Doji-in which the opening and closing prices are the sarne.

Hammer-a bullish reversal signal, showing the bottom of a swing, where the body is at the top of the candle, indicating an upward change of direction, and the shadow is below the body The body may be black or white.

Hanging man-another bearish reversal pattem where the body of the candle represents the high of a swing, and the shadow lies below in the direction of the reversal. The body may be blad; or white.

FIGURE9-10 Popular candle formations.

DOJI

/Low. Own and

HANGING HAN I I-White or Black

I I

SHOOTING STAR .Whiie or Black

ll I.

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Shootmg star-a bearish signal, also occurs at the top of a swing and has its body at the bottom of the candle with the shadow above. The body may be black orwhite.

Engulfing pattern-occurring at a swing high or low, has the current body engulfing the entire prior candle.

Although these patterns are similar to western bar chart formation, none of thern are exactly the same. The hammer, hanging man, and shooting star are reversal pattems but can only be compared with the simple pivot point where the middle day is higher or lower than the bars on either side. None of these candle formations would be a key reversal or island reversal. The engulfing pattem is stronger than the tjpical outside day, because the spanning of the prior days range must be done only by the current days open-close range.

The analjsis of candle charts is a skill involving the understanding of many complex and interrelated panems. For a brief review of this method, readers are referred to Schwager on Futures. Technical Analjsis; for full coverage,Jspanese Candleatick Charting Techniques (New York Inatitute of Finance, 1991), and Beyond Candlesticks-New jspanese Trading Techniques, both by Steve Nison, are recommended.

Quantrfjmg Candle Formations

The preciseness of the candle formations allows some pattems to be tested. One technique uses the shadows as confirmation of direction. We can interpret an increase in the size of the upper shadows as strengthening resistance (prices are closing lower each day), and an increase in the size of the lower shadows represents more support. One way to look at this is by defining

Upper shadow (white) high - close Lower shadow (white) open - low

Upper shadow (blad;) high - open Lower shadow (blad;) close - low

The sequences of upper and lower shadows can be smoothed separately using a moving average to find out whether they are rising or failing."

Another method for determining whether black or white candies dominate recent price movement is to use only the body of the candle, = close - open and spply a momentum calculation

Body momentum =-~"--x 100

where B,p is the sum of the days where B>0 (body is white) Bdown is the sum of the days where B<0 (body is black), the number of days is recommended as 14.

When the body momentum is greater than 70 the whites dominate: when the value is below 20 the blacks dominate.

USING THE BAR CHART

Charting is not precise and the constraction of the trendlines, other geometric formations, and their interpretation can be performed with some latitude. When using the simplest trendline analjsis, it often hsppens that there will be a small penetration of the channel or trendline followed by a movement back into the channel. Some think that this inaccuracy, with respect to the rules, makes charting useless; however, many experienced analjsts interprel this action as confirmation of the trend. The trendline is not redrawn so that the penetration becomes the new low of the trend, but it is left in its original position.

We must dwEEtef. back ™dlO"kforthe unJerlyinepuir.OEe in each meiLod"f analysis, whetiieriecluiical orfun.buental mtiie case the iren.bne we trviiie toiJenbf? the ArecRon - i pnces over s"iiie taiie panod 1 1 ( can use a#iiiple*-3j Lne to visualize tiie ftrectionj tiiey taw tiie ujirendby ctinectine i . - arising mark et even tLiJi each point used varying levels « volatillb and uii conftfions Thf ftances "f thes* points ali - -i perfectly, or freci-hng » perfect price support level, is .luall A tren- is .Tuiply a gufle, it may be too consemative at one time and too aogressive an-tiier, yonil never kn-w Applied ng.T-usly, charting rules rh-uld pr-bice many incirect signals but be right in tiie most imp.itant cases The liallenge tiie chartist is to mterrm tiie pattem pnces in conte: witii the bigger picture

Multiple Signals

Some of the impreciseness of charting can be offset with confirming signals. A simultaneous short- and long-term trend break is a much stronger signal than either one considered separately The break of a head-anddioulders neckline that corresponds to a channel sup

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port line is likely to receive much attention. Whenever there are multiple signals convergmg at, or near, a smgle point, whether based on moving averages, Gaim, cycles, or phases of the moon, that point gains significance. In charl analjsis, the occurrence of multiple signals at one point can compensate for the quality of the interpretation.

Pattem Failures

The failure to adhere to a pattem is equally as important as the continuation of that pattem. Although a trader

might anticipate a reversal as prices near a major siport line, a break of that trendline is significant in continuing the downward move. A failure to stop at the support line should result in setting short positions and abandoning plans for higher prices.

A head-and-shoulders formation that breaks the neckline, declines for a day or two, then reverses and moves above the neckline is another pattern failure. Postpattem activity must confirm the pattern. Failure to do so means thai the market refused to follow through and, therefore, should be traded in the opposite direction. This is not a case of identifjing the wrong pattern; instead, price action actively opposed the completion of the pattem. Wyckoff calls this "Effort and Results," referring to the effort expended by the market to produce a pattem that explains the price direction. If this pattern is not followed by results that confirm the effort, the opposite position should be set.

Consider a trading day in which prices open above the previous close, move higher, then close lower. The expectation is for prices to open lower the next day. If an inside day or a higher open follows, there is a strong sign of higher prices to come. As Thompson concludes, A strongly suggestive pattem that is aborted is just as valuable as a completed pattem.""

Change of Character

Thompson also discusses the completion of a pattern or price trend by identifj-ing a change of character in the movement. As a trend develops, the reactions, or pullbads, tend to become smaller. Traders looking to enter the trend wait for reactions to place their orders; as the move becomes more obvious, these reactions will get smaller and the increments of trend movement will become laiger. When the reaction suddenly is larger, the move is ending; the change in the character of the move signals a prudent exit, even if prices continue erratically in the direction of the trend.

A similar exanple occurs in the way prices react to economic reports or government action. The first time the Federal Reserve acts to raise rates after a prolonged decline the market is not prepared and bond prices react sharply lower. Before the next meeting of the Fed the maiket may be more spprehensive, but is likely to be neutral with regard to expectation of policy However, once there is a pattem of increasing rates following signs of inflation, the market begins to anticipate the action of the Fed. The sharp move occurs when the government fails to take action

TestingYour Skill

Recognizing a panem is both an art and a science. Not everyone has an eye for panems; others will see formations where no one else would. The first decision may be the most important: How much of the chart do you use? It is perfectly normal for different time intervals to show different trends. In some cases, arbitrarily cutting the chart at some previous date might cause a clear trend to disappear. The price scale (the vertical axis) of the chart is another variable not considered by some chartists When appljing methods requir

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ing specific angles, the chart psper is expected to have square boxes. Regardless of the shape of the box, the formations will appear very different from one piece of chart psper, or computerized page, to another.

The timeliness of the pattern identification is the most serious problem. Can the formation be interpreted in time to act on a breakout, or is the pattern only seen afterward? At different stages of development, the lines may sppear to form different patterns. Before using your charting ddlls to frade, practice simulating the day-to-day development of prices as follows:

1. Hold a piece of the psper over the right side of the chart, covering the most recent months, or better still, have someone else give you the partial chart.

2. Look at the chart and analyze the formations.

3. Determine what action will be based on your interpretation. Be specific.

4. Move the paper 1 day to the right, or have someone else give you the next days price.

5. Record any orders that would have been filled based on the prior days analjsis. Dont cheat.

6. Determine whether the new days price would have altered your formations and plans.

7. Retum to step 3 until finished.

This simple exercise might save a lot of money but may be discouraging. With practice you will become better al finding and using formations and will leam to select the ones that work best. Very few traders base their trading