s.
An oversold m arket , on t he ot her hand, is one in which t he
sellers have been in cont rol for several days or w eeks. Prices
have gone down t oo far t oo fast . Most of t he t raders who want
t o sell have done so and t here are bargains - - at least in t he
short t erm - - t o be had.
There are m any overbought and oversold indicat ors, such as
CCI , RSI , and William s' % R. However, one of t he best is
st ochast ics, w hich essent ially m easures t he st ock's price in
relat ion t o it s range usually over t he past 14 periods. CCI
t ypically agrees wit h st ochast ics and is useful for providing
confirm at ion of it s signal. I also alm ost always put a Bollinger
Band on chart s I analyze. John Bollinger creat ed t his t ool t o
include 19 out of every 20 closing prices wit hin t he bands.
Therefore, a close out side t he band is significant . A close
out side t he upper band usually say t he st ock is overbought .
When it is out side t he lower band it is oversold.
When bot h st ochast ics, CCI and t he Bollinger bands agree a
st ock or index is overbought or oversold, I t ake t heir alignm ent
very seriously. There is a good chance a reversal is overdue.
A significant candlest ick t ells m e m ore exact ly when t he
reversal m ight be here.
W H Y CAN D LESTI CKS W ORK
A chart m ay be t hought of as pict ure of t he war bet ween
supply and dem and. When a st ock is m oving up, t he buyers
are in cont rol. There is m ore dem and t han supply. Purchasers
are eager t o acquire t he st ock and will pay up, hit t ing t he ask
price t o do so. When a st ock is declining, t he reverse is t rue.
Sellers are fearful and will not dicker over a few cent s, being
m ore likely t o accept t he bid. Candlest icks graphically show
t he balance bet ween supply and dem and. At key reversal
j unct ures, t his supply/ dem and equat ion shift s and is capt ured
in t he candle chart .
" Th e Ru le of Tw o"
Generally, no one candlest ick should be j udged in isolat ion.
The general principle is even if you see a key reversal
candlest ick, you should wait at least part of one m ore day
before act ing. I f for exam ple, you spot a candle called a doj i,
seek verificat ion from t he act ion of t he next t rading day. I f
t here is a dow n gap and prices begin t o decline t hen it is
prudent t o t ake your posit ion.
CAN D LES I N ACTI ON : D OW JON ES AN ALYSI S
As st at ed, in candlest ick t heory, t here are m any candles which
signal im port ant reversals. To conclude t his sect ion, w e will
focus on only four ( ! ) candlest icks which called every m aj or
t urn in t he Dow Jones I ndust rial Average over nearly a six
m ont h period! Think how m uch m ore accurat ely you could
have t raded t he m arket if you knew t hese candles nam es and
im plicat ions as well as had recognized t hem when t hey
occurred.
The good new s is t hese are reversal signat ures and are apt t o
occur again. Your abilit y t o recognize t hem could lead t o large
t rading gains. First , I will explain t he candlest icks, t hen apply
t his t heory t o analysis of t he graph. The candles are point ed
out on t he Dow chart below.
BULLI SH ENGULFI NG.
The bullish engulfing is m ost significant w hen it occurs aft er a
prolonged dow nt rend. The st ock or index has been selling off
sharply. On t he day of t he bullish engulfing, prices will oft en
st art t he day by falling. However, st rong buying int erest
com es in and t urns t he m arket around.
The bullish engulfing is nam ed because t his candle surrounds
or engulfs t he previous one. When I discuss t his candle wit h
college st udent s enrolled in m y st ock m arket course, I call it
" Pac- Man" because like t he video gam e charact er, it " eat s" t he
candle before it . The bullish engulfing represent s a reversal of
supply and dem and. Whereas supply has previously far
out st ripped dem and, now t he buyers are far m ore eager t han
t he sellers. Perhaps at a m arket bot t om , t his is j ust short covering at first , but it is t he cat alyst which creat es a buying
st am pede.
When analyzing t he bullish engulfing, always check it s size.
The larger t he candle, t he m ore significant t he possible
reversal. A bullish engulfing w hich consum es several of t he
previous candles, speaks of a powerful shift in t he m arket .
THE HAMMER.
This ham m er m arks a reversal off a bot t om or off an im port ant
support level. On t he day of t he ham m er, prices decline. They
hit bot t om and t hen rebound sharply m aking up all t he ground
– and som et im es m ore – com pared t o w here t he sell- off
st art ed. The candle shows t hat t he buyers have seized cont rol.
A bullish candlest ick on t he following day confirm s t his
analysis.
THE DOJI .
I f you w ere t o learn only one candle by nam e, t his would have
t o be t he one. A " com m on" doj i, as I call it , is shaped like a
cross. A doj i has no real body. What it says is t hat t here is a
st alem at e bet ween supply and dem and. I t is a t im e when t he
opt im ist and pessim ist , am at eur and professional are all in
agreem ent . This m arket equilibrium argues against a st rong
upt rend or dow nt rend cont inuing, so a doj i oft en m arks a
reversal day.
A doj i in an overbought or oversold m arket is t herefore oft en
very significant . The opening of t he next day should be
wat ched carefully t o see if t he m arket carries t hrough on t he
reversal. Not e, a candle wit h a very sm all real body oft en can
be int erpret ed as a doj i.
GRAVESTONE DOJI .
The gravest one doj i occurs far less frequent ly t han t he
com m on one, but gives even a clearer signal. At t he t op of an
ext ended m ove, it says t he bulls t ried t o m ove t he m arket
higher and couldn’t do it . The st ock, or in t his case t he index,
can not sust ain t he probe t o new high ground. I t opens and
closes at t he exact sam e level creat ing t he appearance of a
t om bst one.
BACK TO TH E D OW JON ES CH ART
During t he period t he chart pict ures, t he Dow Jones I ndust rial
Average went sideways in a broad t rading range bet ween
10000 and 11000. I have placed only one m oving average on
t he chart , t he 50- day. A 50- day m oving average describes t he
I nt erm ediat e t rend and when it m oves sideways like it does
here, you can also be sure it describes a m arket in a sideways
consolidat ion pat t ern.
Despit e t he sideways m ovem ent , t here were m any good
t rading opport unit ies, bot h long and short . The first cam e in
early March when t he Dow peaked j ust below 11000. All
round num bers represent key support and resist ance in t he
m aj or averages and t his t op was no except ion. The candle
form ed was a gravest one doj i. Not e t he long upper shadow
and t he absence of a real body. This com binat ion signalled
t hat t he bulls did not have t he st rengt h t o push t he Dow
t hrough t he 11000 m ark. Over t he next m ont h t he Dow
ret reat ed nearly 1000 point s, finally bot t om ing right at 10000.
The lat e April bot t om at 10000 is m arked by a bullish engulfing
candle. I m m ediat ely before t he bullish engulfing not e t he
t hree very large back candles w hich saw t he Dow drop nearly
500 point s in t hree days. That left it subst ant ially oversold as
shown by t he st ochast ics indicat or w hich reveals an oversold
reading when it goes below 20 ( above 80 is overbought ) . An
oversold m arket can be described as one which has gone dow n
t oo far, t oo fast .
The bullish engulfing candle was very large, adding t o it s
significance. I t im plied t hat wit h t he Dow able t o hold 10000,
t he short s were covering, buying int erest had em erged at t his
level, or bot h. While t he Dow didn't soar higher in t he com ing
day, neit her did it drop below 10000 again. By early May it
rallied back t o resist ance near 10400. Not e how a horizont al
line can be draw n across t he chart t o m ark t his resist ance level
and how it s role as bot h support and resist ance alt ernat ed
during t he six- m ont h period.
The Minor upt rend brought t he Dow back t o 10400. Traders
looking for t he Dow t o st all at t his level did not have long t o
wait . Here's a sm all t est of what you've learned so far. Can
you nam e t he candlest ick which helped m ark t he peak at t his
t im e. I f you said a gravest one doj i, you get high m arks.
The gravest one doj i candle led t o anot her sm all dow n w ave in
t he Dow. This was part of a secondary bot t om t hat saw t he
index bot t om well above 10000, closer in fact t o 10100. Not e
t here is a candle you have seen before—t he bullish engulfing.
From 10075 t he Dow advanced over t he next m ont h t o a peak
j ust below 10600. For alm ost a m ont h, in what m ust have
seem ed like an et ernit y for t raders, t he Dow vacillat ed in an
excruciat ingly narrow range bet w een 10400 and 10600. When
it finally got beyond resist ance at 10600, it form ed t hree doj ilike candles in a row. ( The candles are doj i- like since t hey
have very sm all real bodies) . These doj is showed t hat t he
bulls and bears were at a st alem at e. Aft er a lengt hy upt rend
t hey indicat ed t hat t he bulls lacked t he buying power t o m ove
t he m arket higher. Not surprisingly a st rong sell- off ensued.
The decline ended well above 10000 t his t im e finding a bot t om
at 10175. The candle which form ed here can be int erpret ed as
a ham m er, despit e t he very sm all upper shadow. The ham m er
candle occurred aft er t he Dow had found support near 10250
for several days.
On t he day of t he ham m er, a dram at ic news event sent prices
sharply lower in t he m orning, but t hen t he selling pressure
dried up. By lat e aft ernoon, prices had t urned posit ive as can
be seen from t he sm all w hit e real body. The ham m er led t o a
subsequent rally which lift ed t he Dow several hundred point s in
t wo t rading days t aking it right back int o t he 10400 t o 10600
range of resist ance it had been in t he m ont h previous.
SUM M ARY
I find it int riguing t hat t he sam e candlest ick pat t erns repeat
over and over. Candles are your personal sent ry providing you
wit h consist ent early warnings of im pending t rend change.
They provide t he earliest signal I know of t hat t he pat t erns in
t he m arket are about t o reverse.
All in all, t here are about 100 candles pat t erns t he t rader can
becom e fam iliar wit h. Of t hese, 21 candles recur frequent ly
enough and are significant enough t hat t he t rader should be
able t o spot t hem by nam e. Knowing t heir nam es allow s you
t o spot t hem m ore easily and assess t heir im plicat ions. When
faced wit h t he need for a quick decision during t he heat of
t rading, t he t rader who can nam e t hese 21 candles has a
dist inct advant age over one w ho can't .
2 1 CAN D LES EVERY TRAD ER SH OULD KN OW BY N AM E
I n t he previous sect ion of t his book, I showed how cert ain key
candlest icks were able t o ident ify every m aj or t rend reversal in
t he Dow Jones I ndust rial Average for a period of several
m ont hs. I t is vit al for t rading success, I argued, t o recognize
candlest icks and assess t heir im plicat ions.
Candles are vit al t o t rading because t hey ident ify possible
reversals in t rend. Failure t o spot t hese key candles can lead
t o cost ly t rading errors. Why should you be able t o ident ify
t hese candles? Because t hey can m ake you m oney!
Here t hen are t he 21 candlest icks I find m ost useful in m y own
t rading.
CAN D LES 1 - 4 : TH E FOUR D OJI S SH OW STOCKS TH AT
H AVE STALLED
I f you w ere t o ask m e w hich of all t he candlest icks is t he m ost
im port ant t o recognize, I would answer unhesit at ingly - - t he
doj i. On a daily chart , t he doj i oft en m arks t he beginning of a
m inor or int erm ediat e t rend reversal. Fail t o recognize t he
doj i's im plicat ions and you run t he risk of buying at t he t op or
st aying far t oo lat e in a t rade and leaving subst ant ial profit s on
t he t able.
There are four t ypes of doj is - - com m on, long- legged,
dragonfly and gravest one. All doj is are m arked by t he fact t hat
prices opened and closed at t he sam e level. I f prices close very
close t o t he sam e level ( so t hat no real body is visible or t he
real body is very sm all) , t hen t hat candle can be int erpret ed as
a doj i.
Aft er a long upt rend, t he appearance of a doj i can be an
om inous warning sign t hat t he t rend has peaked or is close t o
peaking. A doj i represent s an equilibrium bet ween supply and
dem and, a t ug of war t hat neit her t he bulls nor bears are
winning. I n t he case of an upt rend, t he bulls have by definit ion
won previous bat t les since prices have m oved higher. Now, t he
out com e of t he lat est skirm ish is in doubt . Aft er a long
dow nt rend, t he opposit e is t rue. The bears have been
vict orious in previous bat t les, forcing prices down. Now t he
bulls have found courage t o buy and t he t ide m ay be ready t o
t urn.
What I call a " com m on" doj i has a relat ively sm all t rading
range. I t reflect s indecision. Here's an exam ple of a com m on
doj i:
A " long- legged" doj i is a far m ore dram at ic candle. I t says t hat
prices m oved far higher on t he day, but t hen profit t aking
kicked in. Typically, a very large upper shadow is left . A close
below t he m idpoint of t he candle shows a lot of w eakness.
Here's an exam ple of a long- legged doj i:
When t he long- legged doj i occurs ou t side a n u ppe r Bollin ge r
ba n d aft er a sust ained upt rend, m y experience says you
should be ext rem ely vigilant for t he possibilit y of a reversal. A
subsequent sell signal given by an indicat or such as st ochast ics
is t ypically a very reliable warning t hat a correct ion will occur.
A " gravest one doj i," as t he nam e im plies, is probably t he m ost
om inous candle of all. On t hat day, prices rallied, but could not
st and t he " alt it ude" t hey achieved. By t he end of t he day t hey
cam e back and closed at t he sam e level. Here's an exam ple of
a gravest one doj i:
Finally, a " dragonfly" doj i depict s a day on which prices opened
at a high, sold off, and t hen ret urned t o t he opening price. I n
m y experience, dragonflies are fairly infrequent . When t hey do
occur, however, t hey oft en resolve bullishly ( provided t he st ock
is not already overbought as shown by Bollinger bands and
indicat ors such as st ochast ics) . Here's an exam ple of a
dragonfly doj i:
When assessing a doj i, always t ake careful not ice of where t he
doj i occurs. I f t he securit y you're exam ining is st ill in t he early
st ages of an upt rend or downt rend, t hen it is unlikely t hat t he
doj i will m ark a t op. I f you not ice a short - t erm bullish m oving
average crossover, such as t he four- day m oving average
heading above t he nine- day, t hen it is likely t hat t he doj i m arks
a pause, and not a peak. Sim ilarly, if t he doj i occurs in t he
m iddle of a Bollinger band, t hen it is likely t o signify a pause
rat her t han a reversal of t he t rend.
As significant as t he doj i is, one should not t ake act ion on t he
doj i alone. Always wait for t he next candlest ick t o t ake t rading
act ion. That does not necessarily m ean, however, t hat you
need t o wait t he ent ire next day. A large gap dow n, aft er a doj i
t hat clim axed a sust ained upt rend, should norm ally provide a
safe short ing opport unit y. The best ent ry t im e for a short t rade
would be early in t he day aft er t he doj i.
The chart of t he Disk Drive I ndex ( $DDX) shows t hree of t he
four doj is j ust described and gives som e guidance as t o how t o
effect ively int erpret t his candle depending on where it occurs in
a t rend. The Disk Drive I ndex consist s of 11 st ocks in t he
com put er st orage and hard drive businesses. This index's
perform ance t herefore usually correlat es highly w it h t he
Nasdaq Com posit e. I n March, t he $DDX hit a peak of 125.06
and t hen a prolonged sell- off in conj unct ion wit h t he overall
m arket in general and t ech st ocks in part icular. Also, not e,
how in early May, t he $DDX t raded sideways for several days,
finding support or buying int erest at t he m id- 97 level wit h
resist ance or selling pressure near t he psychological barrier of
100.
Finally, t he buyers were able t o overw helm t he sellers and t he
$DDX pierced 100. Not e on t his day, t he four- day m oving
average penet rat ed t he nine- The 4- day m oving average day
and bot h began t o slope upward. That pat t ern suggest ed an
upt rend was beginning. The four- day m oving average going
above t he nine is a bullish m oving average crossover. While I
wouldn't t rade on t his very short - t erm signal in isolat ion, it
provides a useful confirm at ion t hat t he im m ediat e t rend is up.
The next day, a com m on doj i appeared ( labeled " 1" ) . While a
doj i should always be not ed, t his one was early in t he t rend.
The previously described " rule of t wo" also says t o wait anot her
day before t aking t rading act ion. The following day was
posit ive.
Two days lat er a dragonfly doj i appeared ( " 2" ) wit h prices
closing at t heir highs. Again, a dragonfly doj i oft en resolves
posit ively as did t his candle. Three days aft er t hat ( " 3" ) a
second dragonfly doj i occurred. This one was m ore worrisom e
since it cam e aft er a subst ant ial advance and w as close t o t he
t op of a Bollinger band. However, t he upt rend cont inued.
By early June, t he $DDX was t rading close t o 115. I t had
rallied nearly 20% off it s early May low. Whereas during t he
core of t he upt rend, t here had been several large whit e candles
indicat ing bullish ent husiasm , now t he real bodies of
t hecandles t urned sm all showing caut ion on t he part of buyers.
Always observe t he size of t he candles in your analysis.
I n m id- June, t w o consecut ive doj is ( " 4" ) appeared on t he
chart . The first was a com m on doj i; t he second closer t o a
long- legged variet y. For t hose t raders in a long posit ion,
ext rem e vigilance was now warrant ed. Subst ant ial profit s were
t here for nailing dow n in t he $DDX. The index was st alling; t he
bulls and bear were st alem at ed.
I n t he t wo days aft er t he doj is appeared, t he $DDX st ruggled
t o m ove higher wit hout m uch success. On t he second day, t he
candle t urned dark showing selling pressure. Not e also t hat
t he four- day m oving average penet rat ed dow n t hrough t he
nine- day, t he first t im e t his had happened since t he upt rend
began in early May.
The subsequent slide in t he $DDX was not dram at ic. However,
t he t rader who failed t o heed t he doj is' warning surrendered a
large port ion of his or her profit s. Doj is should not be assessed
m echanically. However, aft er a st rong t rend in eit her direct ion
t hey oft en m ark m aj or t urning point s. Always recognize t he
doj i w hen it occurs, and be prepared t he next t rading day t o
t ake appropriat e act ion.
The one kind of doj i not found in t he $DDX chart is t he
gravest one doj i, already seen in t he chart of t he Dow Jones
I ndust rial Average. Candlest ick nam es are t ypically very
colorful and t his one is no except ion. I f you are a bull, t he
gravest one doj i should sound om inous and one should alw ays
be prepared t o t ake rapid act ion on it s appearance. When it
occurs aft er a prolonged upt rend, and t he upper shadow
penet rat es t hrough t he upper Bollinger band, t he candle t akes
on added significance.
To review, a gravest one doj i occurs on a day when prices open
and close at t he sam e level. During t he session, however,
prices m ove sharply higher, but t he bulls can not sust ain t he
advance. This t rading act ion leaves a long upper shadow on
t he chart . I f t he gravest one doj i does not serve as a key
reversal day, it cert ainly will m ark a resist ance area t hat will
norm ally st all an advance for several sessions. I n eit her case,
t he t rader is oft en prudent t o nail dow n profit s aft er it s
appearance.
The chart of airline st ock AMR Corp. ( AMR) is a classic exam ple
of why it 's vit al t o recognize t he gravest one doj i by nam e.
AMR bot t om ed at $9.80 in lat e April. I n early June, it had
advanced nearly 40% and was probing t he $14 area. On June
17 t h it opened at $14 and shot up t o a peak of $14.95. Not ice,
how a large part of t he upper shadow pierced t hrough t he
Bollinger band. But t raders did not like t he alt it ude t hat AMR
was flying at and st ock closed unchanged for t he day. The
session creat ed a long- legged doj i, a warning t hat t he bulls
were not able t o m aint ain cont rol.
Traders who required addit ional evidence t hat a reversal had
occurred did not need t o wait long. Not ice, how t he four daym oving average crossed below t he nine day. A t rendline break
also occurs short ly aft er t his crossover, suggest ing AMR's flight
pat h is now lower. Traders who ignored t hese signals, paid a
high price. By t he end of June, AMR was probing $11, not far
from w here t he rally began. This was one round t rip t hat
would have been avoided t hrough assessing t he im plicat ions of
t he gravest one doj i.
CAN D LES 5 - 6 : H AM M ER AN D H AN GM AN CAN D LESTI CKS
SI GN AL KEY REVERSALS
The doj i candle is probably t he single m ost im port ant candle
for t he t rader t o recognize. Not far behind in value are
ham m er and hangm an.
I t is easy t o get t hese t wo candlest icks confused since t hey
look ident ical. Bot h t he hangm an and ham m er have a very
long shadow and a very sm all real body. Typically, t hey have
no upper shadow ( or at t he very m ost , an ext rem ely sm all
one) . To be an " official" ham m er or hangm an, t he lower
shadow m ust be at least t wice t he height of t he real body. The
larger t he lower shadow, t he m ore significant t he candle
becom es.
How can you t ell t he t wo candles apart ? The hangm an candle,
so nam ed because it looks like a person who has been
execut ed wit h legs swinging beneat h, alw ays occurs aft er an
ext ended upt rend. The hangm an occurs because t raders,
seeing a sell- off in t he shares, rush in t o snap up t he st ock at
bargain prices. To t heir dism ay t hey subsequent ly find t hey
could have bought t he st ock at m uch cheaper levels. The
hangm an looks like t his:
On t he ot her hand, t he ham m er put s in it s appearance aft er
a prolonged dow nt rend. On t he day of t he ham m er candle,
t here is st rong selling, oft en beginning at t he opening bell.
As t he day goes on, how ever, t he m arket recovers and
closes near t he unchanged m ark, or in som e cases even
higher. I n t hese cases, t he m arket is pot ent ially
" ham m ering" out a bot t om . Here is an exam ple of a ham m er
candle:
As wit h all candles, t he " rule of t wo" applies. That is t o say,
a single candle m ay give a st rong m essage, but one should
always wait for confirm at ion from anot her indicat or before
t aking any t rading act ion. I t m ay not be necessary t o wait
an ent ire t rading day for t his confirm at ion. When it com es t o
t he hangm an, for exam ple, confirm at ion m ay be a gap down
t he next day. Wit h t he ham m er, a gap opening wit h
gat hering st rengt h as t he day w ears on m ay be all t hat is
necessary t o init iat e a t rade from t he long side.
I will st art wit h t he ham m er. I n m y experience, when a
ham m er candle appears in t he chart of one of t he m aj or
averages, it is always a signal w ort h not ing. This is
part icularly t rue when it has com e aft er a st eady and
prolonged sell- off.
The chart of t he Nasdaq Com posit e ( $COMPQ) shows t he
value for t he t rader of recognizing t he ham m er candle.
From March t o lat e May, Nasdaq was in a st eep downt rend
having declined from alm ost 2100 t o j ust below 1900. Right
above t he price chart , is anot her t echnical t ool I frequent ly
use, t he Price Relat ive t o $SPX. SPX st ands for t he S&P
500, so t his chart com pares t he perform ance of Nasdaq t o
t he S&P. Not e t hat t he t hick line had a downward slope
t hroughout t he period of t he chart and t hat it w as under t he
t hin line which was t he 20- day m oving average. What t hat
t ells t he t rader, is t hat Nasdaq was under perform ing t he
S&P t hroughout t he ent ire period.
The ham m er candle occurred on t he final day of April. On
t his day, t he Com posit e breached 1900 int raday, but t he
bears did not have t he power t o close it under t hat
psychological support level. I nst ead, t he Com posit e closed
slight ly posit ively on t he day, hence t he sm all w hit e head at
t he t op of t he candle.
I n it self, t he ham m er gave a powerful, warning t hat Nasdaq
was reversing course. The alert t rader m ight t ake a long
posit ion in a leading Nasdaq st ock or an ETF such as t he
QQQQ on t he next t rading day when t he Com posit e bullishly
followed t hrough on t he previous day's act ion. On t he
second t rading day aft er t he ham m er, t he four- day m oving
average crossed above t he nine- day and bot h began t o
slope higher, anot her bullish sign. Short ly t hereaft er, t he
Price Relat ive broke out above it s ow n m oving average and
for several weeks Nasdaq becam e t he m arket leader inst ead
of t he laggard.
Addit ional t echnical confirm at ion of t he ham m er cam e from
t he behavior of t he st ochast ics oscillat or. St ochast ics
com pares t he behavior of price relat ive t o it self. I t is a
rapidly m oving indicat or which gives t im ely buy and sell
signals. I n t his case, st ochast ics dem onst rat ed bullish
m om ent um divergence as m arked on t he chart . Bullish
divergence occurs when price goes lower, but t he st ochast ics
oscillat or rises. The day aft er t he ham m er, st ochast ics gave
it s first buy signal in roughly t wo weeks. The buy signal
occurred as bot h % K and % D broke above 20 on t he
st ochast ics scale.
From t hat t im e onward, t hroughout t he ent ire m ont h of May,
Nasdaq was off t o t he races. The Com posit e rallied roughly
200 point s, from below 1900 t o nearly 2100. The ham m er
candle was t he t echnical signal t hat it w as t im e t o be long
not short Nasdaq.
The candle opposit e of t he ham m er is called hangm an.
When I have t aught candlest icks in college st ock m arket
classes, st udent s have easily becom e confused bet ween t he
t wo. This is because t hey look exact ly alike. The key
difference is where t hey occur in a chart . The ham m er
occurs aft er a long decline when t he m arket is oversold. I n
cont rast , hangm an put s in it s appearance near t he end of an
upt rend when t he m arket is overbought .
There are t im es when a hangm an candle can look a great
deal like t he dragonfly doj i. Such is t he case wit h Forest
Labs ( FRX) . I n April, FRX had gapped down sharply from
t he $38 area when it announced below expect at ion earnings.
Forest bot t om ed at $32.46, in conj unct ion wit h st rengt h in
t he pharm aceut ical st ocks began a gradual m ove higher. On
t he day of t he ham m er, it recovered t o a peak of $40.76,
but t ing up against st rong resist ance in t he $40 t o $42 area
form ed in February and March.
As show n in t he chart below, t he ham m er candle occurred
out side t he Bollinger band, a sign t he st ock was very
overbought . I have also placed t he CCI indicat or on t he
chart . On t his indicat or, + 100 is overbought and + 200
highly overbought . Not e t hat when t he ham m er candle
occurred, CCI was well over 200 and was beginning t o t rend
dow nward. St ochast ics gave t he sam e m essage as it gave a
sell signal aft er having reached overbought levels.
The ham m er was indeed t he profit - t aking signal in FRX. The
next day t he st ock opened j ust above $40 and slid
persist ent ly during t he day, reaching a low of $37.60 before
recovering. A sim ple t rendline drawn from t he $32.46 low
confirm ed t hat it was t im e t o exit t he posit ion. The t rendline
was broken t he next t rading day. CCI also dipped below t he
+ 100 level, giving a sell signal on t his indicat or. When a
candlest ick, indicat or and t rendline all give t he sam e
m essage, it is t im e t o list en t o t hese m essages. While FRX
went sideways rat her t han sharply dow n aft er t he ham m er,
a posit ion in t he st ock w as dead m oney.
CAN D LES 7 - 8 : BULLI SH AN D BEARI SH EN GULFI N G
CAN D LES SPOT TREN D CH AN GES BEFORE TH EY TAKE
PLACE
I f t he doj i wins t he race as t he m ost im port ant candle t o
recognize, and ham m er/ hangm an is a close second t hen t he
" engulfing" candle places t hird. Whereas t he doj i and
ham m er/ hangm an are a single candle, t he engulfing pat t ern
consist s of t wo candles.
The engulfing candle m ust com plet ely " consum e" t he real
body of t he previous candle. Because st ocks have fewer
gaps t han com m odit ies, an engulfing candle m ay violat e t his
rule very slight ly by being j ust above or below t he t op or
bot t om of t he previous candle. I n m ost cases, you should
int erpret t his as an engulfing pat t ern. I f you or your
children are in t he age group t o rem em ber t he early video
gam e Pac Man, you can t hink of t he engulfing candle as
being sim ilar t o t he hero of t hat gam e in t hat it eat s or
consum es t he previous candle.
A bullish engulfing candle occurs aft er a significant
downt rend. Not e t hat t he engulfing candle m ust encom pass
t he real body of t he previous candle, but need not surround
t he shadows. Below you will find an illust rat ion of a bullish
engulfing candle:
A bearish engulfing candle occurs aft er a significant upt rend.
Again, t he shadows need not be surrounded. Below you will
find an illust rat ion of a bearish engulfing candle:
The power of t he engulfing candle is increased by t wo
fact ors - - t he size of t he candle and t he volum e on t he day it
occurs. The bigger t he engulfing candle, t he m ore significant
it is likely t o be. A large bullish engulfing candle says t he
bulls have seized cont rol of t he m arket aft er a downt rend.
Meanw hile, a large bearish engulfing says t he bears have
t aken com m and aft er an upt rend. Also, if volum e is above
norm al on t he day when t he signal is given, t his increases
t he power of t he m essage.
A good exam ple of a bearish engulfing candle ending a rally
is found in Avid Technology ( AVI D) , a m aker of video edit ing
soft ware. I n early March t he st ock peaked in conj unct ion
wit h t he S&P 500 and Nasdaq Com posit e j ust above $68. A
few days lat er, when it was t rading at $62, it m ade an
acquisit ion and was punished severely. I nt raday, t he st ock
was off nearly $5 and left a large gap bet ween
approxim at ely t he $60 and $62 level on t he chart . Not e also
t he large volum e spike on t hat day. As we shall see lat er in
t his book, gaps in candlest ick t heory are called " windows,"
and creat e resist ance t o furt her price advances.
AVI D event ually bot t om ed in lat e April at $47.64 and began
t o recover. By m id- June it was back above $60 and t rading
int o t he window it had creat ed t he day of t he acquisit ion.
That in it self should have m ade any long caut ious on AVI D.
Anot her reason for prudence, however, was t hat it was
overbought . I t was out side t he Bollinger band. I n addit ion
t o being in overbought t errit ory on st ochast ics, t here was
also bearish m om ent um divergence. The day aft er t he
bearish engulfing candle, t he st ock gapped dow n.
St ochast ics and CCI gave clear sell signals and t he t rendline
from t he lat e April low was broken soon aft er. AVI D
ret reat ed t o near $51 before finally going out side t he
Bollinger band and becom ing oversold, t hen st aging a
m odest recovery.
The Ut ilit y TXU Corp ( TXU) provides a good exam ple of a
bullish engulfing candle. From a low j ust under $60 in
January, TXU had a spect acular run t o $86.64 before pulling
back. Readers should not e t he st rong support t hat exist ed
bet ween approxim at ely $73 and $74, a level t he shares did
not did go below from February on.
I n a single day in early May TXU went from j ust over $80
dow n t o support at $74. Not e t he long lower shadow w hich
probed out side t he Bollinger band on t his session. While t his
candle does not m eet t he requirem ent s of a ham m er ( t he
shadow is not double t he real body) , t raders should st ill pay
close at t ent ion t o long shadows especially in areas of
support . They suggest t hat t here is buying int erest at t hat
level.
Not e also t he bullish divergence on t he CCI indicat or w hich
was recovering from oversold levels. Traders needed t o wait
t wo addit ional days for t he bullish engulfing candle, but
when it did com e it was a highly reliable signal. The candle
was fairly large as t he st ock m oved alm ost $2.50 on t he
day. CCU subsequent ly recovered t o near $85, j ust below
t he previous highs.
Bullish and bearish engulfing candles warn of t rend change
before it happens. Com bine t he appearance of t hese candles
wit h ot her t echnical t ools such as CCI , and you should
quickly pick up on t rend changes. The abilit y t o spot t he
t rend change is key t o posit ioning yourself on t he right side
of t he m arket , and is vit al for t rading success.
CAN D LE 9 : D ARK CLOUD COVER W ARN S OF
I M PEN D I N G M I N OR TOPS
The candlest ick we will next explore is called " Dark Cloud
Cover." I t is a close relat ive of t he bearish engulfing, but is
not quit e as negat ive in it s im plicat ions. St ill, t he
appearance of t his candle should be a warning t o t he t rader
t o prot ect profit s in a posit ion. I t also suggest s t hat you
should wat ch a st ock as a possible short candidat e in t he
t rading days ahead.
The Dark Cloud Cover candle occurs aft er a st rong upt rend.
A series of ascending candles is ult im at ely " capped" by a
final whit e candle. At t his point , t he st ock or index seem s
t echnically healt hy and t he bulls m ay be lulled int o a sense
of false com placency.
On t he day of t he dark cloud cover, t he st ock opens above
t he previous day's high. For a t rue dark cloud cover t o
em erge, t herefore, t he st ock should ga p a bove t h e u ppe r
sh a dow of t he previous whit e " capping" candle. At t he
opening bell on t his t rading day, it seem s like t he upt rend
will cont inue.
As t he day wears on, however, t he bears wrest cont rol. On
t he dark cloud cover day, t he st ock closes a t le a st h a lfw a y
int o t he previous whit e " capping" candle. The larger t he
penet rat ion of t he previous candle ( t hat is, t he closer t his
candle is t o being a bearish engulfing) , t he m ore powerful
t he signal. Traders should pay part icular at t ent ion t o a dark
cloud cover candle if it occurs at an im port ant resist ance
area and if t he end- of- day volum e is st rong. Below you will
find an exam ple of a Dark Cloud Cover candle:
Film and digit al cam era m aker East m an Kodak ( EK) provides
an exam ple of t he dark cloud cover. The st ock t raded as
high as $33 in April, im m ediat ely before it released earnings
and it s second quart er forecast . Wit h earnings cam e out in
m id- April t he shares were changing hands at j ust above $30.
Result s were below expect at ions, t he st ock dropped
precipit ously on t heir release, gapping down t o $27.16 and
over t he next several days an falling as low at $24.40. As
we shall see when gaps are explored, t he t rader should now
ant icipat e resist ance bet ween $27.16 t he low end of t he gap
and j ust above $30, t he upper end.
Over t he next m ont h and a half, EK began a grudging
recovery, regaining $27, backing off and t hen finding
consist ent support at $26. The shares t hen broke out
form ing four consecut ive whit e candlest icks and reaching a
high of $28.19. While t he t hird candlest ick was not large, it
if t he four candles were com bined int o one, it cert ainly
would have been.
When t he dark cloud cover em erged t herefore, t raders
should have been wary. While t his candle was relat ively
sm all, it ret reat ed half- w ay back int o t he final whit e candle.
The next day a doj i appeared, em phasizing t he resist ance
near $28. EK t hen ret reat ed t oward t he $26 level before
finding support and rallying. While t he Dark Cloud Cover is
not as pot ent a reversal candle as bearish engulfing, it s
appearance in t he chart should be respect ed.
CAN D LE 1 0 : TH E PI ERCI N G CAN D LE I S A POTEN T
REVERSAL SI GN AL
The dark cloud cover and piercing candles are like bookends.
Whereas t he dark cloud cover w arns t hat an upt rend m ight
be com ing t o an end and is t hus a signal t o t ake profit s on
long t rades, a piercing candle int im at es t hat a downt rend
m ay be about t o reverse and short s should be covered.
The first t hing t o look for t o spot t he piercing pat t ern is an
exist ing dow nt rend. Wit h daily candles, t he piercing pat t ern
will oft en end a m inor downt rend ( a downt rend t hat oft en
last s bet ween five and fift een t rading days) . The day before
t he piercing candle appears, t he daily candle should ideally
have a fairly large dark real body, signifying a st rong down
day. Here is an exam ple of t he piercing candle:
I n t he classic piercing pat t ern, t he next day's candle gaps
below t he lower shadow, or previous day's low. I find wit h
st ocks ( in com parison t o com m odit ies) , however, t hat t he
gap is very oft en below t he previous day's close, but not less
t han t he previous day's low.
On t he piercing day, t he candle com es back int o and closes
a t le a st h a lfw a y int o t he real body of day one. I f it does
not com e at least halfway back, t hen t he candle is not a
piercing candle and needs t o be called by a different nam e.
( The candle is " on- neck" if it closes at day one's low, " inneck" if it closes slight ly back int o day one's real body, and
" t hrust ing" if it closes subst ant ially int o t he real body, but
less t han halfway.) I n a
CANDLESTICKS
EVERY TRADER
SHOULD KNOW
Dr. Melvin Pasternak
Working Title: 21 Candlesticks Every Trader
Should Know
Author:
Dr. Melvin Pasternak
Publisher:
Marketplace Books
Release Date: January 2006
Format:
Paperback
Pages:
approx. 120 pages
Retail Price:
$19.95
UNRELEASED
MANUSCRIPT
21 CANDLESTICKS EVERY TRADER SHOULD KNOW BY NAME
By: Dr. Melvin Pasternak
OUTLI N E
I
II
III
INTRODUCTION
Candles Anticipate, Indicators Follow,
Trendlines Confirm
How To Read A Candlestick Chart
Bar vs. Candlestick Charts
Optimism and Pessimism as Shown by Candles
Advantages of Candle vs. Bar Charts
Candles Anticipate Short Term Reversals
Why Candlesticks Work
"The Rule of Two"
Candles in Action: Dow Jones Analysis
Summary
21 CANDLES EVERY TRADER SHOULD
KNOW BY NAME
Candles 1-4: The Four Dojis Show Stocks That
Have Stalled
Candles 5-6: Hammer and Hangman
Candlesticks Signal Key Reversals
Candles 7-8: Bullish and Bearish Engulfing
Candles Spot Key Trend Changes Before They
Take Place
Candle 9: Dark Cloud Cover Warns of
Impending Market Tops
Candle 10: The Piercing Candle Is a Potent
Reversal Signal
Candles 11-12: The Three Candle Evening and
Morning Star Patterns Signal Major Reversals
Candle 13: The Shooting Star Can Wound
Candle 14: The Inverted Hammer Indicates The
Shorts May Be Ready To Cover
Candle 15: The Harami is "Pregnant" With
Possibilities
Candle 16: The "Full" Marubozu Is a Candle
Without Shadows
Candles 17-18 High Wave and Spinning Top
Express Doubt and Confusion
Candle 19: The Ominous Call of Three Black
Crows
Gaps From a Japanese Candlestick Viewpoint
The Four Types of Gaps: Common,
Continuation, Breakaway and Exhaustion
Candlestick Theory on Gaps
IV
Synthesis of Western Wisdom and Eastern
Insight
A Concluding Challenge
About the Author
I NTRODUCTI ON
Candlest icks are one of t he m ost powerful t echnical analysis t ools
in t he t rader's t oolkit . While candlest ick chart s dat es back t o
Japan in t he 1700's, t his form of chart ing did not becom e popular
in t he w est ern w orld unt il t he early 1990's. Since t hat t im e, t hey
have becom e t he default m ode of chart ing for serious t echnical
analyst s replacing t he open- high- low- close bar chart .
There has been a great deal of cogent inform at ion published on
candlest ick chart ing bot h in book form and on t he worldwide web.
Many of t he works, however, are encyclopedic in nat ure. There
are perhaps 100 individual candlest icks and candle pat t erns t hat
are present ed, a daunt ing am ount of inform at ion for a t rader t o
learn.
I n t his book I have select ed 21 candles t hat I believe every t rader
should know by nam e. These are t he candles t hat in m y
experience occur m ost frequent ly and have t he great est
relevance for m aking t rading decisions. Just as knowing t he
nam e of a person helps you im m ediat ely recognize t hem on a
crowded st reet , so being able t o nam e t he candlest ick allows you
t o pick it out of a chart pat t ern. Being able t o nam e it allows you
t o appreciat e it s t echnical im plicat ions and increases t he accuracy
of your predict ions.
I n m y t rading, I t ry t o int egrat e candlest ick analysis, m oving
averages, Bollinger bands, price pat t erns ( such as t riangles) and
indicat ors such as st ochast ics or CCI t o reach decisions. I find
t he m ore inform at ion w hich is int egrat ed, t he m ore likely t he
decision is t o be correct . I n t his book, I have chosen t o com bine
m oving averages, Bollinger bands and t wo indicat ors, st ochast ics,
and CCI on various chart s. As w e discuss individual candlest icks
or candle pat t erns, I int egrat e t hese t ools int o t he discussion.
Hopefully, you w ill not only learn how t o recognize candles from
t his book, but also appreciat e how you can com bine t hem wit h
t he t radit ional t ools of t echnical analysis.
I n t his book m y focus is on Minor t rend reversals, t he kind of
reversal of m ost int erest t o a t rader. The Minor t rend t ypically
last s 5 t o 15 days alt hough on occasion, I have seen it st ret ch out
t o about 30 t rading days. These sam e candle principles work
equally as well, however, on 5 m inut e or weekly chart s. I t is
sim ply a m at t er of adapt ing t his inform at ion t o t he t im e fram e
you are t rading in.
CAN D LESTI CKS AN TI CI PATE, I N D I CATORS FOLLOW ,
TREN D LI N ES CON FI RM
I call candlest icks an " ant icipat ory" indicat or. You haven't com e
across t his w ording before, since it is m y own t erm inology. An
ant icipat ory indicat or gives a signal in advance of m uch ot her
m arket act ion - - in ot her words it is a leading indicat or of m arket
act ivit y.
Mom ent um indicat ors such as CCI or st ochast ics are also
ant icipat ory since usually m om ent um precedes price. Typically,
however, even rapidly m oving m om ent um indicat ors such as CCI
lag t he candle signal by a day or t wo. When you receive a candle
signal followed by a m om ent um signal such as st ochast ics w hich
com m unicat es t he sam e m essage, it is likely t hat in com binat ion
t hey are accurat ely predict ing what will happen wit h a st ock.
On t he ot her hand, t he break of a t rendline or a m oving average
crossover is w hat I call a " confirm ing" signal. I t usually occurs
days lat er t han t he peak or bot t om of price and m uch aft er t he
candlest ick and indicat or signal.
Depending on your t rading st yle, you can act on t he ant icipat ory
signal. However, if you prefer t o be caut ious and wait for m ore
evidence, candlest icks ant icipat e a change in t rend and put you
on t he alert t hat a reversal m ay be im m inent .
H OW TO READ A CAN D LESTI CK CH ART
I f you are already fam iliar wit h t he basics of candlest icks, you can
skim t his sect ion. I f you have seen candles on t he web, but have
not st udied t hem in som e det ail, t hen you'll now be given t he
background you need t o use candles.
Candles m ay be creat ed for any " period" of chart —m ont hly,
weekly, hourly, or even one m inut e. When I discuss candles in
t his book, I will use daily chart exam ples, but be aware t hat you
can creat e candle chart s for virt ually any period.
BAR VS. CAN D LESTI CK CH ARTS
Below are a t hree m ont h bar chart and a t hree m ont h candlest ick
chart for I BM. See if you can spot any differences in t he " dat a
series."
Hard t o spot t he difference? That 's because t here isn't any. Bot h
t he bar chart and t he candlest ick chart cont ain exact ly t he sam e
inform at ion, only it 's present ed t o t he t rader in different form .
Bot h t he bar chart and t he candle chart cont ain t he sam e dat a:
t he high for t he period ( t he day) , t he low, t he open and t he close.
I n a candlest ick chart , however, t he nam es are changed. The
difference bet ween t he open and t he close is called t he r e a l
body. The am ount t he st ock w ent higher beyond t he real body is
called t he u ppe r sh a dow . The am ount it went lower is called
t he low e r sh a dow . I f t he candle is clear or whit e it m eans t he
opening was low er t han t he high and t he st ock went up. I f t he
candle is colored t hen t he st ock went down. This inform at ion is
shown below:
OPTI M I SM AN D PESSI M I SM AS SH OW N BY CAN D LES
Here is an idea about candlest icks t hat helps m e bet t er use t hem
and w hich I haven't seen in books or on t he web.
I t is generally acknowledged t hat t he opening of t he t rading day
is dom inat ed by am at eurs. The close, on t he ot her hand, is
dom inat ed by professional t raders. The low of t he day, one
m ight say, is set by t he pessim ist s - - t hey believed t he m arket
was going lower and sold at t he bot t om . The high of t he day is
set by t he opt im ist s. They were willing t o pay t op price but were
incorrect in t heir analysis, at least in t he short t erm .
I ndividual candlest icks m ay be underst ood by com bining t his
concept wit h t he candle chart . I will use only t w o exam ples, but
you m ight want t o experim ent wit h t his idea yourself.
Shaven Bot t om / Shaven Head. The shaven bot t om / shaven t op
candle depict s a day in w hich t he m arket opened at t he low and
closed at t he high. I t is a day on which t he am at eurs are also t he
pessim ist s. They sell early and t heir shares are gobbled up by
eager buyers. By t he end of t he day t he opt im ist s and
professionals close t he st ock sharply higher. This bullish candle
frequent ly predict s a higher open on t he next day.
Shaven Head/ Shaven Bot t om . This candle is t he opposit e of t he
one j ust described. Depict ed here is a day when t he am at eurs
are t he opt im ist s. They buy at t he t op of t he day, only t o wat ch
prices st eadily decline. By t he end of t rading, prices have
declined sharply and t he professional pessim ist s are in cont rol of
t he m arket . The opening t he next day is oft en lower.
Candles can be m ade m ore sense of by reasoning t hem out in
t his way. Part icularly when you see a candle wit h a large real
body, ask yourself who w on t he bat t le of t he day, t he opt im ist s or
t he pessim ist s, t he am at eurs or t he professionals. This quest ion
will oft en provide you wit h an im port ant clue t o subsequent
t rading act ion.
AD VAN TAGES OF CAN D LE VS. BAR CH ARTS
There are t hree m aj or advant ages of candlest ick chart s
com pared t o bar chart s.
1. Candlest ick chart s are m uch m ore " visually im m ediat e" t han
bar chart s. Once you get used t o t he candle chart , it is m uch
easier t o see what has happened for a specific period be it a
day, a w eek an hour or one m inut e.
Wit h a bar chart you need t o m ent ally fill in t he price act ion.
You need t o say t o yourself, " The left t ick says t hat 's w here it
opened, t he right t ick where it closed. Now I see. I t was an
up day." Wit h a candlest ick chart it is done for you. You can
spend your energy on analysis, not figuring out what happened
wit h t he price.
2. Wit h candles you can spot t rends m ore quickly by looking for
whet her t he candles are clear or colored. Wit hin a period of
t rend, you can easily t ell what a st ock did in a specific period.
The candle m akes it easier t o spot " large range" days. A large
candlest ick suggest s som et hing " dram at ic" happened on t hat
t rading day. A sm all range day suggest s t here m ay be relat ive
consensus on t he share price. When I spot a large range day,
I check t he volum e for t hat day as well. Was volum e unusual?
Was it say 50% higher t han norm al? I f so, it is very likely t hat
t he large range day m ay set t he t one for m any days aft erward.
3. Most im port ant , candles are vit al for spot t ing reversals. These
reversals are usually short t erm - - precisely t he kind t he t rader
is looking for.
When t radit ional t echnical analysis t alks about reversals,
usually it is referring t o form at ions t hat occur over long periods
of t im e. Typical reversal pat t erns are t he double t op and head
and shoulders. By definit ion, t hese involve sm art m oney
dist ribut ing t heir shares t o naive t raders and norm ally occur
over weeks or even m ont hs.
Candlest icks, however, are able t o accurat ely pick up on t he
changes in t rend which occur at t he end of each short t erm
swing in t he m arket . I f you pay m et iculous at t ent ion t o t hem ,
t hey oft en warn you of im pending changes.
CAN D LES AN TI CI PATE SH ORT TERM REVERSALS
The m essage of candlest icks is m ost pow erful w hen t he
m arket s are at an ext rem e, t hat is when t hey are overbought
or oversold. I define overbought as a m arket w hich has gone
up t oo far t oo fast . Most of t he buyers are in and t he sellers
are eager t o nail down profit s.
An oversold m arket , on t he ot her hand, is one in which t he
sellers have been in cont rol for several days or w eeks. Prices
have gone down t oo far t oo fast . Most of t he t raders who want
t o sell have done so and t here are bargains - - at least in t he
short t erm - - t o be had.
There are m any overbought and oversold indicat ors, such as
CCI , RSI , and William s' % R. However, one of t he best is
st ochast ics, w hich essent ially m easures t he st ock's price in
relat ion t o it s range usually over t he past 14 periods. CCI
t ypically agrees wit h st ochast ics and is useful for providing
confirm at ion of it s signal. I also alm ost always put a Bollinger
Band on chart s I analyze. John Bollinger creat ed t his t ool t o
include 19 out of every 20 closing prices wit hin t he bands.
Therefore, a close out side t he band is significant . A close
out side t he upper band usually say t he st ock is overbought .
When it is out side t he lower band it is oversold.
When bot h st ochast ics, CCI and t he Bollinger bands agree a
st ock or index is overbought or oversold, I t ake t heir alignm ent
very seriously. There is a good chance a reversal is overdue.
A significant candlest ick t ells m e m ore exact ly when t he
reversal m ight be here.
W H Y CAN D LESTI CKS W ORK
A chart m ay be t hought of as pict ure of t he war bet ween
supply and dem and. When a st ock is m oving up, t he buyers
are in cont rol. There is m ore dem and t han supply. Purchasers
are eager t o acquire t he st ock and will pay up, hit t ing t he ask
price t o do so. When a st ock is declining, t he reverse is t rue.
Sellers are fearful and will not dicker over a few cent s, being
m ore likely t o accept t he bid. Candlest icks graphically show
t he balance bet ween supply and dem and. At key reversal
j unct ures, t his supply/ dem and equat ion shift s and is capt ured
in t he candle chart .
" Th e Ru le of Tw o"
Generally, no one candlest ick should be j udged in isolat ion.
The general principle is even if you see a key reversal
candlest ick, you should wait at least part of one m ore day
before act ing. I f for exam ple, you spot a candle called a doj i,
seek verificat ion from t he act ion of t he next t rading day. I f
t here is a dow n gap and prices begin t o decline t hen it is
prudent t o t ake your posit ion.
CAN D LES I N ACTI ON : D OW JON ES AN ALYSI S
As st at ed, in candlest ick t heory, t here are m any candles which
signal im port ant reversals. To conclude t his sect ion, w e will
focus on only four ( ! ) candlest icks which called every m aj or
t urn in t he Dow Jones I ndust rial Average over nearly a six
m ont h period! Think how m uch m ore accurat ely you could
have t raded t he m arket if you knew t hese candles nam es and
im plicat ions as well as had recognized t hem when t hey
occurred.
The good new s is t hese are reversal signat ures and are apt t o
occur again. Your abilit y t o recognize t hem could lead t o large
t rading gains. First , I will explain t he candlest icks, t hen apply
t his t heory t o analysis of t he graph. The candles are point ed
out on t he Dow chart below.
BULLI SH ENGULFI NG.
The bullish engulfing is m ost significant w hen it occurs aft er a
prolonged dow nt rend. The st ock or index has been selling off
sharply. On t he day of t he bullish engulfing, prices will oft en
st art t he day by falling. However, st rong buying int erest
com es in and t urns t he m arket around.
The bullish engulfing is nam ed because t his candle surrounds
or engulfs t he previous one. When I discuss t his candle wit h
college st udent s enrolled in m y st ock m arket course, I call it
" Pac- Man" because like t he video gam e charact er, it " eat s" t he
candle before it . The bullish engulfing represent s a reversal of
supply and dem and. Whereas supply has previously far
out st ripped dem and, now t he buyers are far m ore eager t han
t he sellers. Perhaps at a m arket bot t om , t his is j ust short covering at first , but it is t he cat alyst which creat es a buying
st am pede.
When analyzing t he bullish engulfing, always check it s size.
The larger t he candle, t he m ore significant t he possible
reversal. A bullish engulfing w hich consum es several of t he
previous candles, speaks of a powerful shift in t he m arket .
THE HAMMER.
This ham m er m arks a reversal off a bot t om or off an im port ant
support level. On t he day of t he ham m er, prices decline. They
hit bot t om and t hen rebound sharply m aking up all t he ground
– and som et im es m ore – com pared t o w here t he sell- off
st art ed. The candle shows t hat t he buyers have seized cont rol.
A bullish candlest ick on t he following day confirm s t his
analysis.
THE DOJI .
I f you w ere t o learn only one candle by nam e, t his would have
t o be t he one. A " com m on" doj i, as I call it , is shaped like a
cross. A doj i has no real body. What it says is t hat t here is a
st alem at e bet ween supply and dem and. I t is a t im e when t he
opt im ist and pessim ist , am at eur and professional are all in
agreem ent . This m arket equilibrium argues against a st rong
upt rend or dow nt rend cont inuing, so a doj i oft en m arks a
reversal day.
A doj i in an overbought or oversold m arket is t herefore oft en
very significant . The opening of t he next day should be
wat ched carefully t o see if t he m arket carries t hrough on t he
reversal. Not e, a candle wit h a very sm all real body oft en can
be int erpret ed as a doj i.
GRAVESTONE DOJI .
The gravest one doj i occurs far less frequent ly t han t he
com m on one, but gives even a clearer signal. At t he t op of an
ext ended m ove, it says t he bulls t ried t o m ove t he m arket
higher and couldn’t do it . The st ock, or in t his case t he index,
can not sust ain t he probe t o new high ground. I t opens and
closes at t he exact sam e level creat ing t he appearance of a
t om bst one.
BACK TO TH E D OW JON ES CH ART
During t he period t he chart pict ures, t he Dow Jones I ndust rial
Average went sideways in a broad t rading range bet ween
10000 and 11000. I have placed only one m oving average on
t he chart , t he 50- day. A 50- day m oving average describes t he
I nt erm ediat e t rend and when it m oves sideways like it does
here, you can also be sure it describes a m arket in a sideways
consolidat ion pat t ern.
Despit e t he sideways m ovem ent , t here were m any good
t rading opport unit ies, bot h long and short . The first cam e in
early March when t he Dow peaked j ust below 11000. All
round num bers represent key support and resist ance in t he
m aj or averages and t his t op was no except ion. The candle
form ed was a gravest one doj i. Not e t he long upper shadow
and t he absence of a real body. This com binat ion signalled
t hat t he bulls did not have t he st rengt h t o push t he Dow
t hrough t he 11000 m ark. Over t he next m ont h t he Dow
ret reat ed nearly 1000 point s, finally bot t om ing right at 10000.
The lat e April bot t om at 10000 is m arked by a bullish engulfing
candle. I m m ediat ely before t he bullish engulfing not e t he
t hree very large back candles w hich saw t he Dow drop nearly
500 point s in t hree days. That left it subst ant ially oversold as
shown by t he st ochast ics indicat or w hich reveals an oversold
reading when it goes below 20 ( above 80 is overbought ) . An
oversold m arket can be described as one which has gone dow n
t oo far, t oo fast .
The bullish engulfing candle was very large, adding t o it s
significance. I t im plied t hat wit h t he Dow able t o hold 10000,
t he short s were covering, buying int erest had em erged at t his
level, or bot h. While t he Dow didn't soar higher in t he com ing
day, neit her did it drop below 10000 again. By early May it
rallied back t o resist ance near 10400. Not e how a horizont al
line can be draw n across t he chart t o m ark t his resist ance level
and how it s role as bot h support and resist ance alt ernat ed
during t he six- m ont h period.
The Minor upt rend brought t he Dow back t o 10400. Traders
looking for t he Dow t o st all at t his level did not have long t o
wait . Here's a sm all t est of what you've learned so far. Can
you nam e t he candlest ick which helped m ark t he peak at t his
t im e. I f you said a gravest one doj i, you get high m arks.
The gravest one doj i candle led t o anot her sm all dow n w ave in
t he Dow. This was part of a secondary bot t om t hat saw t he
index bot t om well above 10000, closer in fact t o 10100. Not e
t here is a candle you have seen before—t he bullish engulfing.
From 10075 t he Dow advanced over t he next m ont h t o a peak
j ust below 10600. For alm ost a m ont h, in what m ust have
seem ed like an et ernit y for t raders, t he Dow vacillat ed in an
excruciat ingly narrow range bet w een 10400 and 10600. When
it finally got beyond resist ance at 10600, it form ed t hree doj ilike candles in a row. ( The candles are doj i- like since t hey
have very sm all real bodies) . These doj is showed t hat t he
bulls and bears were at a st alem at e. Aft er a lengt hy upt rend
t hey indicat ed t hat t he bulls lacked t he buying power t o m ove
t he m arket higher. Not surprisingly a st rong sell- off ensued.
The decline ended well above 10000 t his t im e finding a bot t om
at 10175. The candle which form ed here can be int erpret ed as
a ham m er, despit e t he very sm all upper shadow. The ham m er
candle occurred aft er t he Dow had found support near 10250
for several days.
On t he day of t he ham m er, a dram at ic news event sent prices
sharply lower in t he m orning, but t hen t he selling pressure
dried up. By lat e aft ernoon, prices had t urned posit ive as can
be seen from t he sm all w hit e real body. The ham m er led t o a
subsequent rally which lift ed t he Dow several hundred point s in
t wo t rading days t aking it right back int o t he 10400 t o 10600
range of resist ance it had been in t he m ont h previous.
SUM M ARY
I find it int riguing t hat t he sam e candlest ick pat t erns repeat
over and over. Candles are your personal sent ry providing you
wit h consist ent early warnings of im pending t rend change.
They provide t he earliest signal I know of t hat t he pat t erns in
t he m arket are about t o reverse.
All in all, t here are about 100 candles pat t erns t he t rader can
becom e fam iliar wit h. Of t hese, 21 candles recur frequent ly
enough and are significant enough t hat t he t rader should be
able t o spot t hem by nam e. Knowing t heir nam es allow s you
t o spot t hem m ore easily and assess t heir im plicat ions. When
faced wit h t he need for a quick decision during t he heat of
t rading, t he t rader who can nam e t hese 21 candles has a
dist inct advant age over one w ho can't .
2 1 CAN D LES EVERY TRAD ER SH OULD KN OW BY N AM E
I n t he previous sect ion of t his book, I showed how cert ain key
candlest icks were able t o ident ify every m aj or t rend reversal in
t he Dow Jones I ndust rial Average for a period of several
m ont hs. I t is vit al for t rading success, I argued, t o recognize
candlest icks and assess t heir im plicat ions.
Candles are vit al t o t rading because t hey ident ify possible
reversals in t rend. Failure t o spot t hese key candles can lead
t o cost ly t rading errors. Why should you be able t o ident ify
t hese candles? Because t hey can m ake you m oney!
Here t hen are t he 21 candlest icks I find m ost useful in m y own
t rading.
CAN D LES 1 - 4 : TH E FOUR D OJI S SH OW STOCKS TH AT
H AVE STALLED
I f you w ere t o ask m e w hich of all t he candlest icks is t he m ost
im port ant t o recognize, I would answer unhesit at ingly - - t he
doj i. On a daily chart , t he doj i oft en m arks t he beginning of a
m inor or int erm ediat e t rend reversal. Fail t o recognize t he
doj i's im plicat ions and you run t he risk of buying at t he t op or
st aying far t oo lat e in a t rade and leaving subst ant ial profit s on
t he t able.
There are four t ypes of doj is - - com m on, long- legged,
dragonfly and gravest one. All doj is are m arked by t he fact t hat
prices opened and closed at t he sam e level. I f prices close very
close t o t he sam e level ( so t hat no real body is visible or t he
real body is very sm all) , t hen t hat candle can be int erpret ed as
a doj i.
Aft er a long upt rend, t he appearance of a doj i can be an
om inous warning sign t hat t he t rend has peaked or is close t o
peaking. A doj i represent s an equilibrium bet ween supply and
dem and, a t ug of war t hat neit her t he bulls nor bears are
winning. I n t he case of an upt rend, t he bulls have by definit ion
won previous bat t les since prices have m oved higher. Now, t he
out com e of t he lat est skirm ish is in doubt . Aft er a long
dow nt rend, t he opposit e is t rue. The bears have been
vict orious in previous bat t les, forcing prices down. Now t he
bulls have found courage t o buy and t he t ide m ay be ready t o
t urn.
What I call a " com m on" doj i has a relat ively sm all t rading
range. I t reflect s indecision. Here's an exam ple of a com m on
doj i:
A " long- legged" doj i is a far m ore dram at ic candle. I t says t hat
prices m oved far higher on t he day, but t hen profit t aking
kicked in. Typically, a very large upper shadow is left . A close
below t he m idpoint of t he candle shows a lot of w eakness.
Here's an exam ple of a long- legged doj i:
When t he long- legged doj i occurs ou t side a n u ppe r Bollin ge r
ba n d aft er a sust ained upt rend, m y experience says you
should be ext rem ely vigilant for t he possibilit y of a reversal. A
subsequent sell signal given by an indicat or such as st ochast ics
is t ypically a very reliable warning t hat a correct ion will occur.
A " gravest one doj i," as t he nam e im plies, is probably t he m ost
om inous candle of all. On t hat day, prices rallied, but could not
st and t he " alt it ude" t hey achieved. By t he end of t he day t hey
cam e back and closed at t he sam e level. Here's an exam ple of
a gravest one doj i:
Finally, a " dragonfly" doj i depict s a day on which prices opened
at a high, sold off, and t hen ret urned t o t he opening price. I n
m y experience, dragonflies are fairly infrequent . When t hey do
occur, however, t hey oft en resolve bullishly ( provided t he st ock
is not already overbought as shown by Bollinger bands and
indicat ors such as st ochast ics) . Here's an exam ple of a
dragonfly doj i:
When assessing a doj i, always t ake careful not ice of where t he
doj i occurs. I f t he securit y you're exam ining is st ill in t he early
st ages of an upt rend or downt rend, t hen it is unlikely t hat t he
doj i will m ark a t op. I f you not ice a short - t erm bullish m oving
average crossover, such as t he four- day m oving average
heading above t he nine- day, t hen it is likely t hat t he doj i m arks
a pause, and not a peak. Sim ilarly, if t he doj i occurs in t he
m iddle of a Bollinger band, t hen it is likely t o signify a pause
rat her t han a reversal of t he t rend.
As significant as t he doj i is, one should not t ake act ion on t he
doj i alone. Always wait for t he next candlest ick t o t ake t rading
act ion. That does not necessarily m ean, however, t hat you
need t o wait t he ent ire next day. A large gap dow n, aft er a doj i
t hat clim axed a sust ained upt rend, should norm ally provide a
safe short ing opport unit y. The best ent ry t im e for a short t rade
would be early in t he day aft er t he doj i.
The chart of t he Disk Drive I ndex ( $DDX) shows t hree of t he
four doj is j ust described and gives som e guidance as t o how t o
effect ively int erpret t his candle depending on where it occurs in
a t rend. The Disk Drive I ndex consist s of 11 st ocks in t he
com put er st orage and hard drive businesses. This index's
perform ance t herefore usually correlat es highly w it h t he
Nasdaq Com posit e. I n March, t he $DDX hit a peak of 125.06
and t hen a prolonged sell- off in conj unct ion wit h t he overall
m arket in general and t ech st ocks in part icular. Also, not e,
how in early May, t he $DDX t raded sideways for several days,
finding support or buying int erest at t he m id- 97 level wit h
resist ance or selling pressure near t he psychological barrier of
100.
Finally, t he buyers were able t o overw helm t he sellers and t he
$DDX pierced 100. Not e on t his day, t he four- day m oving
average penet rat ed t he nine- The 4- day m oving average day
and bot h began t o slope upward. That pat t ern suggest ed an
upt rend was beginning. The four- day m oving average going
above t he nine is a bullish m oving average crossover. While I
wouldn't t rade on t his very short - t erm signal in isolat ion, it
provides a useful confirm at ion t hat t he im m ediat e t rend is up.
The next day, a com m on doj i appeared ( labeled " 1" ) . While a
doj i should always be not ed, t his one was early in t he t rend.
The previously described " rule of t wo" also says t o wait anot her
day before t aking t rading act ion. The following day was
posit ive.
Two days lat er a dragonfly doj i appeared ( " 2" ) wit h prices
closing at t heir highs. Again, a dragonfly doj i oft en resolves
posit ively as did t his candle. Three days aft er t hat ( " 3" ) a
second dragonfly doj i occurred. This one was m ore worrisom e
since it cam e aft er a subst ant ial advance and w as close t o t he
t op of a Bollinger band. However, t he upt rend cont inued.
By early June, t he $DDX was t rading close t o 115. I t had
rallied nearly 20% off it s early May low. Whereas during t he
core of t he upt rend, t here had been several large whit e candles
indicat ing bullish ent husiasm , now t he real bodies of
t hecandles t urned sm all showing caut ion on t he part of buyers.
Always observe t he size of t he candles in your analysis.
I n m id- June, t w o consecut ive doj is ( " 4" ) appeared on t he
chart . The first was a com m on doj i; t he second closer t o a
long- legged variet y. For t hose t raders in a long posit ion,
ext rem e vigilance was now warrant ed. Subst ant ial profit s were
t here for nailing dow n in t he $DDX. The index was st alling; t he
bulls and bear were st alem at ed.
I n t he t wo days aft er t he doj is appeared, t he $DDX st ruggled
t o m ove higher wit hout m uch success. On t he second day, t he
candle t urned dark showing selling pressure. Not e also t hat
t he four- day m oving average penet rat ed dow n t hrough t he
nine- day, t he first t im e t his had happened since t he upt rend
began in early May.
The subsequent slide in t he $DDX was not dram at ic. However,
t he t rader who failed t o heed t he doj is' warning surrendered a
large port ion of his or her profit s. Doj is should not be assessed
m echanically. However, aft er a st rong t rend in eit her direct ion
t hey oft en m ark m aj or t urning point s. Always recognize t he
doj i w hen it occurs, and be prepared t he next t rading day t o
t ake appropriat e act ion.
The one kind of doj i not found in t he $DDX chart is t he
gravest one doj i, already seen in t he chart of t he Dow Jones
I ndust rial Average. Candlest ick nam es are t ypically very
colorful and t his one is no except ion. I f you are a bull, t he
gravest one doj i should sound om inous and one should alw ays
be prepared t o t ake rapid act ion on it s appearance. When it
occurs aft er a prolonged upt rend, and t he upper shadow
penet rat es t hrough t he upper Bollinger band, t he candle t akes
on added significance.
To review, a gravest one doj i occurs on a day when prices open
and close at t he sam e level. During t he session, however,
prices m ove sharply higher, but t he bulls can not sust ain t he
advance. This t rading act ion leaves a long upper shadow on
t he chart . I f t he gravest one doj i does not serve as a key
reversal day, it cert ainly will m ark a resist ance area t hat will
norm ally st all an advance for several sessions. I n eit her case,
t he t rader is oft en prudent t o nail dow n profit s aft er it s
appearance.
The chart of airline st ock AMR Corp. ( AMR) is a classic exam ple
of why it 's vit al t o recognize t he gravest one doj i by nam e.
AMR bot t om ed at $9.80 in lat e April. I n early June, it had
advanced nearly 40% and was probing t he $14 area. On June
17 t h it opened at $14 and shot up t o a peak of $14.95. Not ice,
how a large part of t he upper shadow pierced t hrough t he
Bollinger band. But t raders did not like t he alt it ude t hat AMR
was flying at and st ock closed unchanged for t he day. The
session creat ed a long- legged doj i, a warning t hat t he bulls
were not able t o m aint ain cont rol.
Traders who required addit ional evidence t hat a reversal had
occurred did not need t o wait long. Not ice, how t he four daym oving average crossed below t he nine day. A t rendline break
also occurs short ly aft er t his crossover, suggest ing AMR's flight
pat h is now lower. Traders who ignored t hese signals, paid a
high price. By t he end of June, AMR was probing $11, not far
from w here t he rally began. This was one round t rip t hat
would have been avoided t hrough assessing t he im plicat ions of
t he gravest one doj i.
CAN D LES 5 - 6 : H AM M ER AN D H AN GM AN CAN D LESTI CKS
SI GN AL KEY REVERSALS
The doj i candle is probably t he single m ost im port ant candle
for t he t rader t o recognize. Not far behind in value are
ham m er and hangm an.
I t is easy t o get t hese t wo candlest icks confused since t hey
look ident ical. Bot h t he hangm an and ham m er have a very
long shadow and a very sm all real body. Typically, t hey have
no upper shadow ( or at t he very m ost , an ext rem ely sm all
one) . To be an " official" ham m er or hangm an, t he lower
shadow m ust be at least t wice t he height of t he real body. The
larger t he lower shadow, t he m ore significant t he candle
becom es.
How can you t ell t he t wo candles apart ? The hangm an candle,
so nam ed because it looks like a person who has been
execut ed wit h legs swinging beneat h, alw ays occurs aft er an
ext ended upt rend. The hangm an occurs because t raders,
seeing a sell- off in t he shares, rush in t o snap up t he st ock at
bargain prices. To t heir dism ay t hey subsequent ly find t hey
could have bought t he st ock at m uch cheaper levels. The
hangm an looks like t his:
On t he ot her hand, t he ham m er put s in it s appearance aft er
a prolonged dow nt rend. On t he day of t he ham m er candle,
t here is st rong selling, oft en beginning at t he opening bell.
As t he day goes on, how ever, t he m arket recovers and
closes near t he unchanged m ark, or in som e cases even
higher. I n t hese cases, t he m arket is pot ent ially
" ham m ering" out a bot t om . Here is an exam ple of a ham m er
candle:
As wit h all candles, t he " rule of t wo" applies. That is t o say,
a single candle m ay give a st rong m essage, but one should
always wait for confirm at ion from anot her indicat or before
t aking any t rading act ion. I t m ay not be necessary t o wait
an ent ire t rading day for t his confirm at ion. When it com es t o
t he hangm an, for exam ple, confirm at ion m ay be a gap down
t he next day. Wit h t he ham m er, a gap opening wit h
gat hering st rengt h as t he day w ears on m ay be all t hat is
necessary t o init iat e a t rade from t he long side.
I will st art wit h t he ham m er. I n m y experience, when a
ham m er candle appears in t he chart of one of t he m aj or
averages, it is always a signal w ort h not ing. This is
part icularly t rue when it has com e aft er a st eady and
prolonged sell- off.
The chart of t he Nasdaq Com posit e ( $COMPQ) shows t he
value for t he t rader of recognizing t he ham m er candle.
From March t o lat e May, Nasdaq was in a st eep downt rend
having declined from alm ost 2100 t o j ust below 1900. Right
above t he price chart , is anot her t echnical t ool I frequent ly
use, t he Price Relat ive t o $SPX. SPX st ands for t he S&P
500, so t his chart com pares t he perform ance of Nasdaq t o
t he S&P. Not e t hat t he t hick line had a downward slope
t hroughout t he period of t he chart and t hat it w as under t he
t hin line which was t he 20- day m oving average. What t hat
t ells t he t rader, is t hat Nasdaq was under perform ing t he
S&P t hroughout t he ent ire period.
The ham m er candle occurred on t he final day of April. On
t his day, t he Com posit e breached 1900 int raday, but t he
bears did not have t he power t o close it under t hat
psychological support level. I nst ead, t he Com posit e closed
slight ly posit ively on t he day, hence t he sm all w hit e head at
t he t op of t he candle.
I n it self, t he ham m er gave a powerful, warning t hat Nasdaq
was reversing course. The alert t rader m ight t ake a long
posit ion in a leading Nasdaq st ock or an ETF such as t he
QQQQ on t he next t rading day when t he Com posit e bullishly
followed t hrough on t he previous day's act ion. On t he
second t rading day aft er t he ham m er, t he four- day m oving
average crossed above t he nine- day and bot h began t o
slope higher, anot her bullish sign. Short ly t hereaft er, t he
Price Relat ive broke out above it s ow n m oving average and
for several weeks Nasdaq becam e t he m arket leader inst ead
of t he laggard.
Addit ional t echnical confirm at ion of t he ham m er cam e from
t he behavior of t he st ochast ics oscillat or. St ochast ics
com pares t he behavior of price relat ive t o it self. I t is a
rapidly m oving indicat or which gives t im ely buy and sell
signals. I n t his case, st ochast ics dem onst rat ed bullish
m om ent um divergence as m arked on t he chart . Bullish
divergence occurs when price goes lower, but t he st ochast ics
oscillat or rises. The day aft er t he ham m er, st ochast ics gave
it s first buy signal in roughly t wo weeks. The buy signal
occurred as bot h % K and % D broke above 20 on t he
st ochast ics scale.
From t hat t im e onward, t hroughout t he ent ire m ont h of May,
Nasdaq was off t o t he races. The Com posit e rallied roughly
200 point s, from below 1900 t o nearly 2100. The ham m er
candle was t he t echnical signal t hat it w as t im e t o be long
not short Nasdaq.
The candle opposit e of t he ham m er is called hangm an.
When I have t aught candlest icks in college st ock m arket
classes, st udent s have easily becom e confused bet ween t he
t wo. This is because t hey look exact ly alike. The key
difference is where t hey occur in a chart . The ham m er
occurs aft er a long decline when t he m arket is oversold. I n
cont rast , hangm an put s in it s appearance near t he end of an
upt rend when t he m arket is overbought .
There are t im es when a hangm an candle can look a great
deal like t he dragonfly doj i. Such is t he case wit h Forest
Labs ( FRX) . I n April, FRX had gapped down sharply from
t he $38 area when it announced below expect at ion earnings.
Forest bot t om ed at $32.46, in conj unct ion wit h st rengt h in
t he pharm aceut ical st ocks began a gradual m ove higher. On
t he day of t he ham m er, it recovered t o a peak of $40.76,
but t ing up against st rong resist ance in t he $40 t o $42 area
form ed in February and March.
As show n in t he chart below, t he ham m er candle occurred
out side t he Bollinger band, a sign t he st ock was very
overbought . I have also placed t he CCI indicat or on t he
chart . On t his indicat or, + 100 is overbought and + 200
highly overbought . Not e t hat when t he ham m er candle
occurred, CCI was well over 200 and was beginning t o t rend
dow nward. St ochast ics gave t he sam e m essage as it gave a
sell signal aft er having reached overbought levels.
The ham m er was indeed t he profit - t aking signal in FRX. The
next day t he st ock opened j ust above $40 and slid
persist ent ly during t he day, reaching a low of $37.60 before
recovering. A sim ple t rendline drawn from t he $32.46 low
confirm ed t hat it was t im e t o exit t he posit ion. The t rendline
was broken t he next t rading day. CCI also dipped below t he
+ 100 level, giving a sell signal on t his indicat or. When a
candlest ick, indicat or and t rendline all give t he sam e
m essage, it is t im e t o list en t o t hese m essages. While FRX
went sideways rat her t han sharply dow n aft er t he ham m er,
a posit ion in t he st ock w as dead m oney.
CAN D LES 7 - 8 : BULLI SH AN D BEARI SH EN GULFI N G
CAN D LES SPOT TREN D CH AN GES BEFORE TH EY TAKE
PLACE
I f t he doj i wins t he race as t he m ost im port ant candle t o
recognize, and ham m er/ hangm an is a close second t hen t he
" engulfing" candle places t hird. Whereas t he doj i and
ham m er/ hangm an are a single candle, t he engulfing pat t ern
consist s of t wo candles.
The engulfing candle m ust com plet ely " consum e" t he real
body of t he previous candle. Because st ocks have fewer
gaps t han com m odit ies, an engulfing candle m ay violat e t his
rule very slight ly by being j ust above or below t he t op or
bot t om of t he previous candle. I n m ost cases, you should
int erpret t his as an engulfing pat t ern. I f you or your
children are in t he age group t o rem em ber t he early video
gam e Pac Man, you can t hink of t he engulfing candle as
being sim ilar t o t he hero of t hat gam e in t hat it eat s or
consum es t he previous candle.
A bullish engulfing candle occurs aft er a significant
downt rend. Not e t hat t he engulfing candle m ust encom pass
t he real body of t he previous candle, but need not surround
t he shadows. Below you will find an illust rat ion of a bullish
engulfing candle:
A bearish engulfing candle occurs aft er a significant upt rend.
Again, t he shadows need not be surrounded. Below you will
find an illust rat ion of a bearish engulfing candle:
The power of t he engulfing candle is increased by t wo
fact ors - - t he size of t he candle and t he volum e on t he day it
occurs. The bigger t he engulfing candle, t he m ore significant
it is likely t o be. A large bullish engulfing candle says t he
bulls have seized cont rol of t he m arket aft er a downt rend.
Meanw hile, a large bearish engulfing says t he bears have
t aken com m and aft er an upt rend. Also, if volum e is above
norm al on t he day when t he signal is given, t his increases
t he power of t he m essage.
A good exam ple of a bearish engulfing candle ending a rally
is found in Avid Technology ( AVI D) , a m aker of video edit ing
soft ware. I n early March t he st ock peaked in conj unct ion
wit h t he S&P 500 and Nasdaq Com posit e j ust above $68. A
few days lat er, when it was t rading at $62, it m ade an
acquisit ion and was punished severely. I nt raday, t he st ock
was off nearly $5 and left a large gap bet ween
approxim at ely t he $60 and $62 level on t he chart . Not e also
t he large volum e spike on t hat day. As we shall see lat er in
t his book, gaps in candlest ick t heory are called " windows,"
and creat e resist ance t o furt her price advances.
AVI D event ually bot t om ed in lat e April at $47.64 and began
t o recover. By m id- June it was back above $60 and t rading
int o t he window it had creat ed t he day of t he acquisit ion.
That in it self should have m ade any long caut ious on AVI D.
Anot her reason for prudence, however, was t hat it was
overbought . I t was out side t he Bollinger band. I n addit ion
t o being in overbought t errit ory on st ochast ics, t here was
also bearish m om ent um divergence. The day aft er t he
bearish engulfing candle, t he st ock gapped dow n.
St ochast ics and CCI gave clear sell signals and t he t rendline
from t he lat e April low was broken soon aft er. AVI D
ret reat ed t o near $51 before finally going out side t he
Bollinger band and becom ing oversold, t hen st aging a
m odest recovery.
The Ut ilit y TXU Corp ( TXU) provides a good exam ple of a
bullish engulfing candle. From a low j ust under $60 in
January, TXU had a spect acular run t o $86.64 before pulling
back. Readers should not e t he st rong support t hat exist ed
bet ween approxim at ely $73 and $74, a level t he shares did
not did go below from February on.
I n a single day in early May TXU went from j ust over $80
dow n t o support at $74. Not e t he long lower shadow w hich
probed out side t he Bollinger band on t his session. While t his
candle does not m eet t he requirem ent s of a ham m er ( t he
shadow is not double t he real body) , t raders should st ill pay
close at t ent ion t o long shadows especially in areas of
support . They suggest t hat t here is buying int erest at t hat
level.
Not e also t he bullish divergence on t he CCI indicat or w hich
was recovering from oversold levels. Traders needed t o wait
t wo addit ional days for t he bullish engulfing candle, but
when it did com e it was a highly reliable signal. The candle
was fairly large as t he st ock m oved alm ost $2.50 on t he
day. CCU subsequent ly recovered t o near $85, j ust below
t he previous highs.
Bullish and bearish engulfing candles warn of t rend change
before it happens. Com bine t he appearance of t hese candles
wit h ot her t echnical t ools such as CCI , and you should
quickly pick up on t rend changes. The abilit y t o spot t he
t rend change is key t o posit ioning yourself on t he right side
of t he m arket , and is vit al for t rading success.
CAN D LE 9 : D ARK CLOUD COVER W ARN S OF
I M PEN D I N G M I N OR TOPS
The candlest ick we will next explore is called " Dark Cloud
Cover." I t is a close relat ive of t he bearish engulfing, but is
not quit e as negat ive in it s im plicat ions. St ill, t he
appearance of t his candle should be a warning t o t he t rader
t o prot ect profit s in a posit ion. I t also suggest s t hat you
should wat ch a st ock as a possible short candidat e in t he
t rading days ahead.
The Dark Cloud Cover candle occurs aft er a st rong upt rend.
A series of ascending candles is ult im at ely " capped" by a
final whit e candle. At t his point , t he st ock or index seem s
t echnically healt hy and t he bulls m ay be lulled int o a sense
of false com placency.
On t he day of t he dark cloud cover, t he st ock opens above
t he previous day's high. For a t rue dark cloud cover t o
em erge, t herefore, t he st ock should ga p a bove t h e u ppe r
sh a dow of t he previous whit e " capping" candle. At t he
opening bell on t his t rading day, it seem s like t he upt rend
will cont inue.
As t he day wears on, however, t he bears wrest cont rol. On
t he dark cloud cover day, t he st ock closes a t le a st h a lfw a y
int o t he previous whit e " capping" candle. The larger t he
penet rat ion of t he previous candle ( t hat is, t he closer t his
candle is t o being a bearish engulfing) , t he m ore powerful
t he signal. Traders should pay part icular at t ent ion t o a dark
cloud cover candle if it occurs at an im port ant resist ance
area and if t he end- of- day volum e is st rong. Below you will
find an exam ple of a Dark Cloud Cover candle:
Film and digit al cam era m aker East m an Kodak ( EK) provides
an exam ple of t he dark cloud cover. The st ock t raded as
high as $33 in April, im m ediat ely before it released earnings
and it s second quart er forecast . Wit h earnings cam e out in
m id- April t he shares were changing hands at j ust above $30.
Result s were below expect at ions, t he st ock dropped
precipit ously on t heir release, gapping down t o $27.16 and
over t he next several days an falling as low at $24.40. As
we shall see when gaps are explored, t he t rader should now
ant icipat e resist ance bet ween $27.16 t he low end of t he gap
and j ust above $30, t he upper end.
Over t he next m ont h and a half, EK began a grudging
recovery, regaining $27, backing off and t hen finding
consist ent support at $26. The shares t hen broke out
form ing four consecut ive whit e candlest icks and reaching a
high of $28.19. While t he t hird candlest ick was not large, it
if t he four candles were com bined int o one, it cert ainly
would have been.
When t he dark cloud cover em erged t herefore, t raders
should have been wary. While t his candle was relat ively
sm all, it ret reat ed half- w ay back int o t he final whit e candle.
The next day a doj i appeared, em phasizing t he resist ance
near $28. EK t hen ret reat ed t oward t he $26 level before
finding support and rallying. While t he Dark Cloud Cover is
not as pot ent a reversal candle as bearish engulfing, it s
appearance in t he chart should be respect ed.
CAN D LE 1 0 : TH E PI ERCI N G CAN D LE I S A POTEN T
REVERSAL SI GN AL
The dark cloud cover and piercing candles are like bookends.
Whereas t he dark cloud cover w arns t hat an upt rend m ight
be com ing t o an end and is t hus a signal t o t ake profit s on
long t rades, a piercing candle int im at es t hat a downt rend
m ay be about t o reverse and short s should be covered.
The first t hing t o look for t o spot t he piercing pat t ern is an
exist ing dow nt rend. Wit h daily candles, t he piercing pat t ern
will oft en end a m inor downt rend ( a downt rend t hat oft en
last s bet ween five and fift een t rading days) . The day before
t he piercing candle appears, t he daily candle should ideally
have a fairly large dark real body, signifying a st rong down
day. Here is an exam ple of t he piercing candle:
I n t he classic piercing pat t ern, t he next day's candle gaps
below t he lower shadow, or previous day's low. I find wit h
st ocks ( in com parison t o com m odit ies) , however, t hat t he
gap is very oft en below t he previous day's close, but not less
t han t he previous day's low.
On t he piercing day, t he candle com es back int o and closes
a t le a st h a lfw a y int o t he real body of day one. I f it does
not com e at least halfway back, t hen t he candle is not a
piercing candle and needs t o be called by a different nam e.
( The candle is " on- neck" if it closes at day one's low, " inneck" if it closes slight ly back int o day one's real body, and
" t hrust ing" if it closes subst ant ially int o t he real body, but
less t han halfway.) I n a