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Task №4. Analysis of Japanese candlestick charts

It is rather difficult to trace the history of such a popular analytical technique as the Japanese candlestick charts. It is known that at the beginning of 18th century, the Japanese merchants developed their own approach to the technical analysis that was widely used in trade. Some researchers suppose that one of the founders of the theory was Munehisa Homma, a rice seller.
A candlestick chart has long been used as a basic instrument for the technical analysis of the forex market. Most trading platforms include the Japanese candlestick charts. The tool gained its popularity due to its easy-to-read and flexible charts which include interval and linear approaches.
The Japanese candlesticks can be used together with various methods of technical analysis. Besides, signals from such candlesticks appear earlier than signals from other tools of technical analysis. Moreover, applying the Japanese candlesticks you can indicate such trading signals that cannot be noted via other analytical tools. That is why this method is preferred by most market participants as their principle instrument of technical analysis.
Let’s look at the Japanese candlestick charts in detail. A candlestick consists of four elements: Open, Max, Min, and Close. The Open element stands for the open price, Max indicates the highest price for a particular period of time, Min reflects the lowest price for a particular period of time, and Close shows the close price.
The main advantage of the Japanese candlesticks is that they accurately indicate a market trend, i.e. bearish or bullish. If a candlestick is long and white, the market is under bulls’ control. If it is long and black, the market is bearish. It should be noted that the open price of a long white candlestick does not exceed the close price. However, the open price of a long black candlestick is usually higher than the close price. A situation when open prices equal close prices is called Doji. In this case, a candlestick does not show any signals amid the sideways movement. But, if it appears in the uptrend, the current trend is likely to make a reversal.

Bullish candlestick patterns and their combinations

The Hammer is a single candlestick pattern that has a long lower shadow and a very small upper shadow or it has not it at all. The pattern’s body is rather small and can be black or white. The Hammer appears at the end of the uptrend and signals a trend reversal. The importance of the signal depends on the candlestick’s length.

Hammer

The Bullish Engulfing is another reversal pattern that is characterized by a large white body engulfing a preceding smaller black body. The pattern is formed within the downtrend. Thus, if the second candlestick has a big body, it usually indicates the strengthening of the bullish market.

The Bullish Engulfing. The market is bearish. Then, a bullish white candlestick appears and it engulfs the preceding black candlestick. Thus, the buying pressure overcomes the selling pressure.

The Morning Star is a combination of candlesticks that is composed of a big black candlestick followed by a short black or white candlestick. Besides, the pattern can have another white candlestick. The Morning Star is a meaningful bottom pattern that signals the beginning of the bullish trend. The importance of the signal depends on the extent of how the first candlestick closes the third one.

Reversal pattern Morning Star. The pattern was proved by a big white candlestick that appeared after the Star formation.

Bearish candlestick patterns and their combinations

The Hanging Man is another type of the Japanese candlestick that consists of a long lower shadow and a small white or black body at the top of its daily trading range. The pattern occurs during an uptrend and signals its reversal.  This type of candlestick is opposite to the Hammer. It is desired that the upper shadow is very small, or better nil.

Hanging Man

The Shooting Star consists of a long upper shadow and a small white or black body at the bottom. The pattern occurs in a bullish background. An optimal Shooting Star should appear immediately after an upward gap. The gap and a rather small body indicate a possible decline in prices and bearish prevalence.

Shooting Star

The Bearish Engulfing is a candlestick of a trend reversal. The pattern appears during an uptrend when a large black body is engulfing a preceding smaller white body. The pattern is an important top reversal signal.

Bearish engulfing. It appears during an uptrend. If a large black body is engulfing a preceding smaller white body, it is a top reversal signal. The trading is becoming more bearish.

The Dark Cloud Cover is a top reversal pattern with two candlesticks: black and white. The key point is that the highest price of a white candlestick must be lower than the open price of a black one. At the same time, the close price of a black candlestick is inside the body of a white candlestick. Usually, both candlesticks are long. Moreover, they may not have shadows. The Dark Cover Pattern points to a further downtrend.

Dark Cloud Cover

The Evening Star is a combination of candlesticks that signals a major top reversal. The pattern is composed of a big white candlestick followed by a small black or white candlestick and a big black candlestick. A star appeared on the top indicates that the trend is changing to the bearish, and a long black candlestick that appears after the gap ends the reversal. The bigger the body of the third candlestick is and the smaller the first candlestick is, the stronger the tendency is.

Evening Star. After a long upward movement, a star is a signal of a possible trend reversal.

Windows (Gaps)

The Windows as they are called in the Japanese Candlestick Charting, or Gaps, as they are called in the West, are an important concept in technical analysis. In the West, people usually say “fill the gap” whereas in Japan, “close the window” is more common.
Thus, a window is a price gap between the current open price and the prior closing price.

If a window appears during an uptrend, it proves a further rise. Engulfing signals that the trend will change.

In the picture, you can see a window during a descending movement. There is no price change between lower shadow of the prior candlestick and upper shadow of the current candlestick.

Windows during a downtrend as patterns of continuation.  Note that the trend reversal was indicated by such reversal patterns as Piercing Pattern and Bullish Engulfing.

In Japan, traders suppose that they should open a deal in the direction indicated by a window. A window also forms zones of support and resistance. Thus, if a window appears during an uptrend, a price will continue rising. In case a price falls, a window will act as support. However, if a window closes after a decline, and buyers’ pressure does not change, the prior uptrend is supposed to be closed.
If a window appears within a downtrend, a price will fall. All corrective increases will meet resistance at this level. If a window is closed, but prices keep on growing, the downtrend is over.

Questions for revision
  1. Describe the main criteria of The Morning Star.
  2. What is the difference between such bearish patterns as Engulfing and Dark Cloud Cover?
  3. What is the Evening Star? What can happen if the pattern appears in a chart?
  4. After which trend the Morning Star can be formed?
  5. How can you understand the importance of the Evening Star signal?
  6. What will you do, if during a downtrend a window appears?
    1. close the opened position;
    2. open a short position;
    3. add to the opened position;
    4. open a long position.

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