Technical Stock-Picking: Candle Charts Can Light Your Way

This technical analysis-based assignment was written by Stockpickr member Ira Krakow.

Candle charts, also known as Japanese candlestick charts, have an old and venerated history, particularly in the Far East. According to a Japanese urban legend, candlestick charts were invented by Homma Munehisa, an 18th century rice merchant who traded in the Ojima Rice Market in Osaka. Legend has it that he was successful in 100 out of 100 trades.

With such a track record, candle charts developed quite a following, particularly among futures traders. Candle charts are now so widely used by stock traders and investors alike that most charting software can display them. So what's the big deal with these candlesticks?

Both the commonly used open-high-low-close (OHLC) charts and candlestick charts display the same price data. However, candle charts give you a much clearer picture of the stock's price action.

How to Profit From the Chart Zen Masters

Suppose that on Feb. 6, you decided to buy Yahoo! (YHOO) because you thought that, at $29 per share, the price will rise to at least the $31 per share offer of Microsoft (MSFT), (see "Microsoft Moves on Yahoo!") or perhaps that another company will bid more than $31 per share for the company. Your plan is to time your stock purchase so that you buy at the lowest price of the day.

That's where charts and candlesticks come in.

We can use a chart to identify the optimal buy point. Here's an intraday OHLC chart of Yahoo!, with each bar representing 15 minutes of Feb. 6's trading.

Click here for larger image.

Source: BigCharts.com

The height of each solid rectangle is represented by the difference between the high and the low price. A tick mark on the rectangle shows the open price, while a tick mark on the right shows the close price. Here's the same data in a candlestick chart.

Click here for larger image.

Source: BigCharts.com

The candle chart, instead, shows the open and close prices as a rectangle -- either transparent when the close is higher than the open or gray when the close is lower than the open. The lines that extend above or below each rectangle are called "wicks." These wicks show the difference between the high and open, and the low and close prices, respectively.

While a deep rectangle indicates a large move, a small rectangle (or a line if the close equals the open, a pattern known as a "doji") means little or no strength in the price change. The three transparent candles enclosed in the green ellipse show a strong uptrend (called the "Three White Soldiers" pattern), while the grsy candles enclosed in the two red ellipses highlight two downtrends. With the OHLC chart, it's difficult to pick these trends up visually.

Trend Reversal Patterns Tell You When to Buy or Sell

What you're really looking for when timing your buys or sells are trend reversals -- bullish reversals that signal the start of an uptrend and a potential buy point or bearish reversals that signal the start of a downtrend and a potential sell point. Here's the Yahoo! chart with possible bullish reversals, indicating potential buy points (circled in blue).

Click here for larger image.

Source: BigCharts.com

When you see a white rectangle immediately after a grey rectangle, this could signal a reversal from bearish to bullish. Unfortunately, you can't rely on just these two candles. In the first signal, appearing just after 10 a.m. (known as a "bullish harami"), the bearish trend indeed reversed. However, the second signal (a "bullish engulfing pattern"), turned out to be false, because the bearish trend continued afterwards.

Before rushing to buy, you need to confirm the pattern by combining your analysis with other technical indicators, such as moving averages, Bollinger Bands and volume trends. It may also pay to wait, watching for later candles that confirm the trend. You could also refine your charting to highlight a trend by shortening the time (say, every five minutes, giving 12 candles per hour) when a candle is produced.

To learn how to view candle charts on your own, check out the appendix at the end of this assignment.