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Checking out the competition: Line, bar, and point and figure charts versus candlesticks

      Ever wonder why a trader or investor would choose candlestick charts over other types of charts when analyzing price action of investments or markets? Well, this chapter provides some answers.

      Trading and investing aren’t easy undertakings, and they’re certainly not easy professions. Most traders — professional and amateur alike — and investors struggle just to keep up with the market’s performance as measured by the Standard & Poor’s 500 index (S&P 500). The S&P 500 is an index comprised of 500 of the largest stocks traded in the United States and is considered to be representative of the stock market as a whole.

      

To be one of the successful few who beat the market and other market participants, you should strive to develop a competitive advantage or some unique insight, commonly referred to as your edge, that you believe most market participants aren’t using or considering. I can’t say that using candlestick charting provides an edge by itself — and I have to say that it does come with a couple of potential problems. But when you combine it with recurring patterns and other technical indicators, you can find your edge!

      BRIEF HISTORY OF CANDLESTICK CHARTING

      The history of candlestick charting stretches back to Japanese rice traders in the 17th or 18th century. This fact is why candlestick charts are frequently referred to as Japanese candlestick charts. A very smart man named Munehisa Homma developed the methodology of monitoring the price of daily rice trading, and his methods eventually evolved into what traders and other market watchers call candlestick charting.

      Homma found that having a visual representation of daily rice trading allowed him to make more informed buy-and-sell decisions during the hectic trading day. It’s said that Homma once had a streak of more than 100 winning trades!

      Fast-forward to the early 1990s, when Steve Nison published a book and a magazine article on candlestick charting. Until then, candlestick charting wasn’t widely used. Nison’s first book, Japanese Candlestick Charting Techniques (Prentice Hall Press), served as an introduction to candlestick charting methods for many traders and investors in the United States, including yours truly. In the years that followed, the acceptance and use of candlestick charting became widespread, and the use of computer software for analyzing recurring patterns proved to be profitable for many traders.

In this chapter, I cover the good and bad of candlestick charts, and I review a handful of alternative charting methods. In the end, you’ll understand why candlestick charting is the way to go!

Recognizing the Many Benefits of Candlestick Charting

      Trading, investing, and charting styles are plentiful. You can spend hours debating what type of approach to the markets is best. For me and a growing number of other traders, the benefits of a candlestick chart versus other types of charts aren’t really debatable. Let me tell you why.

      Changes and developments in the way stocks and other securities are traded (and when they’re traded) have made trading an increasingly complex undertaking. (For more info, see the nearby sidebar “What makes up a day?”) Because trading is becoming more complex, the need for a consistent, dynamic charting method is more important than ever. Traders need easy-to-read charts that allow them to make quick decisions and analyze patterns efficiently. Candlesticks offer those benefits and many more, all of which are covered in this section.

      WHAT MAKES UP A DAY?

      The definition of a trading “day” used to be very simple. Trading was done on a central exchange with specific opening and closing times. Trading on stocks listed on the New York Stock Exchange (NYSE) or Nasdaq, for example, began at 9:30 a.m. and ceased at 4 p.m. These days trading in these stocks commences on some electronic communication networks (ECNs) hours before the formal listed exchanges open hours. (An ECN is a network of brokerage firms and traders, which allows for trading directly between the brokerage firms and traders.) A “day,” therefore, is much different from what it was in the past. Throw in futures exchanges and currency markets that trade almost 24 hours a day, and this issue becomes even more confusing. With all that trading going on outside exchange hours, what constitutes an actual day for data purposes?

      Currently, in the case of stocks, the official open and close are based on the primary exchange they trade on, but in this world of expanding electronic trading, the actual open and close are becoming more blurred. With respect to futures markets that trade almost 24 hours a day, it’s almost impossible to pin down a day. For daily testing, I use data between 7 a.m. Eastern Time and the close at 3 p.m. to constitute a day.

      Seeing is believing: Candlesticks are easy to read

It sounds pretty simplistic, but one noteworthy advantage candlesticks have over other charts is readability. For many people who strain to read fine print, and also for the younger traders who don’t want to deal with the headaches that can come from staring at bar charts all morning, candlesticks are an attractive option. Consider Figure 2-1, which compares a bar and a candlestick.

      Figure 2-1 gives you a basic idea why candlesticks are easier to read, but it doesn’t provide a full picture of why they’re also much better at helping traders visually interpret price action (how the stock or market traded during the day relative to the opening price), which is an essential skill for successful trading. Figure 2-1 shows how a single day would be displayed on a bar chart and a candlestick chart.

      FIGURE 2-1: A bar versus a candlestick.

Notice the dramatic difference between the bar chart and the candlestick chart. By comparing them, you can clearly interpret what occurred from day to day, including the openings, closings, and how they change from day to day. The candlestick chart is superior to a bar chart for interpreting price action from day to day. Don’t worry; I cover how to read candlestick charts extensively in several other chapters. But even in this simplistic example, you can see that knowing where a stock closed relative to its open on a given day is a powerful piece of information that you can glean quickly from a candlestick chart.

      Spotting bears and bulls quickly

      Knowing a security’s closing price relative to its opening price during a certain period is vital information. Candlestick charts allow you to quickly identify the days when a closing price is above an opening price, and vice versa.

      

I like to think of the daily price action as a battle between bears and bulls. Bears win when the price of a security closes lower than its open, and bulls win on the days when the close settles higher than the open.

Figure 2-2 is a great example of bearish and bullish days on a candlestick chart. Although the two candlesticks are the same size and shape, you can tell the difference between a bear and a bull:

       The bear: The black filled-in candlestick indicates a bearish performance by the security because the close is much lower than the opening price.

       The bull: The hollow white candlestick indicates a bullish performance, meaning that the opening is lower than the close.

      Figure 1-1 in Chapter 1 covers hollow candlesticks

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