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By MICHAEL HALLS
In the last five years
candlestick charting —
known to Japanese market
analysts for centuries — has
become increasingly
popular in the west. But
what is it ? And how does it
work ? Technical analysis is not an
invention of the west. For more than two centuries Japanese analysts have used
a system of predicting market movements by diagrams called candlestick charts.
Until the beginning of the 1990s, these charts were rarely, if ever, used by
western analysts, yet they are predicated on the same principles as orthodox
analysis — graphic shapes that help visualize the direction of a market.
Candlestick
charts contrast two features in the market at any trading interval — the
trading range during the day and the market's opening and closing level.
The
trading range is expressed by a thin line going from the bottom
to the top. A thick line, shaped like a candle, represents the open and close
of the market. If the market goes up during the day, the candle is white, if
it goes down the candle is red. (In modern usage this is black.)
Candlesticks
charts, like much technical analysis, put great emphasis on the psychological
relationship between the movements of markets and their openings and closings.
The opening and closing moments are key points in the life of the market and
indicate the direction — and trading mentality — for the day and
the market.
The opening, for example, provides the first clue as to the direction
of the market that day. All the overnight information and speculation has come
to a head. The more anxious a trader feels, the earlier they want to trade. Shorts
may be looking for cover, longs looking to buy. And hedgers may need to take
a new position.
A similar barrage of sentiments will be found at the close of
the day — the time most futures traders decide on market direction.
As
a very simple example, the shooting star illustrates the depth
of market feeling. Here
the trading range — as expressed by the thin line — goes up. However,
the solid block of the candle is small
and red (the market close is only slightly lower than its start). This reveals
that the market tested new levels during the day but could not support them.
The immediate comparison would be one
of using resistance levels — floors and ceilings. There is a close similarity
between candlestick patterns and western terms: the three Buddha top, for example,
corresponds to a head and shoulders formation. "Technical
analysts are realizing that anything you can do with a bar chart in western
terms, you can do with a
candlestick ... "
"Technical analysts are realizing
that anything you can do with a bar chart in western terms, you can do with a
candlestick," says Steve Nison, senior vice president at Daiwa Securities
America Inc, the author of Japanese Candlestick Charting Techniques and leading
US exponent of their use since the 1980s. "And while bar charts will show
you trends within a market, candles can show the trends and the forces behind
them."
One of the main UK protagonists of them, Michael Feeny, economist
at Sumitomo Bank. agrees: "They are immensely flexible and provide a powerful
addition to more common chartist techniques and an extra dimension to your
breakdown
of future trends."
A New York analyst agrees: "They're widely used
by the Japanese in our markets. So by using them, we can get a valuable insight
into the way Japanese institutions are buying and selling.
"They're very
big, for example, in US Treasury refundings, where the Japanese play a leading
role. Quite often you can second-guess something that is not immediately obvious
by looking at the market in the same way as Japanese analysts."
Candlestick
charting should not be used in isolation to other analytical techniques. It
has two structural weaknesses.
The first is that it focuses on the opening
and closing moments of the market — something that is largely absent from
foreign exchange trading, where the markets never sleep.
"
But there
are ways round this," argues one Canadian analyst. "For example, you
can take snapshots of the close of day at London, New York and Tokyo as the new
market takes over. Also, I've been working on taking one-hour cross-sections
of trading patterns as a way of getting over this."
The other flaw with
candlestick charting is that by focusing on market positions at set moments
of the day, it only pays lip-service to market fundamentals. However this is
a frequent charge leveled at much technical analysis concerned with near-term
position taking rather than underlying fundamentals. Many traders are now using
candlesticks as part of their armory. The thinking behind candlestick charting
fits well with trading psychology. The militaristic language used to describe
market trends; for example, such as hanging man, or dark cloud cover, echo the
bearish sentiments contained within the diagram.
There
are about 50 basic candlestick patterns that describe the features of a market — of
which about 10 will be used most days — but candlestick charting is now
being developed hand in hand with western techniques.
"Candlestick techniques
become even more significant if they confirm a western technical signal ... "
"Candlestick techniques
become even more significant if they confirm a western technical signal," says
Steve Nison. This method of looking for confirmation from different technical
indicators is called the rule of multiple techniques. It states that the more
technical indicators that assemble at the same price area, the greater the
chance of an accurate forecast.
The rise of candlestick charting in the US — and
latterly the UK — has been phenomenal. Just 10 years ago the technique
was hardly known outside a few esoteric circles in the US, now candlestick
charts can be obtained on Reuters and Bloomberg screens. The latest step in their
development is
the race to automate recognition of set patterns.
The Origins of Charting
The origins of chartism the origins of candlestick charting go back to one of
the great futures and options markets at the Dojima Rice Exchange in Osaka, where
in the 18th century warehouse coupons were issued instead of physical delivery
of sacks of rice.
Into this market came Munehisa Homma in tfhe l'75Qs. Homma's family, who lived
in Sakata, had a huge rice farming estate, and held considerable sway over the
market. Over the years Homma kept careful records, of rice prices, weather
conditions and records of trading on the exchanges.
The conclusions enabled him to understand the psychology of investors and forecast
the direction of themarkets.
His accuracy in prediction was such that he never left home to cnoduct his trades.
Instead, he placed men on the tops of houses from Osaka to Sakata with a series
of flags giving his selling or buying instuctions.
The results of his discoveries form the basis of candlestick charting techniques
and the term Sakata's rules is frequently used in Japanese candlestick literature.
from Treasury Manager
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