The Power of Japanese Candlestick Charts. Fred K. H. Tam

their popularity and usefulness.

      ■ Historical Background

      After the unification of Japan under the Tokugawa Shogunate (Eighth Shogunate) from 1615 to 1867, its agrarian economy grew. By the seventeenth century, Osaka was regarded as Japan’s capital and commercial centre. Osaka’s easy access to the sea made it a national port for the shipping of supplies, including rice. Strategically located, Osaka soon became the centre for the rice trade, and rice brokerage became the foundation of Osaka’s prosperity. The Dojima Rice Exchange became the centre of rice trade for physical delivery.

      Into this background, Munehisa Homma (1716–1803) was born in the city of Sakata, Yamagata Prefecture, Japan. His real name was Kosaku Kato, but he took up the name Munehisa Homma later in his life after his adoption by the wealthy Homma family. At that time, the port of Sakata was a distribution centre for shonai (rice). Homma concentrated his attention on the rice market and later on the popular fixed rice market. By 1750 he was trading at his local rice exchange in Sakata. After the death of his father, he was placed in charge of managing his family’s assets. With this money he went to the Dojima Rice Exchange in Osaka and began to trade rice futures.

      His detailed attention to the markets and his understanding of candlesticks propelled him to become a very wealthy man. He was considered an elusive and feared trader because of his effective understanding of candlesticks and the psychology of the rice markets. He would keep records of yearly weather conditions. To analyse the psychology of investors, Homma analysed rice prices going back to the time when the rice exchange started. Using his own network of communication links he made a killing in the Osaka Rice Exchange and later in the Edo (now Tokyo) exchange.

      It was believed that Homma even achieved the feat of 100 consecutive winning trades. Munehisa Homma was perhaps the first person in recorded Japanese history to have used past prices to predict futures price movements – and he did it successfully.

      His charismatic personality and highly effective trading methods gained him the nickname “Dewa’s long-nosed goblin” and an honour as the “god of the markets.” He was such a legend that a folk song from Edo was composed to honour his feats. “When it is sunny in Sakata [Homma’s hometown], it is cloudy in Dojima [the Dojima Rice Exchange in Osaka] and rainy in Kuramae [the Kuramae Exchange in Edo].” Interpreted, it means: When there is a good rice harvest in Sakata, rice prices fall on the Dojima Rice Exchange and collapse in Edo. This song underscores Homma’s control over the rice markets during his time.

      In later years, Homma became the financial consultant to the Japanese government and was given the title of “Samurai.” He died in 1803, but his books about the markets (Sakata Senho and Soba Sani No Den), which revealed his trading principles, evolved into the candlestick charting technique that we know today.

      ■ Reasons Candlestick Charts Are So Popular Today

      Here are six reasons that candlestick charts are so popular amongst professional traders today:

1. Leading indicator: Candlestick charts have the ability to show reversal signals earlier than Western charting techniques. As such, candlestick charts are a true leading indicator of market action. They regularly identify potential moves before they become apparent with Western technical tools. Many Japanese candlestick patterns are not found in Western chart techniques. Figure 1.1 shows an example of how candlesticks lead moving average convergence divergence (MACD) in timing entry and exit.

      2. Pictorial: Candlestick charts are very pictorial and describe the state of players’ psychology at a particular moment, which can be utilised to make meaningful trading decisions. Terminology like the “hangman,” “shooting star,” “dark cloud cover,” “hammer,” and “abandoned baby” paints indelible word pictures that can assist the trader to remember the pattern through recalling its name. The candlestick technique consists of hundreds of different pattern groups that accurately identify specific traits and tendencies.

      3. Versatile: Candlestick charts are versatile in that they can be used alone or in combination with Western technical tools. They are unlike point-and-figure charts, which cannot be used alongside other Western technical indicators. Candlesticks use the same price data as bar charts, yet the candlestick technique better promotes the ability to recognise complex pattern groups and predict the next possible outcome based on them.

      4. Can be applied to any time dimension: Candlestick charting techniques can be adapted for either short- or long-term trading. Candlestick charts are excellent for short-term trading through the use of intra-day charts like the 1-minute, 5-minute, 15-minute, 30-minute, and 1-hour charts. They can also be applied for longer-term forecasting through the use of daily, weekly, and monthly charts.

      5. Flexibility and adaptability: Candlestick charts can be applied to follow as many markets as desired – be they stocks, futures, currency, or commodities. In other words, a trader can apply candlestick principles to analyse or trade Malaysian stocks, index futures, or crude palm oil futures. If traders wish to diversify their portfolio, they can trade, for example, U.S. stocks, U.S. futures, foreign currency, Japanese or U.S. Treasury bonds, and for that matter any commodity in any market around the world.

      6. Time-tested, dependable, and useful: The candlestick charting technique is time-tested and had been refined by generations of use in Japan. The fact that it is still very much in use today after more than 300 years since its discovery is testimony to its usefulness.

FIGURE 1.1 Gold Daily (2013) – An example of how candlesticks lead MACD in timing entry and exit

      ■ Construction of the Candlestick Chart

      The word candlestick is a Western term coined by Steve Nison. In Japan it is called Ashi, which means “leg” or “foot.” A daily chart is called Hi Ashi, a weekly chart shu ashi, and a monthly chart tsuki ashi. The word for foot is used by the Japanese to describe a chart probably because, while the foot reveals a person’s past records, a chart reveals the activities of market players. Ashi can also mean “footprint,” and the Japanese could have used it to describe the candle chart, because footprints left behind in the sand will offer clues as to where a person is heading.

      Drawing a candlestick chart requires four elements of price data:

      Here are the four simple steps to draw a candlestick chart.

      Step 1: Mark the open and the close.

      Step 2: Box up the open and the close. This boxed up rectangle is called the “real body.” The real body represents the range between the open and close of the session. If the close is higher than the open, the real body is coloured red (or white in some software). If the close is lower than the open, the real body is coloured black.

      Step 3: Mark the high and join this to the top of the box (real body). This thin line above the box is called the “upper shadow.” Shadows represent the session’s price extreme. The peak of the shadow is thus the high of the session.

      Step 4: Mark the low and join this to the bottom of the box (real body). This thin line below the box is called the lower shadow. The trough of the shadow is thus the low of the session.

      If a candlestick line has no upper shadow, it is said to have a shaven head. A candlestick with no lower shadow has a shaven bottom. A candlestick line where the open and close are at the same or nearly the same price level is called a doji (pronounced do-gee). A doji implies indecision and reflects a market where the bulls and bears are in equilibrium. A doji has no box (real body).

      The Real Body

      The box that is joined by the open and the close is called the real body of the candlestick. If the close is higher than the open, the real body is coloured white (or red in some software). Conversely, if the