Candle Stick Anatomy - Technical Analysis

We discuss about what is technical analysis , assumptions of technical analysis and the chart types of technical analysis in the last posts . Today we discuss about candlestick chart which is very important . 

Candlestick Anatomy - Technical Analysis :

While in a bar chart the open and the close prices are shown by a tick on the left

and the right sides of the bar respectively, however in a candlestick the open and close prices are displayed by a rectangular body.

In a candle stick chart, candles can be classified as a bullish or bearish candle usually represented by blue/green/white and red/black candles respectively. Needless to say, the colors can be customized to any color of your choice; the technical analysis software allows you to do this. In this module we have opted for the blue and red combination to represent bullish and bearish candles respectively.

Let us look at the bullish candle. The candlestick, like a bar chart is made of 3 components.

The Central real body :

The real body, rectangular in shape connects the opening and closing price

Upper shadow :

Connects the high point to the close

Lower Shadow :

Connects the low point to the open

Have a look at the image below to understand how a bullish candlestick is formed:

This is best understood with an example. Let us assume the prices as follows..

Open = 62
High = 70
Low = 58

Close = 67

Likewise, the bearish candle also has 3 components:

The Central real body :

The real body, rectangular in shape which connects the opening and closing price. However the opening is at the top end and the closing is at the bottom end of the rectangle

Upper shadow :

Connects the high point to the open

Lower Shadow :

Connects the Low point to the close

This is how a bearish candle would look like:

This is best understood with an example. Let us assume the prices as follows..

Open = 456
High = 470
Low = 420

Close = 435

Here is a little exercise to help you understand the candlestick pattern better. Try and plot the candlesticks for the given data.

If you find any difficulty in doing this exercise, feel free to ask your query in the

comments box .

Once you internalize the way candlesticks are plotted, reading the candlesticks to identify patterns becomes a lot easier.

This is how the candlestick chart looks like if you were to plot them on a time series. The blue candle indicates bullishness and red indicates bearishness.

Also note, a long bodied candle depicts strong buying or selling activity. A short
bodied candle depicts less trading activity and hence less price movement.

To sum up, candlesticks are easier to interpret in comparison to the bar chart. Candlesticks help you to quickly visualize the relationship between the open and close as well as the high and low price points.

In this post we learn about two types of candlesticks – Bullish candle and Bearish candle. The structure of the candlestick however remains the same .

In the next post we will go to learn about time frames .

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The Chart Types In Technical Analysis

As we discuss about what is Technical Analysis and difference between technical analysis and fundamental analysis by example in last post . We also discuss about Assumptions and versatility of Technical Analysis . Today we are going to discuss about The Chart Types In Technical Analysis .

Having recognized that the Open (O), high (H), low (L), and close (C) serves as the best way to summarize the trading action for the given time period, we need a charting technique that displays this information in the most comprehensible way. If not for a good charting technique, charts can get quite complex. Each trading day has four data points’ i.e the OHLC. If we are looking at a 10 day chart, we need to visualize 40 data points (1 day x 4 data points per day). So you can imagine how complex it would be to visualize 6 months or a year’s data.

As you may have guessed, the regular charts that we are generally used to – like the column chart, pie chart, area chart etc does not work for technical analysis. The only exception to this is the line chart.

The regular charts don’t work mainly because they display one data point at a given point in time. However Technical Analysis requires four data points to be displayed at the same time.

Below are some of the chart types of Technical Analysis :

1. Line chart
2. Bar Chart
3. Japanese Candlestick

The focus of this post will be on the Japanese Candlesticks however before we get to candlesticks, we will understand why we don’t use the line and bar chart.

The Line Chart Of Technical Analysis :

The line chart is the most basic chart type and it uses only one data point to form the chart. When it comes to technical analysis, a line chart is formed by plotting the closing prices of a stock or an index. A dot is placed for each closing price and the various dots are then connected by a line.

If we are looking 60 day data then the line chart is formed by connecting the dots of the closing prices for 60 days.

The line charts can be plotted for various time frames namely monthly, weekly, hourly etc. So ,if you wish to draw a weekly line chart, you can use weekly closing prices of securities and likewise for the other time frames as well.

The advantage of the line chart is its simplicity. With one glance, the trader can identify the generic trend of the security. However the disadvantage of the line chart is also its simplicity. Besides giving the analysts a view on the trend, the line chart does not provide any additional detail. Plus the line chart takes into consideration only the closing prices ignoring the open, high and low. For this reason traders prefer not to use the line charts.

I hope you clearly understand why line chart is not important for technical analysis . If you have any query or doubt write down in comment box . Now we discuss about bar chart .

The Bar Chart Of Technical Analysis :

The bar chart on the other hand is a bit more versatile. A bar chart displays all the four price variables namely open, high, low, and close. A bar has three components.

The central line :

The top of the bar indicates the highest price the security has reached. The bottom end of the bar indicates the lowest price for the same period.

The left mark/tick :

indicates the open

The right mark/tick :

indicates the close

For example assume the OHLC data for a stock as follows:

Open – 67
High – 70
Low – 60
Close – 64

For the above data, the bar chart would look like this:

As you can see, in a single bar, we can plot four different price points. If you wish to view 5 days chart, as you would imagine we will have 5 vertical bars. So on and so forth.

Note the position of the left and right mark on the bar chart varies based on how the market has moved for the given day.

If the left mark, which represents the opening price is placed lower than the right mark, it indicates that the close is higher than the open (close > open), hence a positive day for the markets. For example consider this: O = 46, H = 51, L = 45, C = 49. To indicate it is a bullish day, the bar is represented in blue color.

Likewise if the left mark is placed higher than the right mark it indicates that the
close is lower than the open (close <open), hence a negative day for markets. For example consider this: O = 74, H=76, L=70, C=71. To indicate it is a bearish day, the bar is represented in red color.

The length of the central line indicates the range for the day. A range can be defined as the difference between the high and low. Longer the line, bigger the range, shorter the line, smaller is the range.

While the bar chart displays all the four data points it still lacks a visual appeal. This is probably the biggest disadvantage of a bar chart. It becomes really hard to spot potential patterns brewing when one is looking at a bar chart. The complexity increases when a trader has to analyze multiple charts during the day.

Hence for this reason the traders do not use bar charts. However it is worth mentioning that there are traders who prefer to use bar charts. But if you are starting fresh, I would strongly recommend the use of Japanese Candlesticks. Candlesticks are the default option for the majority in the trading community.

History of the Japanese Candlestick :

Before we jump in, it is worth spending time to understand in brief the history of
the Japanese Candlesticks. As the name suggests, the candlesticks originated from Japan. The earliest use of candlesticks dates back to the 18th century by a Japanese rice merchant named Homma Munehisa.

Though the candlesticks have been in existence for a long time in Japan, and are probably the oldest form of price analysis, the western world traders were clueless about it. It is believed that sometime around 1980’s a trader named Steve Nison accidentally discovered candlesticks, and he actually introduced the methodology to the rest of the world. He authored the first ever book on candlesticks titled “Japanese Candlestick Charting Techniques” which is still a favorite amongst many traders.

Most of the pattern in candlesticks still retains the Japanese names; thus giving an oriental feel to technical analysis.

Conclusion Of The Chart Types In Technical Analysis :

1. Conventional chart type cannot be used for technical analysis as we need to plot 4 data points simultaneously

2. Line chart can be used to interpret trends but besides that no other information can be derived

3. Bar charts lacks visual appeal and one cannot identify patterns easily. For this reason bar charts are not very popular

                  We are going to discuss about Candlestick Anatomy in next post . If you have any query or suggestions write in the comment box . 

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Technical Analysis - Introduction

Everyone want success in stock market . But very few people achieve it . First of all we have to know that developing a well researched point of view is critical for stock market success . A good point of view should have a directional view and should also include information such as:

1. Price at which one should buy and sell stocks

2. Risk involved

3. Expected reward

4. Expected holding period

Technical Analysis (also abbreviated as TA) is a popular technique that allows you to do just that. It not only helps you develop a point of view on a particular stock or index but also helps you define the trade keeping in mind the entry, exit and risk perspective.

Like all research techniques, Technical Analysis also comes with its own attributes, some of which can be highly complex. However technology makes it easy to understand. We will discuss this attribute latter .

Technical Analysis, what is it?

Consider this analogy.

Imagine you are vacationing in a foreign country where everything including the language, culture, climate, and food is new to you. On day 1, you do the regular touristy activities, and by evening you are very hungry. You want to end your day by having a great dinner. You ask around for a good restaurant and you are told about a nice food street which is close by. You decide to give it a try.

To your surprise, there are many vendors selling different varieties of food. Everything looks different and interesting. You are absolutely clueless as to what to eat for dinner. To add to your dilemma you cannot ask around as you do not know the local language. So given all this, how will you make a decision on what to eat?

Well, you have two options to figure out what to eat.

Option 1:

You visit a vendor, figure out what they are cooking / selling. Check on the ingredients used, cooking style, probably taste a bit and figure out if you actually like the food. You repeat this exercise across a few vendors, after which you would most likely end up eating at a place that satisfies you the most.

The advantage with this technique is that you know exactly what you are eating since you have researched about it on your own. However on the flip side, the methodology you adopted is not really scalable as there could be about 100 odd vendors, and with limited time at your disposal, you can probably cover about 4 or 5 vendors. Hence there is a high probability that you could have missed the best tasting food on the street!

Option 2: 

You just stand in a corner and observe all the vendors. You try and find a vendor who is attracting the maximum crowd. Once you find such a vendor you make a simple assumption -‘The vendor is attracting so many customers which means he must be making the best food!’ Based on your assumption and the crowd’s preference you decide to go to that particular vendor for your dinner. Chances are that you could be eating the best tasting food available on the street.

The advantage of this method is the scalability. You just need to spot the vendor

with the maximum number of customers and bet on the fact that the food is good based on the crowd’s preference. However, on the flipside the crowd need not always be right.

If you could recognize, option 1 is very similar to Fundamental Analysis where you research about a few companies thoroughly. We will explore about Fundamental Analysis in greater detail in the other blog .

Option 2 is very similar to Technical Analysis where one scans for opportunities based on the current trend aka the preference of the market.

Technical Analysis is a research technique to identify trading opportunities in market based on the actions of market participants. The actions of markets participants can be visualized by means of a stock chart. Over time, patterns are formed within these charts and each pattern conveys a certain message. The job of a technical analyst is to identify these patterns and develop a point of view.

Like any research technique, technical analysis stands on a bunch of assumptions. As a practitioner of technical analysis, you need to trade the markets keeping these assumptions in perspective. Of course we will understand these assumptions in details as we proceed along.

Also, at this point it makes sense to throw some light on a matter concerning FA and TA. Often people get into the argument contending a particular research technique is a better approach to market. However in reality there is no such thing as the best research approach. Every research method has its own merits and demerits. It would be futile to spend time comparing TA and FA in order to figure out which is a better approach.

Both the techniques are different and not comparable. In fact a prudent trader would spend time educating himself on both the techniques so that he can identify great trading or investing opportunities.

Setting expectations in Technical Analysis :

Often market participants approach technical analysis as a quick and easy way to make a windfall gain in the markets. On the contrary, technical analysis is anything but quick and easy. Yes, if done right, a windfall gain is possible but in order get to that stage one has to put in the required effort to learn the technique.

If you approach TA as a quick and easy way to make money in markets, trading

catastrophe is bound to happen. When a trading debacle happens, more often than not the blame is on technical analysis and not on the trader’s inability to efficiently apply Technical Analysis to markets. Hence before you start delving deeper into technical analysis it is important to set expectations on what can and cannot be achieved with technical analysis.

Trades : 

TA is best used to identify short term trades. Do not use TA to identify long term investment opportunities. Long term investment opportunities are best identified using fundamental analysis. Also, If you are a fundamental analyst, use TA to calibrate the entry and exit points 

Return per trade : 

TA based trades are usually short term in nature. Do not expect huge returns within a short duration of time. The trick with being successful with TA is to identify frequent short term trading opportunities which can give you small but consistent profits.

Holding Period : 

Trades based on technical analysis can last anywhere between few minutes and few weeks, and usually not beyond that. We will explore this aspect when we discuss the topic on timeframes.

Risk : 

Often traders initiate a trade for a certain reason, however in case of an adverse movement in the stock, the trade starts making a loss. Usually in such situations, traders hold on to their loss making trade with a hope they can recover the loss. Remember, TA based trades are short term, in case the trade goes sour, do remember to cut the losses and move on to identify another opportunity.

We discuss about Technical analysis on asset types , assumptions in technical analysis and the trade summary in the next blog . 

Conclusion of Technical Analysis - Introduction :

1.Technical Analysis is a popular method to develop a point of view on markets.
Besides, TA also helps in identifying entry and exit points

2. Technical Analysis visualizes the actions of market participants in the form of stock charts

3. Patterns are formed within the charts and these patterns help a trader identify trading opportunities

4. TA works best when we keep a few core assumptions in perspective

5. TA is used best to identify short terms trades

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Assumptions and Versatility of Technical Analysis

In the previous blog we briefly understood what Technical Analysis was all about. In this blog we will focus on the versatility and the assumptions of Technical Analysis.

Technical Analysis - Application on asset types :

Probably one of the greatest versatile features of technical analysis is the fact you can apply TA on any asset class as long as the asset type has historical time series data. Time series data in technical analysis context is information pertaining to the price variables namely – open high, low, close, volume etc.

Here is an analogy that may help. Think about learning how to drive a car. Once you learn how to drive a car, you can literally drive any type of car. Likewise you only need to learn technical analysis once. Once you do so, you can apply the concept of TA on any asset class – equities, commodities, foreign exchange, fixed income etc.

This is also probably one of the biggest advantages of TA when compared to the other fields of study. For example when it comes to fundamental analysis of equity, one has to study the profit and loss, balance sheet, and cash flow statements. However fundamental analysis for commodities is completely different.

If you are dealing with agricultural commodity like Coffee or Pepper then the fundamental analysis includes analyzing rainfall, harvest, demand, supply, inventory etc. However the fundamentals of metal commodities are different, so is for energy commodities. So every time you choose a commodity, the fundamentals change.

However the concept of technical analysis will remain the same irrespective of the asset you are studying. For example, an indicator such as ‘Moving average convergence divergence’ (MACD) or ‘Relative strength index’ (RSI) is used exactly the same way on equity, commodity or currency.

Assumption in Technical Analysis :

Unlike fundamental analysts, technical analysts don’t care whether a stock is undervalued or overvalued. In fact the only thing that matters is the stocks past trading data (price and volume) and what information this data can provide about the future movement in the security.

Technical Analysis is based on few key assumptions. One needs to be aware of

these assumptions to ensure the best results.

1) Markets discount everything :

This assumption tells us that, all known and unknown information in the public domain is reflected in the latest stock price. For example there could be an insider in the company buying the company’s stock in large quantity in anticipation of a good quarterly earnings announcement. While he does this secretively, the price reacts to his actions thus revealing to the technical analyst that this could be a good buy.

2) The ‘how’ is more important than ‘why’ :

This is an extension to the first assumption. Going with the same example as discussed above – the technical analyst would not be interested in questioning why the insider bought the stock as long he knows how the price reacted to the insider’s action.

3) Price moves in trend :

All major moves in the market is an outcome of a trend. The concept of trend is the foundation of technical analysis. For example the recent upward movement in the NIFTY Index to 7700 from 6400 did not happen overnight. This move happened in a phased manner, in over 11 months. Another way to look at it is, once the trend is established, the price moves in the direction of the trend.

4) History tends to repeat itself :

In the technical analysis context, the price trend tends to repeat itself. This happens because the market participants consistently react to price movements in a remarkably similar way, each and every time the price moves in a certain direction. For example in up trending markets, market participants get greedy and want to buy irrespective of the high price. Likewise in a down trend, market participants want to sell irrespective of the low and unattractive prices. This human reaction ensures that the price history repeats itself.

The Trade Summary For Technical Analysis :

The Indian stock market is open from 9:15 AM to 15:30 PM. During the 6 hour 15 minute market session, there are millions of trades that take place. Think about an individual stock – every minute there is a trade that gets executed on the exchange. The question is, as a market participant, do we need to keep track of all the different price points at which a trade is executed? It will be practically impossible to track all these different price points. In fact what one needs is a summary of the trading action and not really the details on all the different price points.

By tracking the Open, high, low and close we can draw a summary of the price

action.

The open :

When the markets open for trading, the first price at which a trade executes is called the opening Price.

The high :

This represents the highest price at which the market participants were willing to transact for the given day.

The Low :

This represents the lowest level at which the market participants were willing to transact for the given day.

The close :

The Close price is the most important price because it is the final price at which the market closed for a particular period of time. The close serves as an indicator for the intraday strength. If the close is higher than the open, then it is considered a positive day else negative. We will discuss in later .

The closing price also shows the market sentiment and serves as a reference point for the next day’s trading. For these reasons, closing price is more important than the Open, High or Low prices.

The open, high, low, close prices are the main data points from the technical analysis perspective. Each of these prices have to be plotted on the chart and analyzed.

Conclusion of Assumptions and Versatility of Technical Analysis :

1. Technical Analysis is not bound by its scope. The concepts of TA can be applied across any asset class as long as it has a time series data

2. TA is based on few core assumptions.

• Markets discount everything
• The how is more important than why
• Price moves in trends
• History tends to repeat itself

3. A good way to summarize the daily trading action is by marking the open, high, low and close prices usually abbreviated as OHLC

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