Shed Light on the Charts With Candlesticks

According to legend, a 17th-century rice trader posted over 100 winning trades in a row using Japanese candlesticks. That would be an amazing streak, if proved to be true. At the least, it highlights the considerable power of this unique market tool.

Steven Nison and Gregory Morris introduced candlesticks to the western world in the 1990s. Since then, they've become more popular than common price bars. But traders still misinterpret these marvels of technical analysis, in spite of their popularity. The problem lies in the inability to place candlestick patterns within the context of other price action.

Candlesticks enable technicians to view two time frames by looking at a single chart. The "real body" shows price movement within a single candle, by highlighting relative movement between the open and close of the bar.

The real body has one color when the open finishes above the close, and a different color when the close finishes above the open. "Shadows" are drawn at the end of each candle. These thin lines show the extremes of price action into the high and low for the time frame of the bar.

A single candle, or a set of candles, can print complex intrabar relationships that yield popular patterns such as dojis or dark cloud cover. But there's a more urgent message within these sets of bars. Experienced eyes can uncover reversal and continuation patterns in the next lower time frame, without looking at a second chart. This adds a third dimension and a market edge that can be applied in real time.

Placing Bollinger Bands over candlesticks generates a synergy that increases the accuracy of price prediction. This powerful combination measures the central tendency in a developing price movement. Simply stated, a rubber band can stretch only so far before it snaps back to the center. A reversal pattern that pieces the upper or lower band predicts a sharp thrust back in the other direction.

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Alan Farley is a professional trader and author of The Master Swing Trader. Farley also runs a Web site called HardRightEdge.com, an online resource for trading education, technical analysis and short-term investment strategies. At the time of publication, Farley was long USA Interactive, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Farley appreciates your feedback and invites you to send it to [e-mail].. Also, click here to sign up for Farley's premium subscription product The Daily Swing Trade brought to you exclusively by TheStreet.com.

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