Chapter 1

Understanding Charting and Where Candlesticks Fit In

IN THIS CHAPTER

Taking a look at options for charting and why candlesticks are superior

Making sense of candlestick construction

Exploring the wide variety of candlestick patterns

Using technical analysis alongside your candlestick charts

Understanding a few trading and investing basics

The advent of the Internet has leveled the playing field for securities traders. Access to markets once meant placing orders through a broker; now it's little more than a couple of mouse clicks away. Commission rates are dramatically lower and in some cases free. Additionally, access to market information is free in many cases. Getting into securities trading is easier than ever, and the result is that a whole generation of investors and traders handles their finances without professional help. Technology allows these people to enjoy many new types of market information, and one of the best tools available is candlestick charting.

Candlestick charting methods have been around for hundreds of years, but candlesticks have caught on over the past couple of decades or so as a charting standard in the United States. I've been working with candlestick charts for quite a few years, and I've seen many traders - novice to professional - develop a fierce loyalty to candlesticks after taking the time to understand their uses and potential. I think you'll feel the same way, and this book is the first step on your path to conquering candlesticks.

The material contained in this chapter exposes you to many of the facets of candlestick charting that continue to fuel its rise as one of the most popular charting techniques. I begin with the overall role of candlesticks within the context of charting. I cover the advantages of candlestick charting and the basics of candlestick construction. I also take the opportunity at the end of this chapter to discuss how to get started, as well as give you some insight into the characteristics and habits that successful traders employ in their pursuit of profits. Enjoy, and happy charting!

Considering Charting Methods and the Role of Candlesticks

With advancements in technology and the growing availability of trading and investing resources available to traders, many options exist for the charting of securities. There are several types of charts and dozens of variations and features to be configured on each type. It's important that you're clear on the options and - perhaps more important - on why candlestick charting is at the top of the heap. This section explains.

Getting a feel for your options for charting

When it comes to alternatives to candlestick charting, the three main charting contenders are as follows:

• Line charts: These charts are simple and helpful for short-term decisions, but they're quite limited in the amount of data presented.
• Bar charts: These charts are the most common type and are much more useful than line charts, but they're not as versatile as candlestick charts.
• Point and figure charts: These tried-and-true charting methods are great for recognizing support and resistance levels, but they're far less dynamic than candlestick charts.

Each one of these charting methods can be used effectively to ratchet up the effectiveness of your trading strategy, but they pale in comparison with candlestick charts for several reasons, a few of which I describe in the next section.

Realizing the advantages of candlestick charting

You'd be hard-pressed to find someone who's more enthusiastic about candlestick charting than yours truly. I can go on and on about the advantages that candlesticks afford. If you want to read more of my gushing about the many great advantages of candlestick charting, turn to Chapter 2, but here are my top three reasons:

• Two of the best features of candlestick charting in general are visual appeal and readability. You can glance at a candlestick chart and quickly gain an understanding of what's going on with the price of a security. You can also tell whether sellers or buyers have dominated a given day and get a sense of how the price is trending.
• Even after reading up on the most rudimentary candlestick basics, you can easily spot the opening and closing price for a security on a candlestick chart. These price levels can be very important areas of support and resistance from day to day, and knowing where they are can be extremely helpful, especially for short-term traders.
• Candlesticks aren't just pretty faces. Candlestick charts also feature specific patterns that you can identify and use to decide when it's time to buy, sell, or wait on a trade or investment. These patterns can be a real boon to your work with securities, and you can combine them with other technical indicators for even more reliable results.

Understanding Candlestick Components

You can't trade and invest effectively by using candlestick charts unless you understand candlestick patterns, and you may have a very hard time understanding those patterns if you aren't familiar with basic candlestick construction. Candlestick charting starts with the knowledge of what it takes to make a candlestick and how changes in that basic information affect a candlestick's appearance and what it means. For starters, you need to know what goes into creating a candlestick's wick (the thin vertical line) and its candle (the thick part in the middle).

The following four pieces of information are combined to create a candlestick:

• Price on the open: The price at which a security opens in a given period is the first piece of information used in creating a candlestick. Depending on whether the security's performance is bullish or bearish, the opening price corresponds to either the bottom edge of a candlestick's candle or the top edge.

  Candlesticks that represent bullish price action appear white on a chart in this book but green in many charting packages, and candlesticks that represent bearish price action appear black or red when color is available.

• High price: The highest price that a security reaches during a given period corresponds to the top of a candlestick's wick. If a security opens at a certain price and then trades consistently lower than that price throughout the period, there won't be any wick above the candle.
• Low price: The lowest price that a security reaches during a period corresponds to the bottom of a candlestick's wick. If the price action for that period is extremely bullish, and prices trade higher than the open, there won't be any wick below the candle.
• Price on the close: When a security finishes trading during a given period, its closing price is the last piece of information used to create a candlestick. Depending on the security's performance during that period, the closing price can correspond to either the top edge of a candlestick's candle (if the period was bullish) or the bottom edge (if the period was bearish).

As a true candlestick devotee, I believe that you can gain far more insight into a period's trading by looking at a candlestick than you can by looking at another type of charting tool. Want proof? Take a look at Figure 1-1.

FIGURE 1-1: Bullish and bearish candlesticks side by side.

You can tell right away that the up day has a white candle and the down day has a black candle. That simple difference alone clearly reveals the nature of the price action that took place during that period. In the case of the candlestick with the black candle, there was more selling pressure than desire to buy. And the candlestick with the white candle indicates that there was more buying pressure than desire to sell.

Why are these details so important? Candlestick charts quickly clue you in on the type of buying and selling that's been going on during a given period and where it may occur again. In many cases, the buyers continue to buy and the sellers continue to sell during subsequent periods or when the price reaches a level that spurred them to action in the past.

For more information on candlestick construction, see Chapter 3.

Working with Candlestick Patterns

The components of a candlestick may be the bones of candlestick charting, but candlestick patterns are the heart and soul. Patterns appear on candlestick charts as simple, single-stick occurrences or complex, multistick formations, and many types of patterns can tell you what may be in store for a security that you've had your eye on for trading or investing. Knowing what may lie ahead can be the difference between a profitable trade and a flop.

Candlestick patterns indicate when prevailing trends reverse or continue. Both types of patterns are very useful because they tell you when to get into a trade, when to get out of a trade, when a trade you're in may make no sense, and even when to hang on to a trade you're already in. Check out Chapters 5 through 10 for more info on identifying and trading on a wide variety of candlestick patterns.

Simple patterns

Some candlestick patterns are very simple: A...