We owe a debt of thanks to a legendary seventeenth-century Japanese rice broker, Munehisa Homma, who was one of the first Japanese traders to use price history to predict price future. Referred to as „the god of the markets,“ Homma amassed a huge fortune, and as legend has it, he made 100 consecutive winning trades. His trading theories and principles evolved into the candlestick charting techniques we use today.

For now, we're going to explore some major candlestick patterns that when used properly, can produce tidy profits.

Just as a bar chart uses the top and bottom of its bar to indicate high and low prices of the time frame indicated, so does a candlestick. With candlesticks, however, we draw in a „real body“ to connect the opening and closing prices. This gives us a quick and complete picture of the stock's action and denotes prevailing sentiment. The real body shows the opening and closing prices with a clear, or a dark, rectangle. The bar that extends above and below the real body is called the upper and lower „shadow.“

When the rectangle or real body is clear, it means that the stock closed above its opening price. When the real body is dark, it means that the stock closed below its opening price. This gives you an instant picture of a positive or negative close. Those of us who stare at charts for hours at a time find candlesticks are not only easy on the eyes, but they also convey strong signals sometimes missed on bar charts.

The below figures shows basic candlestick formations.

Candlesticks, like bars, each represent a specified time frame. For example, on a weekly chart, each candlestick represents one week; on a daily chart, each candlestick represents one day; and on a fifteen-minute intra-day chart, each candlestick represents a fifteen-minute unit of time.

Now, notice the long, clear real body in Figure A. The long, clear real body, showing the closing price multiple points above the opening price (in this case, five points), indicates extremely positive or bullish sentiment. In B, the long, dark real body, with the closing price multiple points below the open, reveals negative or bearish sentiment.

Next, check out C. This formation, where the stock opens and closes at the same price, is called a „doji.“ With a doji, no real body is present. Because buyers could not apply enough bullish pressure to close the stock higher than the open, and sellers could not force enough bearish pressure to close the stock lower than the open, it reveals a collective mindset of indecision.

Please memorize the doji right this minute! It is a very important candlestick, as it many times presages a shift in, or even a reversal of, a current trend. As short-term traders, we need to stay on top of trend changes and reversals at all times. Why? Because they act as valuable entry, exit, and money-management signals.

Candlestick patterns can be read alone, but are extremely powerful when used in conjunction with other charting indicators. Therefore, a selection of important patterns are detailed in the next few pages.You should learn how to combine them with other indicators to recognize buy and sell signals.

The candlesticks illustrated in the below figure are called the hammer and the hanging man. Their real bodies are small, and can be either clear or dark. Their lower shadows should be twice the „length of the real body. They should have "shaven heads,“ meaning no (or short) upper shadow will be evident.

When you see a hammer form in the context of a downtrend, it may signify that the downtrend will slow and change direction by moving sideways or reversing to move upward. Think: hammer it back up.

If a hanging man appears to an uptrend, the connotation is evident right away. It's time to start playing the funeral march! If you're holding a long position in this stock, take profits right away.

Two-Candlestick Patterns

The next pattern that presages trend change is an „engulfing pattern.“ It's a two-candlestick pattern consisting of opposite-color real bodies. The second real body must completely „engulf' the first real body. Translation: The opening ‚price of the second real body must be lower than the closing price of the first, and the closing price of the real body must be higher than the opening price of the first. That‘s called a "bullish engulfing pattern.“ The flip side of this is a „bearish engulfmg pattern.“ The below figureshows these two patterns in action.

Bullish and bearish engulfing patterns are similar to Western „key reversal“ patterns, in which a stock opens at a new high (or low), then closes lower (or higher) than the previous day's low (or high).

Another important reversal pattern is the dark cloud cover. Also a two-candlestick pattern, it portends change when it appears at the top of an uptrend, or toward the top of a congestion (sideways) move. The first candlestick is a long, clear real body. The second real body opens above the close of the first, then closes near the low of the range and deep within the price range of the first candlestick. The deeper into the 'first real body (range) that the second one closes, the more bearish the signal. Dark cloud cover indicates exactly what the name conveys-a storm is brewing!

The reverse of the dark cloud cover is the bullish piercing pattern. Resembling the bullish engulfing pattern in that the second candlestick (real body) opens below the previous candlestick's clo­se, the piercing pattern shows that the second real body should rise at least halfway into the previous dark real body. The greater the second real body pierces the first, the greater the chance that it is a strong reversal, pattern. So, when this two-candlestick pattern takes place at the bottom of a downtrend,. look for a change in direction to begin.

The below figure illustrates dark cloud cover and bullish piercing patterns. Since these are both powerful patterns, be sure to commit the simple formations' to memory.

The harami and the harami cross are two-candlestick patterns that also indicat~ a trend change. Harami means „pregnant“ in Japanese-the pattern consists of a long real body that engulfs the subsequent small candlestick. The long real body is the „mother“ candlestick and the smaller real body is the „baby.“ In this pattern, the long real body must occur first, with the short real body appearing second. (The reverse of this pattern is the bullish engulfing pattern.) The colors need not be opposite, but you will find they usually appear that way. The below figure illustrates the harami and the harami cross.

If you're thinking this formation is called an „inside day“ in Western terminology, you're right. A Western inside day, however, demands that the second session keep its highs and lows within those of the preceding one. The harami does not. As long as the fust real body is relatively longer than the second, and the second is short, the shadows (session high and low) of the second real body can extend above or below the first.

The harami pattern warns not so much of a dramatic reversal in a trend, as it does that the current trend may slow or drift sideways for a while.

A harami cross forms when the second candlestick is a doji. That means definite opinion-strong bullish for a tall, clear real body, or strong bearish for a tall, dark real body, has dissolved. A doji, as mentioned before, translates into indecision and uncertainty. Thus, a harami cross can be a potent reversal, signal. When you spot this pattern during an uptrend or downtrend, ' pay attention!

Three-Candlestick Patterns

The following patterns consist of three candlesticks that include „stars.“ Star patterns represent strong and valuable reversal warnings. As Steve Nison says, the formation of strong reversal patterns not only keeps us informed of potential setups for entries, they also offer themselves as efficient profit-taking signals. Why? Because if you're long (own) a stock, and you see a reversal pattern forming that indicates the stock may make a V-turn soon, you can grab your gains quickly. Besides, it's fun party conversation to be able to boast that you bought a stock and „got out at the top!“

To qualify for „star“ billing, the candlestick should appear at the top (or bottom) of an uptrend (or downtrend), have a short real body, and gap away (open higher in uptrend (or lower in downtrend) from the previous candlestick.

The co-stars: In the context of an uptrend, the first real body should be long and clear. The third real body should be long and dark, penetrating the real body of the first candle. In a downtrend, the first real body is long and dark, then the star appears next. Finally, the third real body moves up, well into the first dark real body. The Japanese call the first star an evening star, and the second a morning star. When the star emerges as a doji, it's an even more powerful warning that a reversal may be impending.

The below figure depicts the evening and morning stars and evening and morning doji star patterns.

While we're looking at doji, let's check out variations on this extremely powerful candlestick. Maybe we should call it a „dynamite“ stick instead of a candlestick! When you spot a doji – and remember, it's most potent forecasting position is at the top of an uptrend or bottom of a downtrend – the following points should be taken into consideration:

1. Traditionally, the doji opens and closes at the same price. But if you'll spot a „near doji,“ where the prices are within a few decimal points of each other, it's still a significant signal.
2. A doji that appears in a sideways move, accompanied by other doji and short real bodies, are not quite as powerful beacons of change.
3. Doji can be viewed as more powerful at stock/market tops, rather than bottoms. This holds especially true when preceded by a long clear candle, such as in the doji evening star pattern. Think: Long, clear real body equals strong bullish opinion. Then, a doji develops. Doji equals indecision by market players to pay a higher price. Result? Possible pullback or profit-taking may soon follow.
4. Doji that confirm trend tops or bottoms many times tum into support or resistance areas.
5. When a stock in an uptrend pulls back to support and then forms a doji, that indicates the stock may be ready to tum and resume its uptrend. The same is true of a stock in a downtrend; a rebound to resistance, followed by the formation of a doji, may indicate the stock will drop back to the downside. Notice the operative word here is may. Always wait for the next candle to confirm price direction.

The long-legged doji has long upper and lower shadows, and its appearance at stock/market tops should definitely grab your attention. When a longlegged doji opens and closes in the middle of its session, it's referred to as a rickshaw man.

If you think through what actually happened to form one of these doji, you'll realize why their emergence is so meaningful. The stock opens at a certain price, say 50. Buying pressure pushes it strongly higher, then selling pressure shoves it much lower. Still, it closes at or very near the session's opening price of 50. Conclusion? Total indecision! Neither the bulls nor the bears have the strength to raise or lower the price above or below the open. Can you see how that may cause bulls to shrug and take profits during the following session? Remember, the market dislikes indecision.

When you see a gravestone doji form in an uptrend, and you're long that stock, take profits immediately. Then, you can smile smugly and hold the exit door open for the screaming stampede that usually follows!

In Japanese Candlestick Charting Techniques, Steve Nison says, „As we have discussed, many of the Japanese technical terms are based on military analogies,and in this context, the gravestone doji also represents the graves of those bulls or bears who have died defending their territory.“

As you see by the above figure, a gravestone doji opens and closes at the low price of the day. If the price rises to a new high, drawing a long upper shadow, that spells even more gloom and doom for bulls.

Translation: No matter how much the bulls absorbed supply, the bears squashed the price down to the low, and closed it there.

Remember, the point at which a stock or market closes on the day is a very significant signal in itself.

Spinning Tops and High Wave Candlesticks

The final candlesticks we want to look at are spinning tops and high wave candlesticks. Candlesticks with small real bodies, of either color, are referred to as „spinning tops.“ The length and range of their shadows may vary. Think of spinning tops as slightly „kinder, gentler“ versions of doji. Their siblings are „high wave“ candlesticks, which are spinning tops exhibiting very long upper and/or lower shadows. A group of high wave candlesticks may forecast a trend reversal.