The Basic Language Of Candlestick Charting

By Investopedia Staff A A A

A candlestick shows the high, low, open and close for a security each day. Sounds
simple enough, but what can you really do with that information?
This article focuses on continuation patterns and how they could deny or confirm
trends in today's markets, giving the investor a clearer picture of whether to hold
his or her position or execute a buy/sell order.
The Patterns We continue this look at candle charts with some additional patterns
on both the bullish and bearish sides of the equation. On the bullish side of the
market, we'll show you the engulfing pattern, harami and the harami cross. On the
bearish side, we will have a closer look at the engulfing pattern, the evening star
and both the harami and the harami cross.
Engulfing Pattern - BearishAn engulfing pattern (bearish) develops in an uptrend
when sellers outnumber buyers; this action is reflected by a long red real body
engulfing a small green real body.

You can see the opening was higher than the previous day, and, during the trading
session, the issue sold off with volume that was much greater than the previous
session.Engulfing Pattern - BullishAn engulfing pattern on the bullish side of the
market is the opposite of the previous pattern and takes place when buyers outpace
sellers, which is reflected in the chart by a long green real body engulfing a small
red real body.

As you can see, this is a chart of an issue in a downtrend that has now lost
momentum. The buyers may be coming back into this issue, creating a trend
reversal and bottoming out of this downtrend.Evening Star - BearishAn evening
star (bearish) is a top reversal pattern that is very easy to identify because the last
candle in the pattern opens below the previous day's small real body, which can be
either red or green and closes deep into the real body of the trading range of the
candle two days prior.

This pattern shows that investors are perhaps losing confidence in the issue and its
direction. This thought process will be confirmed if the next day is another down
session.
Harami - BearishA harami (bearish) is another very recognizable candlestick
pattern that shows a small real body (red) completely inside the previous day's real
body.

Technicians will watch very closely now because the bearish harami indicates that
the current uptrend may be coming to an end, especially if the volume is light.
Students of candlestick charts will also recognize the harami pattern as the first two
days of the three inside pattern.

Harami - Bullish

Harami (bullish) is just the mirror reflection of the harami bearish. As you can see
in the chart above, a downtrend is in play and a small real body (green) is shown
inside the large real body (red) of the previous day. This tells the technician that the
trend is coming to an end. The harami implies that the preceding trend is about to
conclude. A candlestick closing higher the next day would confirm the trend
reversal.
Harami Cross - BearishA harami cross (bearish) is a pattern of a harami with a doji
instead of a small real body following up on the next trading session.The doji is
within the range of the real body of the prior session.

Like the harami, the trend starts out in play, but the market then decides to reverse
intraday. Volume is virtually non-existent and the pattern is closing at the same
price as the issue opened. The uptrend has been reversed.
Harami Cross - BullishThe harami cross, whether the bullish or bearish version,
starts out looking like the basic harami pattern. The harami cross bullish is the
exact opposite of the harami cross bearish and does not require any further
explanation. Again, a trend has been reversed.

ConclusionIf you want to use candlestick charting to get a sense of where a stock
is headed, you need to learn how to read this unique charting language.
Continuation patterns allow you to get a glimpse of a stock's trend, and thus
capitalize on its next move.

The moving average (MA) is a simple technical analysis tool that smooths out
price data by creating a constantly updated average price. The average is taken
over a specific period of time, like 10 days, 20 minutes, 30 weeks, or any time
period the trader chooses. There are advantages to using a moving average in your
trading, as well options on what type of moving average to use. Moving average
strategies are also popular and can be tailored to any time frame, suiting both long
term investors and short-term traders. (see "The Top Four Technical Indicators

Trend Traders Need to Know.")

Why Use a Moving Average
A moving average can help cut down the amount of "noise" on a price chart. Look
at the the direction of the moving average to get a basic idea of which way the
price is moving. Angled up and price is moving up (or was recently) overall,
angled down and price is moving down overall, moving sideways and the price is
likely in a range.
A moving average can also act as support or resistance. In an uptrend a 50-day,
100-day or 200-day moving average may act as a support level, as shown in the
figure below. This is because the average acts like a floor (support), so the price
bounces up off of it. In a downtrend a moving average may act as resistance; like a
ceiling, the price hits it and then starts to drop again.

The price won't always "respect" the moving average in this way. The price may
run through it slightly or stop and reverse prior to reaching it.
As a general guideline, if the price is above a moving average the trend is up. If the
price is below a moving average the trend is down. Moving averages can have
different lengths though (discussed shortly), so one may indicate an uptrend while
another indicates a downtrend.

Types of Moving Averages

A moving average can be calculated in different ways. A five-day simple moving
average (SMA) simply adds up the five most recent daily closing prices and
divides it by five to create a new average each day. Each average is connected to
the next, creating the singular flowing line.
Another popular type of moving average is the exponential moving average
(EMA). The calculation is more complex but basically applies more weighting to
the most recent prices. Plot a 50-day SMA and a 50-day EMA on the same chart,
and you'll notice the EMA reacts more quickly to price changes than the
SMA does, due to the additional weighting on recent price data.
Charting software and trading platforms do the calculations, so no manual math is
required to use a MA.

One type of MA isn't better than another. An EMA may work better in a stock or
financial market for a time, and at other times an SMA may work better. The time
frame chosen for a moving average will also play a significant role in how
effective it is (regardless of type).
Moving Average Length
Common moving average lengths are 10, 20, 50, 100 and 200. These lengths can

be applied to any chart time frame (one minute, daily, weekly, etc), depending on
the traders trade horizon.
The time frame or length you choose for a moving average, also called the "look
back period", can play a big role in how effective it is.
An MA with a short time frame will react much quicker to price changes than an
MA with a long look back period. In the figure below the 20-day moving average
more closely tracks the actual price than the 100-day does.

The 20-day may be of analytical benefit to a shorter-term trader since it follows the
price more closely, and therefore produces less "lag" than the longer-term moving
average.
Lag is the time it takes for a moving average to signal a potential reversal. Recall,
as a general guideline, when the price is above a moving average the trend is
considered up. So when the price drops below that moving average it signals a
potential reversal based on that MA. A 20-day moving average will provide many
more "reversal" signals than a 100-day moving average.
A moving average can be any length, 15, 28, 89, etc. Adjusting the moving average
so it provides more accurate signals on historical data may help create better future
signals.

Trading Strategies - Crossovers

Crossovers are one of the main moving average strategies. The first type is a price
crossover. This was discussed earlier, and is when the price crosses above or below
a moving average to signal a potential change in trend.

Another strategy is to apply two moving averages to a chart, one longer and one
shorter. When the shorter MA crosses above the longer term MA it's a buy signal as
it indicates the trend is shifting up.This is known as a "golden cross."
When the shorter MA crosses below the longer term MA it's a sell signal as it
indicates the trend is shifting down. This is known as a "dead/death cross"

Disadvantages
Moving averages are calculated based on historical data, and nothing about the
calculation is predictive in nature. Therefore results using moving averages can be
random--at times the market seems to respect MA support/resistance and trade
signals, and other times it shows no respect.
One major problem is that if the price action becomes choppy the price may swing
back and forth generating multiple trend reversal/trade signals. When this occurs
it's best to step aside or utilize another indicator to help clarify the trend. The same
thing can occur with MA crossovers, where the MAs get "tangled" for a period of
time triggering multiple (liking losing) trades.
Moving averages work quite well in strong trending conditions, but often poorly in
choppy or ranging conditions.
Adjusting the time frame can aid in this temporarily, although at some point these
issues are likely to occur regardless of the time frame chosen for the MA(s).
The Bottom Line
A moving average simplifies price data by smoothing it out and creating one
flowing line. This can make isolating trends easier. Exponential moving averages
react quicker to price changes than a simple moving average. In some cases this

may be good, and in others it may cause false signals. Moving averages with a
shorter look back period (20 days, for example) will also respond quicker to price
changes than an average with a longer look period (200 days). Moving average
crossovers are a popular strategy for both entries and exits. MAs can also highlight
areas of potential support or resistance. While this may appear predictive, moving
averages are always based on historical data and simply show the average price
over a certain time period.
Channeling: Charting A Path To Success
By Justin Kuepper A A A
Channel trading is a powerful yet often overlooked form of trading that capitalizes
on the tendencies of markets to trend. It combines several forms of technical
analysis to provide traders with precise points from which to buy and sell, put stoploss and take-profit levels and much more! This article will show you how to create
and effectively trade these amazing instruments.
SEE: Technical Analysis
Channel Characteristics
In the context of technical analysis, a channel is defined as the area between two
parallel trendlines and is often taken as a measure of a trading range. The upper
trendline connects price peaks (highs) or closes, and the lower trendline connects
lows or closes. An example of a channel is shown below. Breakout points in
channels indicate bullish (on upward trends) or bearish (on downward trends)
signals.

Channels are useful for short-to medium-term trading - not long-term trading or
investing. The technique often works best on stocks with a medium amount of
volatility. Remember, the volatility determines your profit per trade. Channeling
also tends to work best when the technique is combined with other forms of
technical analysis, at which we take a closer look below.
Finding an Equity
Not all equities can utilize this technique as it requires that the underlying equity
has an existing channel in its chart. Generally, a channel consisting of four contact

points is necessary for the channel to be considered "tradeable." There are three
ways to locate an equity to which this strategy can be applied:
1. Manually look through charts to locate channel patterns.
2. Utilize software or a service that automatically recognizes channel patterns.
3. Subscribe to a company that provides you with a list of equities to which this
technique can be applied.
Creating a Channel
Channels are relatively easy to create using these four simple steps:
1. Locate a relative high and a relative low in the past from which to begin the
channel.
2. Locate another subsequent high and low that follows one of the three
following patterns (see table below):
a. Ascending channel - higher high and higher low.
b. Descending channel - lower low and lower high.
c. Horizontal channel - horizontal highs and lows.
3. Draw two trend lines - one connecting the two highs, and one connecting the
two lows. Note that these two lines should be near parallel.
4. These two lines form your basic channel after there are at least two contact
points with the upper channel and two with the lower channel. More contact
points enhance the reliability of the channel.

Trading the Channel

Channels provide a clear, systematic way to trade. In fact, these simple instruments

can show you when to buy and sell, where to place your stop-loss and take-profit
points, how to determine the reliability of the trade and how long you should
expect the trade to take! Let's look at how these can be done.
Locating Buy and Sell Points
Channels help locate optimal buying and selling points. Here are the standard
channel trading rules:
When the price hits the top of the channel, sell your existing position and/or
take a short position.
When the price is in the middle of the channel, hold.
When the price hits the bottom of the channel, add to your existing position,
cover your short and/or buy.
Two exceptions to these rules:
1.
1. If the price breaks through the top or bottom of the channel, then the
channel play ends until a new channel is established.
2. If the price drifts between the channels for a prolonged period of time,
a new narrower channel may be established.
There may be times when other forms of technical analysis are needed to enhance
the accuracy of the channel plays, and verify the overall strength of the channel.
Using other techniques in conjunction with channeling can also help you avoid the
side effects of the two exceptions listed above. A few useful ones to keep in mind
are:
Moving average convergence divergence - These can be used to confirm
channel movements, especially after a contact is made.
Stochastics - These are useful to confirm channel movements.
Volume - Analyzing volume ratios can also help you determine the strengths
of different channel movements, which determine the overall channel
strength.
Short-term moving averages - These can provide you with a short-term
outlook on a channel play. They are most useful after a contact is made to
confirm the change in direction.
Candlestick patterns - These are useful for spotting channel breakouts.

Determining Stop-Loss and Take-Profit Levels

Channels provide built-in money-management capabilities in the form of stop-loss
and take-profit points. Here are the standard rules for determining these points:
If you have bought at the bottom of the channel, set a (moving) take-profit
point at the top of the channel. Also, set a (moving) stop-loss point slightly
below the bottom of the channel, allowing room for regular volatility (taking
the beta into consideration).
If you have taken a short position at the top of the channel, set a (moving)
take-profit point at the bottom of the channel. Also, set a (moving) stop-loss
slightly above the top of the channel, allowing room for regular volatility
(taking the beta into consideration).
Determining Trade Reliability
Channels provide the ability to determine how likely your trade is to be successful.
This is done through something known as confirmations. Confirmations represent
the number of times the price has rebounded from the top or bottom of the channel
- in essence confirming the accuracy of the channel. Here are the important
confirmation levels to remember:
1-2:Weak channel (non-tradeable).
3-4: Adequate channel (tradeable).
5-6: Strong channel (reliable).
6+: Very strong channel (very reliable).
Estimating Trade Length
The amount of time a trade takes to reach a sell point from a buy point can also be
calculated using channels. This is done by recording the amount of time it has
taken for trades to execute in the past, then averaging the amount of time for the
future. This strategy relies on the theory that channel price movements tend to be
nearly equal in time and price.
Conclusion
Channels provide one of the most accurate methods from which to trade in any
market. By "encasing" an equities price movement into two parallel trend lines,
this simple chart can provide the exact points from which to buy and sell, create
stop-loss and take-profit points, check channel strength and even estimate how
long the trade will take. This technique is a valuable asset to any trader.
Relative Strength Index - RSI

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DEFINITION
A technical momentum indicator that compares the magnitude of
recent gains to recent losses in an attempt to determine
overbought and oversold conditions of an asset. It is calculated
using the following formula:
RSI = 100 - 100/(1 + RS*)
*Where RS = Average of x days' up closes / Average of x days'
down closes.

As you can see from the chart, the RSI ranges from 0 to 100. An
asset is deemed to be overbought once the RSI approaches the
70 level, meaning that it may be getting overvalued and is a good

candidate for a pullback. Likewise, if the RSI approaches 30, it is

an indication that the asset may be getting oversold and
therefore likely to become undervalued.
Moving Average - MA
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DEFINITION
A widely used indicator in technical analysis that helps smooth
out price action by filtering out the noise from random price
fluctuations. A moving average (MA) is a trend-following or
lagging indicator because it is based on past prices. The two basic
and commonly used MAs are the simple moving average (SMA),
which is the simple average of a security over a defined number
of time periods, and the exponential moving average (EMA),
which gives bigger weight to more recent prices. The most
common applications of MAs are to identify the trend direction
and to determine support and resistance levels. While MAs are
useful enough on their own, they also form the basis for other
indicators such as the Moving Average Convergence Divergence
(MACD).

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As an SMA example, consider a security with the following closing
prices over 15 days:
Week 1 (5 days) 20, 22, 24, 25, 23
Week 2 (5 days) 26, 28, 26, 29, 27
Week 3 (5 days) 28, 30, 27, 29, 28
A 10-day MA would average out the closing prices for the first 10
days as the first data point. The next data point would drop the
earliest price, add the price on day 11 and take the average, and
so on as shown below.

As noted earlier, MAs lag current price action because they are
based on past prices; the longer the time period for the MA, the
greater the lag. Thus a 200-day MA will have a much greater
degree of lag than a 20-day MA because it contains prices for the
past 200 days. The length of the MA to use depends on the
trading objectives, with shorter MAs used for short-term trading
and longer-term MAs more suited for long-term investors. The
200-day MA is widely followed by investors and traders, with
breaks above and below this moving average considered to be
important trading signals.
MAs also impart important trading signals on their own, or when
two averages cross over. A rising MA indicates that the security is
in an uptrend, while a declining MA indicates that it is in a
downtrend. Similarly, upward momentum is confirmed with a
bullish crossover, which occurs when a short-term MA crosses

above a longer-term MA. Downward momentum is confirmed with

a bearish crossover, which occurs when a short-term MA crosses
below a longer-term MA.
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A trend-following momentum indicator that shows the relationship
between two moving averages of prices. The MACD is calculated
by subtracting the 26-day exponential moving average (EMA)
from the 12-day EMA. A nine-day EMA of the MACD, called the
"signal line", is then plotted on top of the MACD, functioning as a
trigger for buy and sell signals.

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INVESTOPEDIA EXPLAINS
There are three common methods used to interpret the MACD:
1. Crossovers - As shown in the chart above, when the MACD falls
below the signal line, it is a bearish signal, which indicates that it
may be time to sell. Conversely, when the MACD rises above the
signal line, the indicator gives a bullish signal, which suggests
that the price of the asset is likely to experience upward
momentum. Many traders wait for a confirmed cross above the
signal line before entering into a position to avoid getting getting
"faked out" or entering into a position too early, as shown by the
first arrow.

2. Divergence - When the security price diverges from the MACD.

It signals the end of the current trend.
3. Dramatic rise - When the MACD rises dramatically - that is, the
shorter moving average pulls away from the longer-term moving
average - it is a signal that the security is overbought and will
soon return to normal levels.
Traders also watch for a move above or below the zero line
because this signals the position of the short-term average
relative to the long-term average. When the MACD is above zero,
the short-term average is above the long-term average, which
signals upward momentum. The opposite is true when the MACD
is below zero. As you can see from the chart above, the zero line
often acts as an area of support and resistance for the indicator.
Are you interested in using the MACD for your trades? Check out

our own Primer On The MACD and Spotting Trend Reversals With
MACD for more information!
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Gain the Financial Knowledge You Need to Succeed.
Investopedias FREE Term of the Day helps you gain a better
understanding of all things financial with technical and easy-tounderstand explanations. Click here to begin developing your
financial language with this daily newsletter.