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

Examining 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 by way of a broker; now it takes little more than a couple of mouse clicks. Commission rates are dramatically lower, and sometimes even free. Additionally, access to market information is free in many cases. Breaking 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. Candlestick charts allow for an easy way to visualize market information, which has created a fierce loyalty among traders who use them. We think you'll feel the same way, and this book is the first step on your path to conquering candlesticks.

The material we spell out 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. We begin with the overall role of candlesticks within the context of charting. We cover the advantages of candlestick charting and the basics of candlestick construction. We also take the opportunity at the end of this chapter to discuss how to get started and then 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 advances in technology and the growing availability of trading and investing resources available to traders, many options exist for the charting of securities. Several types of charts and dozens of variations and features can be configured for each type. It's important that you're clear on what other charting options are out there and - perhaps more important - on why candlestick charting is at the top of the heap. We provide answers to both questions.

Getting a feel for your options for charting

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

• Line charts: These charts are simple and helpful for short-term decisions, but they're quite limited when it comes to the amount of data presented.
• Bar charts: These charts, the most common type, are much more useful than line charts, but they're not as versatile as candlestick charts.
• Point and figure charts (also known as P&F charts): These tried-and-true charting methods are helpful for recognizing support and resistance levels, but they're far less dynamic than candlestick charts. These charts, discussed in Chapter 2, have been around since the 19th century as a way of tracking price movements. The Xs and Os were incorporated in the 1930s as a way of standardizing the price movement.

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

Realizing the advantages of candlestick charting

You'd be hard-pressed to find people who are more enthusiastic about candlestick charting than we are. We can go on and on about the benefits that candlesticks afford. If you want to read more of our gushing about the many fantastic features of candlestick charting, turn to Chapter 2, but for now, here are our 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 gain a sense of how the price is trending. This isn't easily seen in the other types of charting, such as line charts, bar charts, and point and figure charts.
• Even after reading up on the most rudimentary candlestick basics, you can easily spot on a candlestick chart the opening and closing price of a security. These price levels can be vital areas of support and resistance from day to day, and knowing where they are can be extremely helpful, especially for short-term traders. Support and resistance are, in essence, the floor and ceiling of pricing: The level at which the price naturally doesn't fall below is the support; on the other hand, the price level at which the asset doesn't break through, like a glass ceiling, is the resistance. Asset prices can, of course, break through either the support or resistance level; they usually don't, however.

• Candlesticks aren't just pretty faces - candlestick charts also feature specific patterns you can identify and use to determine when it's time to buy, sell, or wait on a trade or an investment. These patterns can be a true boon to your work with securities, and you can combine them with other technical and economic indicators for even more reliable results.

Differentiating Candlestick Components

You can't trade and invest effectively by using candlestick charts unless you understand candlestick patterns, and you may have difficulty 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 its 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 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, no wick appears above the candle.
• Low price: The lowest price 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, no wick appears 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 true candlestick devotees, we believe that you can gain far more insight into a period's trading by looking at a candlestick than you can by looking at any other type of charting tool. Want proof? Take a look at Figure 1-1.

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.

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

Why are these details important? Candlestick charts quickly clue you in on the type of buying and selling that has 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. This activity describes momentum or trends, which is a large part of short-term trading.

For more information on candlestick construction, see Chapter 3.

Working with Candlestick Patterns

The components of a candlestick may form the bones of candlestick charting, but candlestick patterns are its heart and soul. Patterns appear on candlestick charts as simple, single-stick occurrences...