Recently, I've discussed moving averages and Bollinger bands, two of the most popular chart maven’s tools.
Now I will introduce a special type of chart, the candle chart, also known as the Japanese candlestick chart, and show how to use it to trade financial stocks such as JPMorgan (JPM), Citigroup (C) and Wells Fargo (WFC).
Candle charts have an old and venerated history. According to a Japanese urban legend, they 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, first in the Orient and later in the West, particularly among day traders. Famous chart gurus, such as Dan Fitzpatrick, use candle charts extensively. In, a recent "3 Stocks I Saw On TV" video featuring Nucor (NUE), U.S. Steel (X) and Agnico-Eagle Mines (AEM), all three of his charts were candle charts.
What Candle Charts Tell You About Market Action
Candle charts capture the price action in a concise, visual form. Pictured below is a one-month chart of the Financial Select Sector SPDR (XLF), an ETF that tracks the financial stocks in the S&P 500 index. XLF is used as a barometer for the performance of financial stocks, in this chart from Jan. 2 to Feb. 3.
Source: BigCharts.com
Candle charts focus on the opening and closing prices. Think of the daily market action like a sports contest to determine which is higher: the open or the close. The whistle opens at 9:30 a.m. and closes at 4:00 p.m. The price zigs and zags all day. Who won the game? Was it a close match, or did one side trounce the other?
You see a mixture of grey rectangles and transparent rectangles. The height and color of the rectangles are based on the opening and closing prices for that day. The rectangle’s height is the difference between those prices. The rectangle’s color is based on whether the opening price was higher or lower than the closing price. If the closing price is higher than the opening price, the rectangle is transparent. If the closing price is lower than the opening price, the rectangle is grey.
On most candles, you can see little lines, called wicks, that stick up or down from the rectangle. The height of the wicks is either the difference between the high price and the opening price (for the wicks that stick up) or between the closing price and the low price (for the wicks that stick down).
For example, in the XLF chart above, on Jan. 2, we know the following:
* XLF closed at $12.66, 13 cents higher than its opening price of $12.53. Since the close was higher than the open, the rectangle is transparent.
* During the day, XLF rose to as high as $12.81, 15 cents above its close.
* Also during the day, XLF rose to as low as $12.21, 32 cents below its open.
Multiple Day Patterns Show Large Price Moves
Let’s look at the XLF chart in more depth.
Source: BigCharrts.com
A quick look at the color and the depth of the rectangle tells you both the direction and the strength of the action for that particular day and whether the bulls or the bears won. On Jan. 20, the deep, gray rectangle showed a sharp price drop, from $9.3 to nearly $8. The deep, transparent rectangle on the next day indicated nearly as sharp a recovery, with a close higher than the previous open. Shallow rectangles, such as those that occur on Jan. 2, 5 and 6, indicate indecisive price action, a draw between the bulls and the bears.
Candle chart analysts look for multiple-day patterns. From Jan. 14 to 16, there were three consecutive days, circled in red, when XLF closed lower than its open, with increasing depth, indicating that XLF was falling off a cliff. Although there was another down day on the Jan. 20, the stock ended up going sideways for the next week.
On Jan. 27 and 28, the dates circled in blue, XLF shot up, with two positive days when the stock closed higher than it opened. Unfortunately, this pattern wasn’t confirmed in subsequent trading days.
Your Candle Chart Homework
Your homework is to find the exact time to buy or sell a stock based on its candlestick chart pattern.
Step 1: On Stockpickr, create a portfolio called “Candlestick Chart Trades: [Your Stockpickr Username]". (To create a portfolio on Stockpickr, you'll need to first log in. If you're currently not a Stockpickr member, you can register here.)
Step 2: Pick five stocks you are interested in buying or selling. Using your favorite charting software, such as Bigcharts.com’s interactive charting software, which does a great job with intraday charts, plot an intraday, or one-day, chart of your stocks, with a 15-minute interval.
Can you spot the uptrends and downtrends in price? Can you see the trend reversals? Pick the right time to buy or sell. Check out volume as well; a move on heavier-than-average volume makes the buy or sell signal even stronger. Document the times and prices for your trades in the Reason for Picking box. At the end of the day, did you buy at the lowest point?
Step 3: The next day, repeat Step 2, but use a five-minute interval, giving you 12 candles per hour instead of four. You should get more buy and sell signals, although some of them may be false. Again, pick the time to buy or sell and document in Reason for Picking box. Was your timing better than it was yesterday?
Step 4: Repeat Steps 2 and 3 for the following two days, to hone your skills.
Use caution. Candle chart analysis doesn’t predict the future with 100% accuracy. A pattern may persist, but it may also reverse. I also found this in my Stockpickr portfolio.
Maybe those 18th-century Japanese rice traders knew some things we don’t know.
