NEW YORK (TheStreet) -- All investors and traders should always strive to put the odds in their favor -- after all, no approach to investing is 100% perfect. Fundamental investors should do their research and comparisons and keep up with the news. Chartists too should have a checklist of technical tools.
When using Japanese candlestick charts, we learned about a three-step approach from Steve Nison, the person most responsible for the rapid adoption of candlestick charting in the U.S. in the 1990s.
The three-step approach to spotting and capitalizing on candlestick reversals requires one to first spot a trend -- up or down -- to reverse. This is a subjective call, as experience will tell us how long of a trend is important.
The second part is identifying the correct pattern. After these two parts are satisfied, the chartist needs to see confirmation the next day or the next week on a weekly chart. Confirmation for a bullish reversal would need a bullish move in the next session.
Let's look at the weekly candle chart of the Dow Jones Industrial Average:
In the chart above we can see the DJIA started a downtrend in May. The accelerating decline in August gives us something to reverse. The last weekly candlestick is what is commonly known as a "hammer." This pattern is dramatic with a big range. Perhaps Japanese rice traders some two hundred years ago drawing on their knowledge of metal working imagined the market was hammering out a bottom.
How is this hammer formed? Starting with Monday's opening, the market moves sharply lower, but by the end of the week, prices rally back and close above the opening. The lower shadow of candle in a proper hammer formation needs to be two to 3x the height of the real body. The real body is the distance from the open on Monday to the close on Friday (see this example).
We can see a similar pattern on the S&P 500 in the chart below.
Now for the last step in the approach. We need to see confirmation. For a bottom reversal pattern like a hammer, we need to see the market closing higher than the open this week.
Time will tell.