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Reading the candle at both ends
By MICHAEL HALLS
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," 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," 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.
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