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WHY DO CANDLESTICKS WORK?
The Japanese first started using candlestick technical analysis hundreds of years ago to trade the rice futures. But why do candlestick charts give such an amazingly accurate summary of the market sentiment? In this report, we will explore some of
the inner workings of the candlestick and how they can help us better trade the market. Below is a diagram of a green candlestick (shown in Exhibit 1). The green color of the candlestick indicates that the closing price of the stock at the end of the day is higher than the opening price at the beginning of the day. As you will see, the candlestick's color and size provide very important clues regarding the TRADER'S SENTIMENT toward a given stock's future price. Notice that 'trader's sentiment' is the key phrase here. In short term trading, it is critical for the trader to have a clear understanding of what other traders are thinking. As you will see, the most direct way to get that understanding is through proper interpretation of the candlestick. Let's look at an example. Below is a candlestick of XYZ company which opened at 25 and closed at 25 3/8. The candlestick is green in color, which gives us a quick visual signal that the stock price has rallied higher during this period.
Exhibit 1.
How can we use this information to help us understand what other traders are thinking? To answer this question, we will follow the candlestick's changes step by step to understand the mechanism which is driving the stock price to move higher. In Exhibit 2, we see the stock opens at 25, and then quickly rallies to 25 1/8. The reason the price moves to 25 1/8 is because there is a high demand to buy the stock at 25 1/8, and a short supply of sellers offering stock at 25 1/8. Once all of the stock available at 25 1/8 is snatched up, the next group of sellers step up to offer their stock at 25 1/4. All of the 25 1/4 stock is quickly snatched up because there is still a larger number of traders willing to buy at 25 1/4 than sellers willing to sell stock at 25 1/4. Once the 25 1/4 stock is gone, the next group of sellers step up to offer their stock at 25 3/8. The 25 3/8 stock is quickly snatched up too. This process will repeat itself until the buyers loose interest in buying the stock resulting in a reduction of demand. The result of combining these steps is a green candlestick with an opening price of 25, rallying to a closing price of 25 3/8. During the rally period; however, the astute candlestick reader will be able to observe the long green color of the candlestick, and deduce that buyer demand is high. Now there is only one reason why traders would increase demand by stepping up to buy the stock, and that is because they think that the stock will go up in the near future. So by observing the candlestick color and size, the astute candlestick reader is able to deduce exactly what other traders are thinking, and that is that they think the stock price will go higher in the future.
Exhibit 2.
In Exhibit 3 & 4 we show an example of how the same principle in reverse applies to the analyses of a red candlestick. Below is a diagram of a red candlestick (shown in Exhibit 3). The red color of the candlestick indicates that the closing price of the stock at the end of the day is lower than the opening price at the beginning of the day.
Exhibit 3.
In Exhibit 4, we see the stock opens at 25 3/8, and then quickly drops to 25 1/4. The reason the price moves to 25 1/4 is because there are many sellers looking to unload there stock at 25 1/4, and a low number of buyers willing to buy at 25 1/4.
Once all of the buyers have bought the stock at 25 1/4, the next group of buyers step up to bid for stock at the lower price of 25 1/8. All of the stock at 25 1/8 is quickly sold by the desperate sellers, and then the next set of buyers step up at the price of 25. This process will repeat itself until all of the sellers have unloaded all of the stock that they want to sell, resulting in a reduction of supply. The result is a red candlestick with an opening price of 25 3/8, falling to a closing price of 25. During the stock's price fall; however, the astute candlestick reader will be able to observe the long red color of the candlestick, and deduce that demand for the stock is low. Now there is only one reason why traders would increase the the supply of stock to sell, and that is because they think that the stock will go down in the near future. So by observing the candlestick color and size, the astute candlestick reader is able to deduce exactly what other traders are thinking, and that is that they think the stock price will go lower in the future.
Exhibit 4.
You have probably noticed that during this analysis we have not mentioned any details about the actual company who's stock is being traded. The reason for this is because in short term trading, the most important element is a good understanding of what other traders are thinking about the direction of a stock's price, and not so much knowledge regarding the company itself. As shown in our example, the only element that will move a stock's price higher, is the willingness for another trader to buy it at a higher price. A stock can have rock solid financials, a stellar ROI and earnings per share number, but if no one is willing to buy the stock, it will not go up! This is why it is so important to learn how to read the market through the eyes of other traders, not just through the eyes of a financial analyst. The best way to see a stock through the eyes of the entire market is by looking at the candlestick chart to methodically unravel the clues, regarding the sentiments of other traders.
Alan Williams
www.candlestickshop.com
If you have any questions regarding this report or the CANDLESTICKSHOP.COM website in general, please do not hesitate to contact the author at
staff@candlestickshop.com
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