Candlestick Patterns; The Basic of Stock Prices and FX Charts

The first time I looked at a stock price chart, I was confused by the shapes and design of what is called “candlestick charts.”  These kinds of charts are easily identified by their distinctive empty or filled vertical sticks.

candlestick pattern

These charts can actually be quite complicated. One new popular trading app, Robinhood for example, shows price changes as lines in order to avoid candlestick chart complexity. However, the complexity of the candlestick is what allows this style of charting to reveal so much information. This information is so valuable and interesting that candlestick patterns have been developed and analyzed since the 17th century in Japan.

Even as we specialize in advanced emerging technology such as AI and deep learning, we also make the most out of proven analytics such as candlestick patterns.  Last month, we released AlpacaScan, a daily notification that screens chart patterns based on popular candlestick configurations. Next we explain the basics of candlestick patterns.

 

What is a ‘candlestick’?

A candlestick displays price changes for an unit period, such as 1 minute, 5 minutes, 15 minutes, 1 hour, 4 hours, 1 day or 1 week.[1] It is called ‘candlestick’ because the shape resembles a candlestick.

スクリーンショット 2016-06-17 10.10.21

A candlestick pattern shows the high, low, open and close values. The thick portion of the candlestick that is either hollow or filled is called “the real body” while the long thin lines that resemble candle wicks above and below the body are called “shadows.”

 

Basic candlesticks

There are nine basic candlestick shapes.

スクリーンショット 2016-06-17 10.12.56

Although the shapes appear simple,they reveal a great deal of information about price changes quickly and visually. Although each candlestick  displays multiple data points ,  much more highly valuable information can be extracted from a set of candlesticks.

 

The history of candlestick pattern according to Wikipedia

Some of the earliest technical trading analysis was used to track prices of rice in the 17th century. Much of the credit for candlestick charting goes to Munehisa Homma (1724–1803), a rice merchant from Sakata, Japan who traded in the Ojima Rice market in Osaka during the Tokugawa Shogunate.[2]

In 1755, he wrote (三猿金泉秘録, San-en Kinsen Hiroku, The Fountain of Gold – The Three Monkey Record of Money), the first book on market psychology. In this, he claims that the psychological aspect of the market is critical to trading success and that traders’ emotions have a significant influence on rice prices. He notes that recognizing this can enable one to take a position against the market: “when all are bearish, there is cause for prices to rise”(and vice versa).

He describes the rotation of Yang (a bull market), and Yin (a bear market) and claims that within each type of market is an instance of the other type. He appears to have used weather and market volume as well as price in adopting trading positions.[3]

 

Academic proof

Japanese candlesticks differ from the typical North America bar chart style in the way it is visually represented. Although both identify the same points of open, close, high and low, the stylistic properties of the candlestick put a visual emphasis on the relationship between the opening and closing prices with the same day and within a larger pattern. Many chartists and technical analysts make use of these visual cues to better understand the market sentiment.

Candlestick pattern analysis however, is very complex, and the usefulness of a pattern depends on certain external factors. For example, because candlestick chart patterns have become so popular over the last several years, many financial firms have invested a great deal in deconstructing known patterns and developing algorithms to take advantage of that. The automation of trading means that market movement and sentiment can be captured much more quickly and alter the meaning of the candlestick in ways not previously conceived.

Despite the accelerated evolution in candlestick analysis, reliable patterns that stay true to the fundamentals continue to appear, allowing for short and long term profit opportunities.

There is a man who takes an in-depth look at 103 candlestick formations, from identification guidelines and statistical analysis of their behavior to detailed trading tactics. His name is Thomas Bulkowski and he published a bestseller, “Encyclopedia of Candlestick Charts”.[4]

 

At the next post, I am going to introduce AlpacaScan, and will walk you through how members at Alpaca use it to actually make trades.

 

[1] “Candlestick Definition’(http://www.investopedia.com/terms/c/candlestick.asp)
“Introduction to Candlesticks”(http://stockcharts.com/school/doku.php?id=chart_school:chart_analysis:introduction_to_candlesticks)
[2] “Wikipedia:Candlestick pattern”(https://en.wikipedia.org/wiki/Candlestick_pattern)
[3]
Wikipedia:Homma Munehisa”(https://en.wikipedia.org/wiki/Homma_Munehisa)
[4](http://www.amazon.com/Encyclopedia-Candlestick-Charts-Thomas-Bulkowski/dp/0470182016/ref=la_B001IGOYSE_1_3?s=books&ie=UTF8&qid=1464993282&sr=1-3)

 

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