Technical Analysis Pt. 2: Candlesticks

In order to start this second part of the introduction to technical analysis, we will start this article with a bit of history.

The candle sticks discussed in the previous article find their origins in Japan and were predominantly used in the rice market. People at the time (1650-1710) had been searching for new ways to represent the rice market for multiple decades until the (fictional?) character “Honma” was able to graphically represent the total market movements through new, mysterious drawings which largely resembled candle sticks. This provided a significant advantage over his fellow traders and was thus considered a large intellectual breakthrough.  

Figure 1: Honma and his initial candle stick drawings. Now widely considered the foundations for the usage of candle sticks in graphs as we know them.

Technical analysis gained prominence in the US a few decades ago, while it has been adopted in Japan for hundreds of years by now. The reason this type of analysis still functions after all these years is because of the unchanged human psychology: technical analysis shows us how investors have reacted to certain events throughout history. Close market analysis shows that the human has not changed his emotions regarding these trading decisions. Thus, TA has become increasingly reliable, despite mechanisms in the markets changing.

Which assumptions can be made looking solely at candlestick graphs?

As the limit of the main body represents open and closing prices of the time frame and the wicks represents heights and lows, numerous assumptions can be made.

If the upper wick is very close to the body, one can say that it was a strong close. In other words, a limited number of investors sold their shares and took their profits after the rise. Thus, belief is indicated in a further upward trend. On the other hand, if the lower wick stretches out very long below the main body, it means that the bulls were trying to buy the dips. In fact, the longer the distance between the wick and the main body, the more bullish traders were.

Basically, the longer the upper wick, the more shares that were sold and hence the more profits that were taken. As a large selloff of a share can indicate a lack of confidence in its upward continuation, you should be careful if you are long on that share. The longer the lower wick, the more shares that were bought and the more bulls that jumped in. This should give you confidence about an upward trend. However, general market movements do not always speak the truth and hence a healthy sense of skepticism should be held before making drastic decisions.

Volume and moving averages (MA)

As said last week, the volume is the total amount of shares traded in a chosen time frame. You should be aware of the difference between dollar volume and simple volume. Simple volume is just the pure number of shares traded that day and the dollar volume indicates the total value of the shares traded during the time.

Let us take a hypothetical example of a company which has 2 shares, each worth $1 million. If one share is sold during a particular day, the dollar volume will be $1 million, even though only one trader took a buy or sell action. This example shows you should always look at both the dollar volume and normal volume to avoid walking into the above explained trap of the dollar volume.

Volume indicates liquidity. It is very important to look for liquid assets as those are easier to trade during highs and lows and hence more reliable to chart. They are also less likely to jump around randomly, as trading is more frequent and much more precise for liquid assets. Also, buying non-liquid shares can be difficult to sell when you want to do so and thus liquidity represents trading opportunity for a certain security.

So what are the assumptions one can make based on volume?

If trading volume is increasing during an upward of downward trend, this should give you confidence that the trend is going to continue because traders are supporting the price movement. On the contrary, if trading volume is decreasing during a particular trend, you should be skeptical and maybe wait for the trend to be confirmed or shift towards a new increase in volume. Basically, volume gives confidence to price actions.

There are also volume climaxes which change from bearish volume to bullish volume and vice versa. If this happens frequently, we would advise you to look at options as this indicates strong volatility.

What are the assumptions one can make based on moving averages?

You can calculate moving averages on different time frames. Within this, one can find simple moving averages (SMAs) and exponential moving averages (EMAs). So far, we will only explain simple moving averages in detail. To calculate the simple moving average you simply take the average of the closing prices during a certain period. On the other hand, exponential moving averages include recent price movements stronger and thus will adapt more to new price patterns.

To express the time frame you are using you will write for example SMA(20) which will represent the moving average for 20 trading days. SMA(100) will be the average for 100 trading days.

How to spot support and resistance using moving averages

Moving averages can also be used to spot trading opportunities based on supports or resistances. For example, if the share is trading above the SMA, we will say that this average represents a support and if the asset is trading below, we will characterize it as resistance.

The longer the MA, the more reliable it is. For example an SMA(200) which acts as a resistance and gets broken through is much more representative than an SMA(20) breakthrough. After being broken, a resistance becomes support and a support becomes resistance.

Intuitively, technical analysis is largely a self-fulfilling prophecy as the more traders use this type of analysis, the more the price action will represent moving averages as support or resistance. As technical analysis is becoming more and more popular, we consider indicators like this to become more reliable over time.

Last but not least, we advise you to always use the same colors when charting. This will help you to quickly assess the urgency of a change in the price direction. For example, if you are always using red for your SMA(200) and green for your SMA(20), as soon as you see that one resistance has changed to support of the other way round, you will be able to assess the strength of the change through the colors.