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21 CANDLESTICKS EVERY TRADER SHOULD KNOW

Table of Contents
Preface

Published by the Marketplace Books 2007

LESSON 1 - WHAT YOU SHOULD KNOW

ABOUT CANDLESTICKS

All rights reserved.

Reproduction or translation of any part of
this work beyond that permitted by section 107 or 108
of the 1976 United States Copyright Act without the
permission of the copyright owner is unlawful. Requests
for permission or further information should be addressed
to the Permissions Department at Marketplace Books,
9002 Red Branch Road, Columbia, MD 21045,
(410) 964-0026, fax (410) 964-0027.

CANDLESTICKS ANTICIPATE, INDICATORS FOLLOW,

4
AND TRENDLINES CONFIRM

ISBN 13: 978-1-59280-313-2

ISBN 10: 1-59280-313-X

How to Read a Candlestick Chart

Bar vs. Candlestick Charts

Optimism and Pessimism as Shown by Candles

Advantages of Candle vs. Bar Charts

Candles Anticipate Short Term Reversals

Why Candlesticks Work

The Rule of Two

Candles in Action: Dow Jones Analysis

Bullish Engulfing

The Hammer

The Doji

Gravestone Doji

Back to the Dow Jones Chart

Summary
The publisher is pleased to present this book in digital
formata more sustainable and interactive alternative
to traditional print publishing. The electronic medium
significantly reduces carbon emissions and ensures that
more trees can remain standingespecially if you can
refrain from printing your book to hard copy.

page 

10

LESSON 2 - JAPANESE CANDLESTICK CHARTING

11

21 CANDLES EVERY TRADER SHOULD

KNOW BY NAME

11

Candles 1-4: TheFour Dojis Show Stocks That

Have Stalled

11

Candles 5-6: H
 ammer & Hangman Candlesticks
Signal Key Reversals
Candles 7-8: Bullish andBearish Engulfing Candles
Spot Trend Changes Before
They Take Place
Candle 9:

 ark Cloud Cover Warns of

D
Impending Minor Tops

LESSON 4 - GAPS FROM A JAPANESE CANDLESTICK

VIEWPOINT
44

15

WHAT IS A GAP?
The Four Types of Gaps
Candlestick Theory on Gaps

18
20

Candle 10:

 he Piercing Candle Is a Potent

T
22
Reversal Signal
Candles 11-12: The Three Candle Evening and Morning
Star Patterns Signal Major Reversals 24
27
Candle 13:
The Shooting Star Can Wound
Candle 14:
The Inverted Hammer Indicates the
28
Shorts May Be Ready To Cover
Candle 15:
The Harami is Pregnant With
Trading Possibilities
30
Candle 16:
TheFull Marubozu Is a Candle
Without Shadows
31
Candles 17-18 High Wave and Spinning Top Express
33
Doubt and Confusion
Candle 19:
The Ominous Call of Three Black Crows 34
Candle 20: Three White Soldiers Can
36
Help You Fight for Profits
Candle 21:
Tweezers Can Help You Pull Profits
38
Out of the Market
LESSON 3 - INTEGRATING MULTIPLE CANDLESTICKS
& INDICATORS
40
Round Number Resistance, Candlesticks,
and Indicators

40

page 

44
44
46

SYNTHESIS OF WESTERN WISDOM AND

EASTERN INSIGHT

47

A CONCLUDING CHALLENGE

48

ABOUT THE AUTHOR

49

Preface

apanese Candlesticks are one

of the most powerful technical
analysis tools in the traders
toolkit. While candlestick charts
date back to Japan in the 1700s,
this form of charting did not become popular in the Western world
until the early 1990s. Since that
time, they have become the default
mode of charting for serious technical analysts, replacing the openhigh-low-close bar chart.
Because of this surge in popularity, there has been a great deal of
cogent information published on
candlestick charting both in book
form and on the worldwide Web.
Many of the works, however, are
encyclopedic in nature. There are
perhaps 100 individual candlesticks and candle patterns that are
presented: a daunting amount of
information for a trader to learn.
In this book, I have selected 21
candles that I believe every trader
should know by name. These are
the candles that in my experience
occur most frequently and have

the greatest relevance for helping

you make trading decisions. Just
as knowing the name of a person
helps you immediately recognize
them on a crowded street; so being
able to name the candlestick allows
you to pick it out of a chart pattern.
Being able to name it allows you
to appreciate its technical implications and increases the accuracy of
your predictions.
In my trading, I try to integrate
candlestick analysis, moving
averages, Bollinger bands, price
patterns (such as triangles), and indicators such as stochastics or CCI
to reach decisions. I find that the
more information that is integrated, the more likely it is that the decision will be correct. In this book,
I have chosen to combine moving
averages, Bollinger bands, and two
indicatorsstochastics, and CCI
on various charts. As we discuss
individual candlesticks or candle
patterns, I will integrate these
tools. Hopefully, you will learn not
only how to recognize candles, but
also appreciate how you can combine them with the traditional tools
of technical analysis.

In this book, my focus is on minor trend reversals: those of most

interest to a trader. The minor
trend typically lasts 5 to 15 days
although, on occasion, I have seen
it stretch out to about 30 trading
days. These same candle principles
also work equally well on 5-minute or weekly charts. It is simply
a matter of adapting this information to the time frame in which
you are trading.
Candles are your personal sentry
providing you with consistent
early warnings of impending trend
change. They provide the earliest
signal I know of that the patterns
in the market are about to reverse.

page 

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STEVE PALMQUIST
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new 90-minute course
shows you the
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should avoid.

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Lesson 1

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CANDLESTICKS ANTICIPATE, INDICATORS

FOLLOW, and TRENDLINES CONFIRM

call candlesticks an anticipatory indicator. You havent

come across this wording before because it is my own
terminology. An anticipatory indicator gives a signal in
advance of other market actionin other words, it is a leading
indicator of market activity.

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Momentum indicators such as CCI (Commodity Channel

Index) or stochastics are also anticipatory, because momentum
usually precedes price. Typically, however, even rapidly moving momentum indicators such as CCI lag the candle signal
by a day or two. When you receive a candle signal followed by
a momentum signal such as stochastics, which communicates
the same message, it is likely that in combination they are accurately predicting what will happen with a stock.
On the other hand, the break of a trendline or a moving average
crossover is what I call a confirming signal. It usually occurs days after the peak or bottom of price and much after the
candlestick and indicator signal.

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Depending on your trading style, you can act on the anticipatory signal.
However, if you prefer to be cautious and wait for more evidence, candlesticks anticipate a change in trend and alert you that a reversal may be imminent. In this case, you use candlesticks to confirm other indicators.

Figure 1 - International Business Machine (IBM) NYSE

HOW TO READ A CANDLESTICK CHART

If you are already familiar with the basics of candlesticks, you can skim
this section. If you have seen candles on the web, but have not studied
them in some detail, then youll now be given the background you need to
use them.
Candles may be created for any period of chartmonthly, weekly,
hourly, or even by minute. When I discuss candles in this book, I use daily
chart examples: But be aware that you can create candle charts for virtually any period.
Source: StockCharts.com

BAR VS. CANDLESTICK CHARTS

Figure 1 is a three-month bar chart and Figure 2 a three-month candlestick chart for IBM. See if you can spot any differences in the data series.

Figure 2 - International Business Machine (IBM) NYSE

Hard to spot the difference? Thats because there isnt any. Both the bar
chart and the candlestick chart contain exactly the same information,
only presented in different form. Both the bar chart and the candle chart
contain the same data: the high for the period (the day), the low, the open,
and the close.
In a candlestick chart, however, the names are changed. The difference
between the open and the close is called the real body. The amount the
stock price moved higher beyond the real body is called the upper shadow.
The amount the stock price moved lower is called the lower shadow. If the
candle is clear or white it means the opening was lower than the high, and
the stock went up. If the candle is colored, then the stock went down. This
information is shown below:

page 

Source: StockCharts.com

Bar Chart

Shaven Head/Shaven Bottom.

Candlestick Chart

High
Close
Open
Low

This candle is the opposite of the one just described. Depicted here is a
day when the amateurs are the optimists. They buy at the top of the day,
only to watch prices decline steadily. By the end of trading, prices have
declined sharply and the professional pessimists are in control of the
market. The opening the next day often is lower.

High
Upper Shadow
Close
Real Body
Open
Lower Shadow

Up Period

Down Period

Shaven Head/Shaven Bottom

OPTIMISM & PESSIMISM AS SHOWN BY CANDLES
Here is an idea about candlesticks that helps me use them better and
which I havent seen in books or on the Web.
It is generally acknowledged that the opening of the trading day is dominated by amateurs. The close, on the other hand, is dominated by professional traders. The low of the day, one might say, is set by the pessimiststhey believed the market was going lower and sold at the bottom.
The high of the day is set by the optimists. They were willing to pay top
price but were incorrect in their analysis, at least in the short term.
Individual candlesticks may be understood by combining this concept
with the candle chart. I will use only two examples, but you might want
to experiment with this idea yourself.
Shaven Bottom/Shaven Head.

The shaven bottom/shaven head candle depicts a day in which the market
opened at the low and closed at the high. It is a day on which the amateurs are also the pessimists. They sell early and their shares are gobbled
by eager buyers. By the end of the day, the optimists and professionals
close the stock sharply higher. This bullish candle frequently predicts a
higher open on the next day.

Shaven Bottom/Shaven Head

Candles can be understood better by reasoning them out in this way.

Particularly when you see a candle with a large real body, ask yourself who
won the battle of the day, the optimists or the pessimists, the amateurs or
the professionals. This question will often provide you with an important
clue to subsequent trading action.

ADVANTAGES OF CANDLE VS. BAR CHARTS

There are three major advantages of candlestick charts compared to bar
charts.
1. Candlestick charts are much more visually immediate than bar
charts. Once you get used to the candle chart, it is much easier to see
what has happened for a specific periodbe it a day, a week, an hour, or
one minute.
With a bar chart you need to mentally project the price action. You need
to say to yourself, The left tick says thats where it opened, the right tick
where it closed. Now I see. It was an up day. With a candlestick chart,
it is done for you. You can spend your energy on analysis, not on figuring
out what happened with the price.
2. With candles you can spot trends more quickly by seeing if the candles are clear or colored. Within a period of a trend, you can tell easily
what a stock did in a specific period.

page 

The candle makes it easier to spot

large-range days. A large candlestick suggests something dramatic happened on that trading
day. A small range day suggests
there may be relative consensus
on the share price. When I spot a
large range day, I check the volume
for that day as well. Was volume
unusual? Was it, say, 50% higher
than normal? If so, it is very likely
that the large-range day may set the
tone for many days afterward.

tion to them, they often warn you

of impending changes.

3. Most important, candles are

vital for spotting reversals. These
reversals are usually short term
precisely the kind the trader is
looking for.

An oversold market, on the other

hand, is one in which the sellers
have been in control for several
days or weeks. Prices have gone
down too far too fast. Most of the
traders who want to sell have done
so, and there are bargainsat least
in the short termto be had.

When traditional technical analysis

talks about reversals, it is usually
referring to formations that occur
over long periods of time. Typical
reversal patterns are the double top
and head and shoulders. By definition, these involve smart money
distributing their shares to naive
traders, and they normally occur
over weeks or even months.
Candlesticks, however, are able to
accurately pick up on the changes
in trend, which occur at the end of
each short term swing in the market. If you pay meticulous atten-

CANDLES ANTICIPATE
SHORT TERM REVERSALS
The message of candlesticks is most
powerful when the markets are at
an extreme, that is when they are
overbought or oversold. I define
overbought as a market that has
gone up too far too fast. Most of
the buyers are in, and the sellers are
eager to nail down profits.

There are many overbought and

oversold indicators, such as CCI,
RSI (Relative Strength Index) and
Williams %R. However, one of the
best is stochastics, which essentially measures the stocks price in
relation to its range, usually over
the past 14 periods. CCI typically
agrees with stochastics and is useful for providing confirmation of
its signal. I also almost always put a
Bollinger Band on charts I analyze.

John Bollinger created this tool to

include 19 out of every 20 closing
prices within the bands. Therefore,
a close outside the band is significant. A close outside the upper
band usually indicates the stock is
overbought. When it is outside the
lower band it is oversold.
When stochastics, CCI, and the
Bollinger bands all agree, a stock or
index is overbought or oversold, I
take their alignment very seriously
because there is a good chance a
reversal is overdue. A significant
candlestick tells me more exactly
when the reversal might occur.

WHY CANDLESTICKS
WORK
A chart may be viewed as a picture
of the war between supply and
demand. When a stock is moving up, the buyers are in control.
There is more demand than supply.
Purchasers are eager to acquire the
stock and will pay up, hitting the
ask price to do so. When a stock
is declining, the reverse is true.
Sellers are fearful and will not
dicker over a few cents, being more
likely to accept the bid. Candlesticks graphically show the balance
between supply and demand. At

page 

key reversal junctures, this supply/demand equation shifts and is

captured in the candle chart.

The Rule of Two

Generally, no one candlestick
should be judged in isolation. The
general principle is that even if
you see a key reversal candlestick,
you should wait at least part of
one more day before acting. If, for
example, you spot a candle called
a doji, seek verification from the
action of the next trading day. If
there is a down gap and prices begin to decline, then it is prudent to
take your position.

CANDLES IN ACTION:
DOW JONES ANALYSIS
As stated in candlestick theory,
there are many candles that signal
important reversals. To conclude
this section, we will focus on only
four candlesticks that called every major turn in the Dow Jones
Industrial Average over nearly a six
month period! Think how much
more accurately you could have
traded the market if you knew
these candles, names, and implications and had recognized them
when they occurred.

The good news is that these are reversal signatures and are apt to occur
again. Your ability to recognize them could lead to large trading gains.
First, I will explain the candlesticks, then apply this theory to analysis
of the graph. The candles are shown on the Dow chart that follows the
explanation.

THE HAMMER

BULLISH ENGULFING
The bullish engulfing is most significant when it occurs after a prolonged downtrend. The stock or index has been selling off sharply. On
the day of the bullish engulfing, prices often will start the day by falling.
However, strong buying interest comes in and turns the market around.

Bullish Engulfing

The bullish engulfing is named thus because this candle surrounds or

engulfs the real body of the previous one. When I discuss this candle
with college students enrolled in my stock market course, I call it PacMan because, like the video game character, it eats the candle before
it. The bullish engulfing represents a reversal of supply and demand.
Whereas supply has previously far outstripped demand, now the buyers are far more eager than the sellers. Perhaps at a market bottom, this
is just short-covering at first, but it is the catalyst that creates a buying
stampede.
When analyzing the bullish engulfing, always check its size. The larger
the candle, the more significant the possible reversal. A bullish engulfing that consumes several of the previous candles speaks of a powerful
shift in the market.

This hammer marks a reversal off a bottom or off an important support level. On the day of the hammer, prices decline. They hit bottom
and then rebound sharply, making up all the groundand sometimes
morecompared to where the sell-off started. The candle shows that
the buyers have seized control. A bullish candlestick on the following
day confirms this analysis.

Hammer

THE DOJI
If you were to learn only one candle by name, this would have to be
the one. A common doji, as I call it, is shaped like a cross. A doji has
no real body. What it says is that there is a stalemate between supply
and demand. It is a time when the optimist and pessimist, amateur
and professional, are all in agreement. This market equilibrium argues
against a strong uptrend or downtrend continuing, so a doji often marks
a reversal day.

Doji

Therefore a doji in an overbought or oversold market is often very significant. The opening of the next day should be watched carefully to see
if the market carries through on the reversal. Note, a candle with a very
small real body often can be interpreted as a doji.

page 

GRAVESTONE DOJI
The gravestone doji occurs far less frequently than the common one, but
gives an even clearer signal. At the top of an extended move, it says the
bulls tried to move the market higher and couldnt do it. The stock, or
in this case the index, cannot sustain the probe to new high ground. It
opens and closes at the exact same level creating the appearance of a
gravestone.

Gravestone Doji

BACK TO THE DOW JONES CHART

veals an oversold reading when it goes below 20 (above 80 is overbought).

An oversold market can be described as one which has gone down too far,
too fast.
The bullish engulfing candle was very large, adding to its significance.
It implied that with the Dow able to hold 10000, the shorts were covering, buying interest had emerged at this level, or both. While the Dow
didnt soar higher in the coming day, neither did it drop below 10000
again. By early May it rallied back to resistance near 10400. Note how
a horizontal line can be drawn across the chart to mark this resistance
level and how its role as both support and resistance alternated during
the six-month period.
Figure 3 - Dow Jones Industrial Average ($INDU)

During the period the chart illustrates, the Dow Jones Industrial Average
went sideways in a broad trading range between 10000 and 11000. I have
placed only one moving average on the chart, the 50-day. A 50-day moving average describes the intermediate trend, and when it moves sideways
like it does here, you can also be sure it describes a market in a sideways
consolidation pattern.
Despite the sideways movement, there were many good trading opportunities, both long and short. The first came in early March when the Dow
peaked just below 11000. All round numbers represent key support and
resistance in the major averages, and this top was no exception. The candle
formed was a gravestone doji. Note the long upper shadow and the absence
of a real body. This combination signalled that the bulls did not have the
strength to push the Dow through the 11000 mark. Over the next month
the Dow retreated nearly 1000 points, finally bottoming right at 10000.
The late April bottom at 10000 is marked by a bullish engulfing candle.
Immediately before the bullish engulfing, note the three very large back
candles, which saw the Dow drop nearly 500 points in three days. That
left it substantially oversold as shown by the stochastics indicator that repage 

Source: StockCharts.com

The minor uptrend brought the Dow back to 10400. Traders looking for
the Dow to stall at this level did not have long to wait. Heres a small test
of what youve learned so far. Can you name the candlestick that helped
mark the peak at this time? If you said a gravestone doji, you get high
marks.
The gravestone doji candle led to another small down-wave in the Dow.
This was part of a secondary bottom that saw the index bottom well
above 10000, closer in fact to 10100. Note there is a candle you have seen
beforethe bullish engulfing.

familiar. Of these, 21 candles recur frequently enough and are significant

enough that you should be able to spot them by name. Knowing their
names allows you to spot them more easily and assess their implications.
When faced with the need for a quick decision during the heat of trading,
the trader who can name these 21 candles has a distinct advantage over
one who cant.

From 10075 the Dow advanced over the next month to a peak just below
10600. For almost a month, in what must have seemed like an eternity
for traders, the Dow vacillated in an excruciatingly narrow range between 10400 and 10600. When it finally got beyond resistance at 10600, it
formed three doji-like candles in a row. (The candles are doji-like because they have very small real bodies). These dojis showed that the bulls
and bears were at a stalemate. After a lengthy uptrend they indicated that
the bulls lacked the buying power to move the market higher. Not surprisingly, a strong sell-off ensued.
The decline ended well above 10000 this time, finding a bottom at 10175.
The candle that formed here can be interpreted as a hammer, despite the
very small upper shadow. The hammer candle occurred after the Dow
had found support near 10250 for several days. On the day of the hammer, a dramatic news event sent prices sharply lower in the morning, but
then the selling pressure dried up. By late afternoon, prices had turned
positive as can be seen from the small white real body. The hammer led
to a subsequent rally that lifted the Dow several hundred points in two
trading days, taking it right back into the 10400 to 10600 range of resistance it had been in the previous month.

SUMMARY
I find it intriguing that the same candlestick patterns repeat continuously.
All in all, there are about 100 candle patterns with which you can become

page 10

Lesson 2

Candles 1-4

Japanese
Candlestick
Charting

THE FOUR DOJIS

SHOW STOCKS THAT
HAVE STALLED

f you were to ask me which of all the candlesticks is the most

important to recognize, I would answer unhesitatinglythe
doji. On a daily chart, the doji often marks the beginning of
a minor or intermediate trend reversal. Fail to recognize the dojis
implications, and you run the risk of buying at the top or staying
far too late in a trade and leaving substantial profits on the table.

21 Candles every trader should

know by name

n the previous section of this book, I showed how

certain key candlesticks were able to identify every
major trend reversal in the Dow Jones Industrial
Average for a period of several months. It is vital for
trading success, I argued, to recognize candlesticks and
assess their implications.

There are four types of dojiscommon, long-legged, gravestone

and dragonfly. All dojis are marked by the fact that prices opened
and closed at the same level. If prices close very near the same level
(so that no real body is visible or the real body is very small), then
that candle can be interpreted as a doji.

Candles are vital to trading because they identify possible

reversals in trend. Failure to spot these key candles can lead
to costly trading errors. Why should you be able to identify
these candles? Because they can make you money!

After a long uptrend, the appearance of a doji can be an ominous

warning sign that the trend has peaked or is close to peaking. A
doji represents an equilibrium between supply and demand, a tug
of war that neither the bulls nor bears are winning. In the case
of an uptrend, the bulls have by definition won previous battles
because prices have moved higher. Now, the outcome of the latest

page 11

skirmish is in doubt. After a long downtrend, the opposite is true. The

bears have been victorious in previous battles, forcing prices down. Now
the bulls have found courage to buy, and the tide may be ready to turn.

they achieved. By the end of the day, they came back and closed at the
same level. Heres an example of a gravestone doji:

What I call a common doji has a relatively small trading range. It

reflects indecision. Heres an example of a common doji:

Gravestone Doji

Doji

A long-legged doji is a far more dramatic candle. It says that prices

moved far higher on the day, but then profit taking kicked in. Typically,
a very large upper shadow is left. A close below the midpoint of the
candle shows a lot of weakness. Heres an example of a long-legged doji:

Finally, a dragonfly doji depicts a day on which prices opened at a

high, sold off, and then returned to the opening price. In my experience,
dragonflies are fairly infrequent. When they do occur, however, they
often resolve bullishly (provided the stock is not already overbought as
shown by Bollinger bands and indicators such as stochastics). Heres an
example of a dragonfly doji:

Dragonfly Doji
Long-Legged Doji

When the long-legged doji occurs outside an upper Bollinger band

after a sustained uptrend, my experience says you should be extremely
vigilant for the possibility of a reversal. A subsequent sell signal given by
an indicator such as stochastics typically is a very reliable warning that
a correction will occur.
A gravestone doji, as the name implies, is probably the most ominous
candle of all. On that day, prices rallied, but could not stand the altitude

When assessing a doji, always take careful notice of where the doji occurs. If the security youre examining is still in the early stages of an
uptrend or downtrend, then it is unlikely that the doji will mark a top or
a bottom. If you notice a short-term bullish moving average crossover,
such as the four-day moving average heading above the nine-day, then
it is likely that the doji marks a pause, and not a peak. Similarly, if the
doji occurs in the middle of a Bollinger band, then it is likely to signify a
pause rather than a reversal of the trend.
As significant as the doji is, one should not take action on the doji alone.
Always wait for the next candlestick to take trading action. That does

page 12

not necessarily mean, however, that you need to wait the entire next day.
A large gap down, after a doji that climaxed a sustained uptrend, should
normally provide a safe shorting opportunity. The best entry time for a
short trade would be early in the day after the doji.
The chart of the Disk Drive Index ($DDX) shows three of the four dojis
just described and gives some guidance on how to effectively interpret
this candle, depending on where it occurs in a trend. The Disk Drive
Index consists of 11 stocks in the computer storage and hard drive businesses. Therefore this indexs performance usually correlates highly
with the Nasdaq Composite. In March, the $DDX hit a peak of 125.06
Figure 4 - Disk Drive Index - AMEX ($ddx)

and then a prolonged sell-off in conjunction with the overall market

in general and tech stocks in particular. Also, note how in early May
the $DDX traded sideways for several days, finding support or buying
interest at the mid-97 level with resistance or selling pressure near the
psychological barrier of 100.
Finally, the buyers were able to overwhelm the sellers and the $DDX
pierced 100. Note on this day, the 4-day moving average penetrated the
9-day. The 4-day moving average and the 9-day both began to slope
upward. That pattern suggested an uptrend was beginning. The 4-day
moving average going above the 9 is a bullish moving average crossover.
While I wouldnt trade on this very short-term signal in isolation, it
provides a useful confirmation that the immediate trend is up.
The next day, a common doji appeared (labeled 1). While a doji
should always be noted, this one was early in the trend. The previously
described rule of two also says to wait another day before taking trading action. The following day was positive.
Two days later a dragonfly doji appeared (2) with prices closing at their
highs. Again, a dragonfly doji often resolves positively as did this candle.
Three days after that (3) a second dragonfly doji occurred. This one
was more worrisome because it came after a substantial advance and was
close to the top of a Bollinger band. However, the uptrend continued.
By early June, the $DDX was trading close to 115. It had rallied nearly
20% off its early May low. Whereas during the core of the uptrend, there
had been several large white candles indicating bullish enthusiasm, now
the real bodies of the candles turned small, showing caution on the part
of buyers. Always observe the size of the candles in your analysis.
In mid-June, two consecutive dojis (4) appeared on the chart. The
first was a common doji; the second was closer to a long-legged variety.
For those traders in a long position, extreme vigilance was now warranted. Substantial profits were there for nailing down in the $DDX.
The index was stalling; the bulls and bear were stalemated.

Source: StockCharts.com

page 13

In the two days after the dojis

appeared, the $DDX struggled to
move higher without much success. On the second day, the candle
turned dark showing selling pressure. Note also that the four-day
moving average penetrated down
through the nine-day, the first time
this had happened since the uptrend began in early May.
The subsequent slide in the $DDX
was not dramatic. However, the
trader who failed to heed the dojis
warning surrendered a large portion of his or her profits. Dojis
should not be assessed mechanically. However, after a strong trend
in either direction they often mark
major turning points. Always recognize the doji when it occurs, and
be prepared the next trading day to
take appropriate action.
The one kind of doji not found in
the $DDX chart is the gravestone
doji, already seen in the chart of
the Dow Jones Industrial Average. Candlestick names typically
are very colorful, and this one is
no exception. If you are a bull,
the gravestone doji should sound
ominous and you should always be
prepared to take rapid action on its

appearance. When it occurs after a

prolonged uptrend, and the upper
shadow penetrates through the
upper Bollinger band, the candle
takes on added significance.

Figure 5 - AMR Corp. (amr) NYSE

To review, a gravestone doji occurs

on a day when prices open and close
at the same level. During the session, however, prices move sharply
higher, but the bulls cannot sustain
the advance. This trading action
leaves a long upper shadow on the
chart. If the gravestone doji does
not serve as a key reversal day, it
certainly will mark a resistance area
that normally will stall an advance
for several sessions. In either case,
the trader often is prudent to nail
down profits after its appearance.
The chart of airline stock AMR
Corp. (AMR) is a classic example of
why its vital to recognize the gravestone doji by name. AMR bottomed at $9.80 in late April. In early June, it had advanced nearly 40%
and was probing the $14 area. On
June 17, it opened at $14 and shot
up to a peak of $14.95. Notice how
a large part of the upper shadow
pierced through the Bollinger band.
But traders did not like the altitude
that AMR was flying at, and stock

Source: StockCharts.com

closed unchanged for the day. The

session created a long-legged doji, a
warning that the bulls were not able
to maintain control.
Traders who required additional
evidence that a reversal had occurred did not need to wait long.
Notice how the 4-day moving
average crossed below the 9 day. A

page 14

trendline break also occurs shortly

after this crossover, suggesting
AMRs flight path was now lower.
Traders who ignored these signals
paid a high price. By the end of
June, AMR was probing $11, not
far from where the rally began.
This was one round trip that could
have been avoided by assessing the
implications of the gravestone doji.

Candles 5-6
HAMMER & HANGMAN
CANDLESTICKS SIGNAL
KEY REVERSALS

How can you tell the two candles apart? The hangman candle, so
named because it looks like a person who has been executed with
legs swinging beneath, always occurs after an extended uptrend.
The hangman occurs because traders, seeing a sell-off in the shares,
rush in to grab the stock at bargain prices. To their dismay, they
subsequently find they could have bought the stock at much cheaper levels. The hangman looks like this:

Hangman

Clear Real Body

Black Real Body

On the other hand, the hammer puts in its appearance after a prolonged
downtrend. On the day of the hammer candle, there is strong selling, often
beginning at the opening bell. As the day goes on, however, the market recovers and closes near the unchanged mark, or in some cases even higher.
In these cases, the market potentially is hammering out a bottom. Here
is an example of a hammer candle:

he doji candle probably is the single most important candle

for the trader to recognize. Not far behind in value are
hammer and hangman.

It is easy to confuse these two candlesticks because they look identical. Both the hangman and hammer have a very long shadow and
a very small real body. Typically, they have no upper shadow (or at
the very most, an extremely small one). To be an official hammer
or hangman, the lower shadow must be at least twice the height of
the real body. The larger the lower shadow, the more significant the
candle becomes.

Hangman

Hammer

Hammer

Clear Real Body

Black Real Body

As with all candles, the rule of two applies. That is to say, a single candle
may give a strong message, but you should always wait for confirmation
from another indicator before taking any trading action. It may not be necessary to wait an entire trading day for this confirmation. When it comes
to the hangman, for example, confirmation may be a gap down the next
day. With the hammer, a gap opening with gathering strength as the day
wears on may be all that is necessary to initiate a trade from the long side.
Both hangman and hammer may appear in an up day (clear real body) or a
down day (black real body).
I will start with the hammer. In my experience, when a hammer candle
appears in the chart of one of the major averages, it is always a signal worth
noting. This is particularly true when it has come after a steady and prolonged sell-off.

page 15

The chart of the Nasdaq Composite

($COMPQ) shows the value of the
trader recognizing the hammer
candle. From March to late May,
Nasdaq was in a steep downtrend,
having declined from almost 2100
to just below 1900. Right above the
price chart is another technical tool
I frequently use, the Price Relative to $SPX. SPX stands for the
S&P 500, so this chart compares

the performance of Nasdaq to the

S&P. Note that the thick line had
a downward slope throughout the
period of the chart and that it was
under the thin line, which was the
20-day moving average. That tells
the trader that Nasdaq was under
performing the S&P throughout
the entire period.

The hammer candle occurred on

the final day of April. On this
day, the Composite breached 1900
intraday, but the bears did not have
the power to close it under that
psychological support level. Instead, the Composite closed slightly
positively on the day, hence the
small white head at the top of the
candle.
In itself, the hammer gave a powerful warning that Nasdaq was
reversing course. The alert trader
might take a long position in a
leading Nasdaq stock or an ETF
(Exchange Traded Fund) such as
the QQQQ on the next trading
day when the Composite bullishly
followed through on the previous days action. On the second
trading day after the hammer, the
4-day moving average crossed
above the 9-day and both began to
slope higher, another bullish sign.
Shortly thereafter, the Price Relative broke out above its own moving average, and for several weeks
Nasdaq became the market leader
instead of the laggard.

Figure 6 - nasdaq composite ($compq)

Additional technical confirmation

of the hammer came from the behavior of the stochastics oscillator.
Source: StockCharts.com

page 16

Stochastics compares the behavior

of price relative to its long-term
price trend. It is a rapidly moving indicator which gives timely
buy and sell signals. In this case,
stochastics demonstrated bullish
momentum divergence as marked
on the chart. Bullish divergence occurs when price goes lower, but the
stochastics oscillator rose. After the
hammer, stochastics gave its first
buy signal in roughly two weeks.
The buy signal occurred as both
%K and %D broke above 20 on the
stochastics scale.
From that time onward, throughout
the entire month of May, Nasdaq
was off to the races. The Composite
rallied roughly 200 points, from
below 1900 to nearly 2100. The
hammer candle was the technical
signal that it was time to be long on
the Nasdaq.
The candle opposite of the hammer
is called hangman. When I have
taught candlesticks in college stock
market classes, students have easily
become confused between the two.
This is because they look exactly
alike. The key difference is where
they occur in a chart. The hammer
occurs after a long decline when

the market is oversold. In contrast,

hangman puts in its appearance
near the end of an uptrend when
the market is overbought.
There are times when a hangman
candle can look a great deal like
the dragonfly doji. Such is the case
with Forest Labs (FRX). In April,
FRX had gapped down sharply

from the $38 area when it announced below expectation earnings. Forest bottomed at $32.46
and in conjunction with strength in
the pharmaceutical stocks began a
gradual move higher. On the day of
the hammer, it recovered to a peak
of $40.76, butting up against strong

Figure 7 - Forest Laboratories Inc. (frx) NYSE

Source: StockCharts.com

resistance in the $40 to $42 area

formed in February and March.
As shown in the chart, the hammer
candle occurred outside the Bollinger band, a sign the stock was
very overbought. I have also placed
the CCI indicator on the chart. On
this indicator, +100 is overbought
and +200 highly overbought. Note
that when the hammer candle occurred, CCI was well over 200 and
was beginning to trend downward.
Stochastics gave the same message
as it gave a sell signal after having
reached overbought levels.
The hangman at the mid-June
$40.76 point was indeed the profittaking signal in FRX. The next
day the stock opened just above
$40 and slid persistently during
the day, reaching a low of $37.60
before recovering. A simple trendline drawn from the $32.46 low
confirmed that it was time to exit
the position. The trendline was
broken the next trading day. CCI
also dipped below the +100 level,
giving a sell signal on this indicator. When a candlestick, indicator,
and trendline all give the same
message, it is time to listen. While
FRX went sideways rather than

page 17

sharply down after the hangman,

a position in the stock was dead
money.

Candles 7-8
BULLISH AND BEARISH
ENGULFING CANDLES SPOT
TREND CHANGES BEFORE
THEY TAKE PLACE

f the doji wins the race as the most important candle to recognize, and hammer/hangman is a close second, then the
engulfing candle places third. Whereas the doji and hammer/hangman are single candles, the engulfing pattern consists of
two consecutive candles.
The engulfing candle must completely consume the real body of
the previous candle. Because stocks have fewer gaps than commodities, an engulfing candle may violate this rule very slightly by
being just above or below the top or bottom of the previous candle.
In most cases, you should interpret this as an engulfing pattern. If
you or your children are in the age group to remember the early
video game Pac Man, you can think of the engulfing candle as being similar to the hero of that game in that it eats or consumes the
previous candle.
A bullish engulfing candle occurs after a significant downtrend.
Note that the engulfing candle must encompass the real body of the
previous candle, but need not surround the shadows. Below is an
illustration of a bullish engulfing candle:

Bullish Engulfing
A bearish engulfing candle occurs after a significant uptrend. Again, the
shadows need not be surrounded. Below is an illustration of a bearish engulfing candle:

Bearish Engulfing

The power of the engulfing candle is increased by two factorsthe size

of the candle and the volume on the day it occurs. The bigger the engulfing candle, the more significant it is likely to be. A large bullish engulfing
candle implies that the bulls have seized control of the market after a downtrend. Meanwhile, a large bearish engulfing implies that the bears have
taken command after an uptrend. Also, if volume is above normal on the
day when the signal is given, this increases the power of the message.
A good example of a bearish engulfing candle ending a rally is found in
Avid Technology (AVID), a maker of video editing software. In early
March the stock peaked in conjunction with the S&P 500 and Nasdaq
Composite just above $68. A few days later, when it was trading at $62, it
made an acquisition and was punished severely. Intraday, the stock was off
nearly $5 and left a large gap between approximately the $60 and $62 level
on the chart. Note also the large volume spike on that day. As we shall see
later in this book, gaps in candlestick theory are called windows, and create resistance to further price movement.
AVID eventually bottomed in late April at $47.64 and began to recover. By
mid-June it was back above $60 and trading into the window it had created
the day of the acquisition. That in itself should have made any long traders
page 18

just under $60 in January, TXU

had a spectacular run to $86.64 by
May before pulling back. Readers
should note the strong support that
existed between approximately $73
and $74, a level the shares did not
go below from February on.

Figure 8 - Avid Technology, Inc. (avid) Nasdaq

In a single day in early May, TXU

went from just over $80 down to
support at $74. Note the long lower

shadow that probed outside the

Bollinger band on this session.
Although this candle does not meet
the requirements of a hammer
(the shadow is not double the real
body), traders should still pay close
attention to long shadows, especially in areas of support. These
shadows suggest that there is buying interest at that level.

Figure 9 - TXU CORP. (TXU) NYSE

Source: StockCharts.com

cautious on AVID. Another reason

for prudence, however, was that
it was overbought. It was outside
the Bollinger band. In addition to
being in overbought territory on
stochastics, there was also bearish
momentum divergence. The day
after the bearish engulfing candle,
immediately after the stock topped
at 61.39, it then gapped down. Sto-

chastics and CCI gave clear sell signals and the trendline from the late
April low was broken soon after.
AVID retreated to near $51 before
finally going outside the Bollinger
band and becoming oversold, then
staging a modest recovery.
The Utility TXU Corp (TXU)
provides a good example of a bullish engulfing candle. From a low
page 19

Source: StockCharts.com

Note also the bullish divergence on the CCI indicator that was
recovering from oversold levels. Traders needed to wait two additional days for the bullish engulfing candle. But when it did
come after the bottom of $74.20 it was a highly reliable signal. The
candle was fairly large as the stock moved almost $2.50 on the day.
CCU subsequently recovered to near $85, just below the previous
highs.

Candle 9
DARK CLOUD COVER
WARNS OF IMPENDING
MINOR TOPS

he candlestick we will next explore is called dark cloud

cover. It is a close relative of the bearish engulfing, but is
not quite as negative in its implications. Still, the appearance of this candle should be a warning to the trader to protect
profits in a position. It also suggests that you should watch a stock
as a possible short candidate in the trading days ahead.
The dark cloud cover candle occurs after a strong uptrend. A series
of ascending candles is ultimately capped by a final white candle.
At this point, the stock or index seems technically healthy, and the
bulls may be lulled into a sense of false complacency.
On the day of the dark cloud cover, the stock opens above the previous days high. For a true dark cloud cover to emerge, therefore,
the stock should gap above the upper shadow of the previous white
capping candle. At the opening bell on this trading day, it seems
like the uptrend will continue.
As the day wears on, however, the bears wrest control. On the dark
cloud cover day, the stock closes at least halfway into the previous
white capping candle. The larger the penetration of the previous
candle (that is, the closer this candle is to being a bearish engulfpage 20

ing), the more powerful the signal. Traders should pay particular attention to a dark cloud cover candle if it occurs at an important resistance
area and if the end-of-day volume is strong. Below is an example of a
dark cloud cover candle:

Figure 10 - Eastman Kodak Co. (ek) NYSE

Dark Cloud Cover

Film and digital camera maker Eastman Kodak (EK) provides an example of the dark cloud cover. The stock traded as high as $33 in April,
immediately before it released earnings and its second quarter forecast.
When earnings came out in mid-April, the shares were changing hands
at just above $30. Results were below expectations, the stock dropped
precipitously on their release, gapping down to $27.16 and over the next
several days were falling as low at $24.40. As we shall see when gaps are
explored, the trader should now anticipate resistance between $27.16, the
low end of the gap, and just above $30, the upper end.
Over the next month and a half, EK began a grudging recovery, regaining $27, backing off, and then finding consistent support at $26. The
shares then broke out forming four consecutive white candlesticks and
reaching a high of $28.19. While the third candlestick was not large, if
the four candles were combined into one, it certainly would have been.
When the dark cloud cover emerged after the high of $28.19, traders
should have been wary. While this candle was relatively small, it retreated half-way back into the previous white candle. The next day a
doji appeared, emphasizing the resistance near $28. EK then retreated
toward the $26 level before finding support and rallying. While the
dark cloud cover is not as potent a reversal candle as bearish engulfing,
its appearance in the chart should be respected.
page 21

Source: StockCharts.com

On the piercing day, the candle comes back into and closes at least
halfway into the real body of the prior day. If it does not come at
least halfway back, then the candle is not a piercing candle and
needs to be called by a different name. (The candle is on-neck if it
closes at the prior days low, in-neck if it closes slightly back into
day ones real body, and thrusting if it closes substantially into
the real body, but less than halfway.) In addition, the previous days
candle cannot totally make up the ground lost in day one, otherwise it would be a bullish engulfing.

Candle 10
THE PIERCING CANDLE IS
A POTENT REVERSAL SIGNAL

Here are a few other points on the piercing candle. The closer it is
to becoming a bullish engulfing candle, the more positive it is, and
thus the greater the possibility of a reversal. Second, take particular note of the piercing candle if it occurs at an important support
level. Third, if volume is strong on the piercing day, then the candle
gains added significance.

he dark cloud cover and piercing candles are like bookends.

Whereas the dark cloud cover warns that an uptrend might
be coming to an end and is thus a signal to take profits on
long trades, a piercing candle indicates that a downtrend may be
about to reverse and shorts should be covered.

An interesting example of a piercing candle is found in the chart of

Avici Systems (AVCI), a VOIP or Voice Over Internet Protocol play.
In mid-April, AVCI had bottomed near $3.70 for several days, creating a short-term basing formation. Toward the end of the month,
it created a gap between approximately the $4.15 and $4.50 area,
and then retreated to $4.16. Note the long lower shadow of the day
the $4.16 bottom was made. Large lower shadows often serve as
support areas. This one was doubly significant because it held the
very upper end of the gap or window created several days earlier.

The first thing to look for in spotting the piercing pattern is an

existing downtrend. With daily candles, the piercing pattern often
will end a minor downtrend (a downtrend that often lasts between
five and fifteen trading days). The day before the piercing candle
appears, the daily candle should ideally have a fairly large dark
real body, signifying a strong down day. Here is an example of
the piercing candle: In the classic piercing pattern, the next days
candle gaps below the lower shadow, or previous days low. I find
with stocks (in comparison to commodities), however, that the gap
is very often below the previous days close, but not less than the
previous days low.

AVCI then advanced from $4.16 to $4.90 in mid-May, topping out

just below round number resistance at $5. From there the stock
went into a minor decline of 21 trading days, finally bottoming at
$4.20. Note that at this level AVCI was at an important support
created by the $4.16 low and was still above its late April gap.
The piercing candle appeared at support two days later. It was not
a large range day and was accomplished on low volume. A trader

Piercing

page 22

who observed it might have made a mental note and watched with
interest the trading action of the second day. Now the trend became much clearer. AVCI broke the downtrend line off the $4.90
high. It went back above its four and nine day moving average,
which gave a buy signal. Eventually, AVCI ran to $5.10 in midJune before topping. Even if the trader had purchased at $4.50 and
sold a few days later near $5, the percentage gain was substantial.

Figure 11 - Avici Systems (avci) Nasdaq

The piercing candle is a less powerful signal than the doji or bullish
engulfing. Nevertheless, it is potent. Make a mental note to include
it in your analysis the next time it occurs in a stock you own or are
watching.

Source: StockCharts.com

page 23

Candles 11-12

The evening star pattern occurs during a sustained uptrend. This is my

nursery rhyme for the evening star: IF YOU SEE THE EVENING STAR, A
TOP OFTEN IS NOT VERY FAR.

THE THREE CANDLE EVENING

AND MORNING STAR PATTERNS
SIGNAL MAJOR REVERSALS

y this point in 21 Candlesticks, you should be able to spot

several reversal candles. Many times, only one candle is
necessary to put a trader on high alert that a reversal may
be happening. A doji candlestick, whether it occurs after a long
uptrend or downtrend, indicates that supply and demand are in
equilibrium and that the recent trend may be ending.
Several major reversal patterns consist of two candlesticks. A bullish or bearish engulfing candle often signals a trends conclusion.
This two-candle pattern is also relatively easy to spot.
The evening star and morning star are, in my experience, harder
patterns for the eye to discern. The reason for this is simplebecause both patterns consist of three candles, these candles must be
perceived as a group. However, once youve identified one of these
patterns, then your job is pretty much over. Unlike most other
candle formations, no further confirmation is needed. The evening
and morning star are complete in and of themselves, so the trader
should strongly consider taking trading action immediately upon
their appearance.

Evening Star

On the first day we see a candle with a long white body. Everything looks
normal and the bulls appear to have full control of the stock. On the second day, however, a star candle occurs. For this to be a valid evening star
pattern, the stock must gap higher on the day of the star. The star can be
either black or white. A star candle has a small real body and often contains a large upper shadow.
The star communicates that the bulls and bears are involved in a tug of
war, yet neither side is winning. After a sustained uptrend, those who want
to take profits have come into balance with those eager to buy the stock. A
large upper shadow indicates that the stock could not sustain its probe into
new high ground. A potential reversal has been signaled.
On the third day, a candle with a black real body emerges. This candle
retreats substantially into the real body of the first day. The pattern is made
more powerful if there is a gap between the second and third days candles.
However, this gap is unusual, particularly when it comes to equity trading.
As such, it is not a required part of the pattern. The further this third candle retreats into the real body of the first days candle, the more powerful the reversal signal. Because the third day affirms the stars potentially
bearish implications, no further confirmation is needed.
Continental Airlines (CAL) provides a good illustration of the evening star
formation. The shares bottomed in late April as the stock created a ham-

page 24

mer candle. The bottom was deceptivethe next day, the hammer was
followed by a bearish engulfing and that candle was in turn succeeded
by a large white candle. CAL rallied up close to its previous high of
$13.36 of mid-April, backed off, and then soared. The shares completed
an ascending triangle breakout on high volume and reached a peak of
$15.60 in early June.
Figure 12 - Continental Airlines, Inc. (cal) NYSE

The evening star pattern is circled on the chart on the next page. On
the first day, there is a reasonably large white candle. The second session sees a gap higher, indicated by the top of the black candle being
somewhat higher than the white candle before it. Note the large upper shadow on this candle, indicating that CAL was not able to sustain
prices above $15. The upper shadow occurred entirely above the top
Bollinger band, indicating that CAL was substantially overbought.
On the third day of the formation, prices closed well back into the range
of the first day, the final requirement of the evening star. Daily stochastics and CCI gave sell signals during this session also suggesting that the
top for CAL was in. Note, how much earlier these signals were than the
broken uptrend line that lagged the evening star by almost two weeks.
And remember my traders rhyme, if you see the evening star, a top
often is not very far.
Having explored the evening star in detail, we need say little more about
the morning star formation because it is the exact opposite of the evening star. It occurs in a downtrend and starts with a large black candle.
On the second day, a star forms on a gap. The third day completes the
reversal by closing well into the real body of day one.

Morning Star

Source: StockCharts.com

Pharmaceutical giant and Dow Jones Industrial Average component

Merck (MRK) experienced a long-term downtrend. In 2001 the shares
peaked near $100 and began a steady decline that took the shares to
the mid-$40s in late 2004. Then the news hit that a key drug of Merck,
VIOXX, increased the risk of heart attack and stroke. The headlines

page 25

After reaching $34.95, MRK went sideways for several weeks and then hit
a secondary peak of $34.79 in early May. From here, MRK went into a
prolonged slide reaching a low of $30.12 (notice again the $5 interval) in
late June, rallying slightly and then testing a slightly lower low of $29.90
in early July.

Figure 13 - Merck & Co., Inc. (MRK) NYSE

The second low was revealing in a number of ways. First, as shown by the
stochastics and CCI oscillators, there was bullish momentum divergence
as price was lower, but stochastics and CCI itself were higher. The test
of the lower day was also the second candle of the three-candle morning
star formation.
Note, that on the first day there is a large dark candle. The middle day
is not a perfect star, because there is a small lower shadow, but the upper shadow on top of a small real body gives it a star quality. The third
candle is a large white candle that completes the reversal. Note how the
third candle recovered nearly to the highs of the first day and occurred
on strong volume. Also observe the buy signal generated by stochastics
on the day of the Morning Star. After this candle, Merck bounced higher
reaching a peak near $32 several days later. The Morning Star, true to its
name, led to Mercks prospects brightening considerably.

Source: StockCharts.com

caused the stock to lose more than a third of its market capitalization in
late September and continue to its rock bottom low of $25 in November.
From there, Merck began a very gradual recovery that saw the stock peak
at $34.95 in early April. If you noticed that $25 and $35 were round numbers and reflected that these are both option strike prices, youve seen an
important pattern.
page 26

Candle 13

be either no lower shadow or a very small one. Here is a graphic representation of a shooting star candle:

THE SHOOTING STAR

CAN WOUND

Shooting Star

The small real body shows that the bulls and bears are at war with each
other. Whereas the bulls had been in control during the uptrend, the two
sides are now evenly matched.
andle theory identifies four kinds of stars: morning,
evening, doji, and shooting. I now want to focus on the
shooting star.

The shooting star can appear only at a potential market top. If you
are looking at a daily chart, then it is possible that this candle will
warn of a reversal in the minor uptrend. Since a minor uptrend
typically lasts between six and fifteen days, the swing trader should
be very alert if the minor uptrend is mature.
If a shooting star occurs after a candle with a large real body, typically it is that much stronger a warning because it shows that the
price cannot sustain high levels. The day the shooting star occurs,
the market ideally should gap higher (although with stocks rather
than commodities, this gap is sometimes not present).
The stock should then rally sharply. At this point, it appears as
though the longs are in complete control. Sometime during the day,
however, profit taking ensues. The stock closes near the unchanged
market, as shown by a small real body. Therefore a shooting star
has a small real body and a large upper shadow. Typically, there will

The Semiconductor Index provides a clear example of why it is important

to pay attention to the shooting star candle. The semis bottomed with the
rest of Nasdaq in late April at 376.64. On that day, the $SOX broke support at 380 intraday, but then rallied strongly to close within the previous
range. Note the hammer-like candle (it has a small upper shadow so is not
a classical hammer) and long lower shadow.
From here, the $SOX commenced a strong rally that lifted the index nearly
64 points or approximately 17% in 24 trading days to the 440 level. At this
point, both Nasdaq and the $SOX hit resistance. The $SOX tried to break
440 on six separate occasions, but was unable to do so. Finally it retreated
to just below 420 and began another rally back toward resistance.
Toward the end of June, it broke through 440 intraday, briefly approaching
important resistance (not shown on this chart) near the 450 level where it
had stalled twice before in November 2004 and March 2005. The candle
that formed was a shooting star. Note how the large upper shadow went
above the upper Bollinger band and the small real body. The $SOX had
tested important resistance and failed.
The next trading day, it sold off sharply, bearishly engulfing the real body
of the star candle. The $SOX then retreated to support near 418. The trader who missed the implications of the shooting star would have needlessly
page 27

held semiconductor stocks through a sharp decline. If you can accurately

recognize the shooting star candle, then youll have another important
tool to assist you in spotting early signs of a reversal. The candle will warn
of the end of a minor uptrend before trend following tools such as moving
averages or MACD. Recognize the shooting star or suffer the slings and
arrows of stock market misfortune.

Candle 14
THE INVERTED HAMMER
INDICATES THE SHORTS
MAY BE READY TO COVER

Figure 14 - Semiconductor Index - Philadelphia ($sox)

elow you will find an illustration of the inverted hammer

candlestick:

Inverted Hammer

The inverted hammer looks so familiar because it is identical in

appearance to the shooting star discussed earlier. The difference
is that the shooting star occurs at the end of a long uptrend. The
inverted hammer, on the other hand, occurs after a significant
decline has taken place.

Source: StockCharts.com

page 28

If you examine the inverted hammer carefully, it hardly looks like

a bullish candle. Prices opened low and then rallied strongly. By
the close of trading, however, the stock has given back almost all of
the days gains. That leaves a small real body and a very large upper
shadow. If anything, the candle looks bearish. The bulls could not
sustain a rally, so the bears took the stock back toward its lows for
the day.

So, why should this candle potentially set up an important reversal?

My theory is that the inverted hammer often is a signal that shorts are
beginning to cover their positions.
Here is my reasoning. Because the
inverted hammer can only occur

after a sustained downtrend, the

stock is in all probability already
oversold. Therefore, the inverted
hammer signifies that traders
who have held long positions in
the security, most of whom are
now showing large losses, often
are quick to dump their shares by

Figure 15 - National Information Consortium, Inc. (EGOV) NASD

selling into strength. This will also

serve to drive the stock back down.
With this candle, it is imperative to
watch the next days trading action.
If the stock opens strongly and remains strong during the day, then
a key reversal is likely in progress.
Not every inverted hammer will
tune you in to this kind of shortcovering situation. However, when
you do see its appearance on a
chart, then I suggest you do two
things. First, check the short interest in the stock. Second, if that
short interest is substantial, follow
the stock closely the next trading
day. Recognition of the inverted
hammer may help you build market-beating profits.
National Information Consortium
(EGOV) is a small cap stock that
provides Web-building and software services to local, state, and the
federal government. Prior to when
this chart was taken, the stock had
been in a narrow trading range
with resistance just under $5.50
and support just over $4 for nearly
six months.
EGOV peaked at $5.44 in early
March and by late April had retreated to $4.13, a support level in

Source: StockCharts.com

page 29

the vicinity of its October low. On

the day the stock bottomed, EGOV
went outside the lower Bollinger
band. Although it formed a large
black candle, note the large lower
shadow as well, confirming that
there was support just over $4.
The next day, EGOV formed an
inverted hammer. The real body
was small, and the upper shadow
probed back toward the middle
of the previous candle. The alert
trader would have noticed that daily
stochastics were bullishly divergent
during this period. Again, bullish
divergence occurs when the momentum indicators make a higher
low while price itself is making a
lower low. Because momentum
often proceeds price, it can be an
important signal that a reversal is
imminent.
That reversal came the next day,
as EGOV formed a large white
candle that reached approximately
halfway back into the bottoming
candle of two days previous.
From there, EGOV traded into
resistance at $4.60, backed off to
a test of support, and then rallied
sharply toward $5. The inverted
hammer signaled the stock was
close to a low.

Candle 15
THE HARAMI
IS PREGNANT WITH
TRADING POSSIBILITIES

hen you visualize the harami candle, you should

imagine that the first candle is like a mother and the
second candle the child that emerges from its belly.
That is where the name harami or pregnant comes from.

Harami

The harami candle can occur both after an uptrend or downtrend.

However, to keep this discussion clear, for the sake of example, I
will assume a stock is in an uptrend. Immediately preceding the
harami candle, there should be a large, real body dark candle.
When this candle occurs, it is a bearish signal. The trend appears
poised for a reversal.
A small real body candle appears within the larger real body. In my
experience, the signal is more powerful if the second days candle is
near the middle of the trading range of the first.

The bullish harami candle can also occur in either bullish or bearish
trends, but the colors are reversed: A large black body precedes a smaller
white real body, and this gives out a bullish signal; it implies that the stock
is poised to move upward. In either bullish or bearish haramis, the upper and lower shadows can be of any size, and theoretically could even
go above the real body of the clear candle day. In practice, however, the
harami days shadows often are small and typically are contained well
within the real body of the previous days candle.
Always look carefully at the next days candlethe one that follows the
harami candle. Sometimes harami merely signifies that the stock is entering a period of consolidation (the shares will trade sideways). If, however,
the stock youre examining after a bearish harami rallies the day after the
harami candle takes place, then there is an increased likelihood that the
shares have put in a minor bottom.
Polycom is a company that makes equipment for video-conferencing. As
the 150-day moving average shows, the shares were in a long-term downtrend. In late May, PLCM hit a low of $14.80 and then rallied close to the
resistance formed by the declining 150-day moving average at $17.99 in
mid-May. From there, the shares fell rapidly, breaking the previous low of
$14.80 in late June and continuing down to $13.97 at the beginning of July.
The day before the harami appeared, PLCM fell from near the $15 range
to just below $14. A large dark candle appeared on the chart, marked by
volume, approximately 250% higher than normal.
When the bullish harami appeared the next session (a large black real
body followed by a smaller, clear real body), it held well above the lows of
the previous day. The day after, a doji-like candle appeared, suggesting
that the bears were not able to force prices any lower. From there, PLCM
rallied nicely. By mid-month, the shares were testing $16, a gain of nearly
50% of the ground lost during the decline. Note that the stochastics buy
signal from oversold levels, which confirmed the harami candle did not
come until several days after the candlesticks signaled the reversal.

page 30

Although the harami candle is considered less potent than many of the
key reversal candles, nevertheless it has substantial predictive power. If it
occurs in a stock in which you have a position, then you should be alert to
a change in trend from up to sideways, or from up to down. (If the stock
is in a downtrend, then the harami candle can also warn of an impending
period of sideways trading, or perhaps even an uptrend.) The next time you
observe the harami candle, take heed, as it can provide you with a valuable
tool to help you protect your profits.

Candle 16
THE FULL MARUBOZU
IS A CANDLE WITHOUT
SHADOWS

Figure 16 - Polycom, Inc. (PLCM) Nasdaq

n Japanese, the term marubozu means close-cropped. Other

common names for the marubozu include shaven head or
shaven bottom. Typically, the marubozu is a long candle that
implies the days trading range has been large. A marubozu candle
lacks either an upper or lower shadow. On rare occasions it can lack
both an upper or lower shadow. I am going to add a new term to
candlestick terminology and call a long candle without either an upper or lower shadow a full marubozu.

Marubozu

If you spend a lot of time at the trading screen, then you probably
realize that a full marubozu is a very unlikely occurrence. Even after a strong up gap, most stocks experience a minor reversal, which
leaves a small lower shadow. The same is true for the down gap. In
addition, if a stock has moved sharply higher during the day, day
traders often seek to nail down profits toward the end of the sesSource: StockCharts.com

page 31

sion. This creates a small upper

shadow. Conversely, if a stock has
sharply declined, then some short
sellers will tend to cover before the
close of trading. Because of this,
stocks rarely close on their absolute
low. In these cases there will be a
small lower shadow.
When a full marubozu occurs, or
one that is very close to full, it is
very well worth noting. If it is a
white candle, then it signals extreme conviction among buyers.
Conversely, if it is a dark candle,
then it indicates sellers were eager to flee. As always, you should
pay careful attention to the next
days trading to see if there is follow through. A full or nearly full
marubozu implies that there is
strong buying or selling interest
depending on the color. If there is
follow-through early the next day,
the stock is likely to trend in that
same direction for the next few
sessions. That awareness can be
important for the trader.
The chart in Figure 17 shows a
stock that forms many nearly full
marubozu candles: Amerada Hess
(AHC) an oil company. Why does
Amerada form so many marubozu

or close to marubozu candles?

Because trading in the stock correlates very closely with the price
of crude oil. When oil is down,
the stock sells off, usually falling
consistently during the day. The
reverse is true when oil rises.

Figure 17 - Amerada Hess Corp. (ahc) NYSE

As shown by the 50-day moving

average that is sloping higher and
below the share price, AHC was
in a strong uptrend during this
period. In less than a two-month
period there were eight candles
that were close to full marubozu.
Five of these candles were bullish (clear real body). If one had
bought any time after the marubozu candle within two trading days
in all cases, the trade would have
been profitable. That is because
the marubozu signaled a strong
thrust in the trend often after a
short period of consolidation.
The full marubozu usually is not
considered a major candlestick. In
my opinion, however, it should be
added to this category. Although it
is infrequent, this candlestick tends
to be significant when it occurs.

page 32

Source: StockCharts.com

Candles 17-18

on a securitys value. They portray a market in which uncertainty and

indecision prevail. Neither the buyers nor the sellers have a clear sense of
which direction the market will head. The forces of supply and demand are
equally balanced.

HIGH WAVE AND

SPINNING TOP EXPRESS
DOUBT AND CONFUSION

What is the difference between the spinning top and the high wave? In the
spinning top, the shadows are relatively small and the candle has a very
small range. When combined with low volume, traders may be expressing
disinterest.

ere is an interesting question, which candle is most

opposite of the marubozu? Since the marubozu can be
either white or black, the correct answer here cannot be
another marubozu candle. Instead, opposite candles should include both spinning tops and high waves. Ive provided you with
an illustration of both of these candles below.

Spinning Top

High Wave

Why should these candles be considered opposites relative to the

marubozu? When a marubozu candle occurs, it shows a great deal
of conviction on the part of the market. A black marubozu portrays a very weak market in which the sellers are eager to exit and
willing to get out of their positions at almost any price. Meanwhile,
a white marubozu portrays the opposite situation, where buyers are
willing to pay higher and higher prices to enter the stock.
In contrast, spinning tops and high wave candles denote situations where the market is having difficulty coming to a consensus

A high wave candle, on the other hand, portrays a situation where there is
an active tug of war between the bulls and the bears. This candle shows a
market that has lost a clear sense of direction. If it occurs on high volume,
then it indicates the markets general confusion about the direction prices
are headed.
Zimmer Holdings (ZMH) is a company that makes artificial joints used
in such operations as hip and knee replacements. Prior to this chart, the
stock had been within a prolonged wide-swinging trading range with much
of the action concentrated in the mid-$70 to mid-$80 range.
In late April, Zimmer peaked at $83.70 outside the upper Bollinger band
and began a slow, rolling decline that brought it back to the lower Bollinger
band in both mid-May and early June. At the June low, we can observe
first a high wave candle and, on the next trading day, a spinning top. Note
on the high wave the long upper and lower shadows. With its small real
body, the candle is close to a long-legged doji. On the next trading session,
the spinning top occurred. Both of these candles occurred near key support just above $75. Take note of the very light volume on both of these
sessions. The volume was well below the moving average line.
Altogether, the technical indicators and two candles suggested that doubt
and confusion existed in the minds of both buyers and sellers. Sellers were
no longer motivated to exit the position, but buyers were not willing to step
forward either. That situation changed the next day, when ZMH bounced
sharply off support and formed a large white candle. On this session,
Zimmers future direction became clear in the short term: up.
page 33

ZMH ultimately recovered to a high of $81.28 before succumbing to profit

taking and retreating to support near $75. But for the alert trader, the
combination of candle signals and technical indicators pointed to a good
opportunity.

Candle 19

As the old clich goes, when in doubt, stay out. The spinning top and
high wave candles expressed doubt and confusion on the part of the market when it came to ZMH. When the market does tip its hand, however,
the alert trader can seize a good trading opportunity.

THE OMINOUS CALL

OF THREE BLACK CROWS

Figure 18 - Zimmer Holdings. Inc. (ZMH) NYSE

he three black crows candle formation does not happen

very frequently in stock trading, but when it does occur
swing traders should be very alert to the crows caw.

The candlesticks metaphor is three crows sitting in a tall tree. On

the day the first black crow makes its appearance, the formation
is most predictive if the first crowor dark candlestickcloses
below the previous candles real body.

Two more long-bodied consecutive down days then ensue. On each

of these days, it appears as if the stock wants to regain its former
strength, as the stock opens higher than the close on the previous
day. By the end of each session, however, the sellers regain control
and the stock drops to a new closing low. Here is what the three
black crows candlestick pattern looks like:

Three Black Crows

Source: StockCharts.com

page 34

Note that the lower shadows on three black crows are small, or
in some cases even nonexistent. Although three black crows is a
complete pattern, traders should always be alert to what happens

on the fourth day after the pattern

is formed. Since there has been
intense selling throughout the pattern, the stock may be overextended to the downside. However, if the
stock continues its negative pattern
on the fourth day, then it is likely
that the issue is going much lower.
The chart of Macromedia (MACR)
was taken during the period the
stock was acquired by Adobe
Systems. During this time, MACR
advanced from a late April low
of $32.68 to an early June peak
of $44.67. MACR then began to
weaken, but found support just
above the $42.50 level. Note the
large black candle about 10 days
into the decline. The lower shadow
probed the $40 area, a key level of
round number support.

MACR went laterally for the next

four days. Eventually, the shares
tested $35 before finding a shortterm bottom.

Figure 19 - Macromedia, Inc. (MACR) NYSE

Three black crows is an infrequent,

but powerful candle formation.
After observing its occurrence,
the trader should likely resist the
temptation to short since the issue
is already short-term oversold.
Rather, in most cases, the better approach is to watch the stock
carefully. If it rallies weakly and
then begins to falter, a short position can in most cases be initiated
safely with a stop just above the
high of the first black crow.

Several days later, the first of the

three black crows formed just
above $40. The second crow
broke decisively through the $40
level and the third crow took the
shares down toward $38. By this
time, MACR had fallen almost
$4 in three days and on a very
short term basis was substantially
oversold. Oversold conditions may
be relieved by a stock going either
up or sideways, and in this case,

Source: StockCharts.com

page 35

Candles 20
THREE WHITE SOLDIERS
CAN HELP YOU FIGHT
FOR PROFITS

open within the real body of day one. The pattern is valid as long as the
candle of day two opens in the upper half of day ones range. By the end of
day two, the stock should close near its high, leaving a very small or nonexistent upper shadow. The same pattern is then repeated on day three.
Although this candle pattern is very potent when a stock is at or near its
lows, it should be regarded skeptically if it appears following a long advance in price. If you spot three white soldiers after a sustained rally, then
it may mean a top is near. Be on the alert then for a reversal candle such as
a doji or negative engulfing.
An extremely interesting example of three white soldiers occurred in the
Biotech Index ($BTK). Two charts are necessary to illustrate a stunning
reversal marked by three white soldiers.

he bullish counterpart of three black crows is known as

three white soldiers and is considered by some candle
theorists as one of the most bullish candle patterns.

Three White Soldiers

The three white soldiers pattern is most potent when it occurs after
an extended decline and a period of subsequent consolidation.
When a particular stock posts a decline followed by a sideways
movement, the appearance at that point of three white soldiers
signals that higher prices are likely ahead.
The first of the three white soldiers is a reversal candle. It either
ends a downtrend or signifies that the stock is moving out of a
period of consolidation after a decline. The candle on day two may

The first chart focuses on the period from late December to early March.
The Biotech index peaked along with the rest of the market in late December at 555. From there it began a steady downtrend. Note the very strong
selling throughout this period.
There were several factors that tipped the alert analyst that the Biotech
had changed course. The first was a hammer-like candle outside the Bollinger band. Note also the bullish divergence in stochastics on this second
bottom. Bullish divergence occurs when price makes a lower low and the
momentum indicator a higher low. The first of three white soldier candles
also was a bullish engulfing, again providing strong evidence that the index was turning around.
The $BTK then rallied with a vengeance. This advance can be seen more
clearly in the second chart. The decline from late December to early April
took more than three months and saw the biotechs lose nearly 70 points.
In three days, this group rallied to an intraday peak of 515.69, a recovery of
34 points or nearly half of the ground lost in three months.
Note how the biotechs went from one end of the Bollinger band to the other and stochastics from oversold to overbought. The three white soldiers

page 36

Figure 20a - Biotech Index - AMEX ($BTK)

Figure 20b - Biotech Index - AMEX ($BTK)

Source: StockCharts.com

had consumed a lot of buying power! After that the biotechs went sideways for most of the month, resolving the overbought condition.
The three white soldiers pattern does not occur frequently, but as a swing
trader you definitely should be on the lookout for it. These soldiers make
great allies in your battle for swing trading profits.

page 37

Source: StockCharts.com

Candle 21
TWEEZERS CAN HELP
YOU PULL PROFITS
OUT OF THE MARKET

n my experience, tweezers candles do not occur all that often

in the stock market. However, when they do indeed take place,
they are almost always significant.

What are tweezers candles?

Tweezers
Candlestick theory recognizes both a tweezers top and a tweezers
bottom. The tweezers formation always involves two candles. At
a tweezers top, the high price of two nearby sessions is identical
or very nearly so. In a high priced stock there may be a few cents
variation, and I believe it should still be considered a tweezers. At
a tweezers bottom, the low price of two sessions that come in close
succession is the same.
For simplicity, lets talk just about the tweezers bottom. In some
instances, the tweezers bottom is formed by two real candlestick
bodies that make an identical low. In other instances, the lower

shadows of two nearby candles touch the same price level, and the stock
then bounces higher. A third possibility is that the lower shadow of one
day and the real body of a nearby session hit the same bottom level.
Most traders are familiar with a double bottom or double top. For this
formation to occur, the chart youre looking at should generally show at
least fifteen trading days between the two tops or bottoms. The double top
or bottom typically is a forecasting formation that applies to intermediateterm reversals.
In my mind, the tweezers pattern is analogous to a very short-term double
top or double bottom. What the tweezers candles say is that prices held
twice at the exact same level or very close to it. At the bottom, sellers
were not able to push the stock lower. At the top, the bulls were not able
to drive prices higher. Tweezers thus signify very short-term support and
resistance levels.
Tweezers sometimes occur on two consecutive trading sessions. In these
cases they are relatively easy to spot. However, they can also occur several
sessions apart, say six or eight. (If they are spread further apart than that,
then the formation is beginning to approach the double bottom or top
described above.) When the tweezers occur consecutively, their forecasting value generally increases. Why? Well, in these cases a bullish or bearish
move has been absolutely stopped in its tracks and is more likely to reverse.
As with any candles, swing traders should watch carefully the price action
that occurs immediately after the tweezers candles. If the tweezers bottom is to be a meaningful reversal, then the low formed by the two candles
should hold. If the bottom is penetrated, then prices are likely to descend to
at least the next important support level. The opposite is true for a tweezers
top. Burlington Northern Railroad (BNI) was a stock on fire as investors
bid up much of the Dow Jones Transportation Average of which it forms a
part. The stock ran from the low $46 range in early February to a peak of
$56.28 in late March, a price that formed a peak for the stock. Burlington
then formed a small head and shoulders top and then took a round trip
right back to the $46 level in mid-April.
page 38

I have also included a 150-day moving average on the chart. Note that
the moving average was sloping up. To define the long term trend, I typically put the 150-day moving average on the chart. When it is rising and
below the share price, it provides support and often stops a correction
particularly the first time it is tested.

Figure 21 - Burlington Northern Santa Fe Corp. (BNI) NYSE

From the mid-$46 range, BNI rallied to $51.62 on May 6 and $51.59 on
May 9. These days were Friday and Monday, so they were consecutive. A
tweezers top stalled the recovery and the shares again pulled back falling
this time to a low just over $47.
Tweezers candles do not occur as frequently as other candles such as
dojis. When they do arise, however, they generally give rise to high-probability trading opportunities. Recognize this candle formation and youll
have a much easier time extracting money from the market.

Source: StockCharts.com

A tweezers bottom then marked the conclusion of the selling pressure.

The first low occurred at $46.59. Eight trading days later, BNI tested
$46.54, five cents lower then the first tweezers candle. Note the long lower
shadows on both candles saying sellers were eager to step in and buy in
this zone of support.

page 39

21 CANDLESTICKS EVERY TRADER SHOULD KNOW

Lesson 3
Integrating
Multiple
Candlesticks &
Indicators
ROUND NUMBER RESISTANCE,
CANDLESTICKS, AND INDICATORS

hus far in this book, we have focused on the power

of individual candlesticks or candlestick patterns.
We have seen that certain individual candles such
as the doji have the power to signal significant reversals in
and of themselves.
Two candle patterns such as bearish engulfing, and three
candle formations such as morning star, can mark entirely
new directions in trend. These candles and candle patterns
begin key reversals, often anticipating any other kind of
technical evidence such as from indicators or trendlines.
A key variation in the one- to three-candle reversal pattern
sometimes occurs in individual stocks or indices. There are
times when the market stalls at key levels and goes sideways
for what can seem to the trader like an interminable pe-

riod. During this time, many of the 21 candlesticks Ive asked you to learn
by name occur. However, the balance between the bulls and the bears,
between supply and demand, is so fine that neither side can win a decisive
advantage. A bullish candle may be followed by a bearish one, and that
candle reversed in turn.
These sideway movements often occur at times of significant support or
resistance. Resistance, you may remember, occurs when prices have risen
to such a level that new buyers are reluctant to enter the market. Support
emerges when the opposite occurs: sellers are exhausted and buyers must
bid higher to enter a position.
Technicians identify resistance and support as coming from a large number of factors. Resistance may occur at a price level that has been hit many
times before, from an important moving average such as the 50 or 200 day
or from the top Bollinger band. It can also emerge when prices push up
against the upper end of a channel or even when certain round numbers
are reached.
Of these varieties of resistance, round-number resistance is the kind I
find the most fascinating and potentially the most far reaching for making trading decisions. This resistance occurs when prices reach a certain
whole number and then stall. Perhaps one of the most dramatic instances
of this phenomenon was the inability of the Dow Jones Industrial Average
to meaningfully penetrate the 1000 level for approximately 16 years from
1966 to 1982. But the alert trader will note this kind of resistance in virtually every stock and at every different price level.
For a low price stock, an even dollar amount will usually cause buyers to
enter and prices to stall. I often notice that the $5 and $10 levels are difficult to penetrate on the first or second try. After that, even $5 amounts
such as $15, $20, and $25 are common prices at which stocks stall in their
advance. One might imagine that when shares reach elevated price levels
such as $60 or $70, that $1 would be such a small percentage change that
it wouldnt make a difference, but I have seldom found that to be the case.

page 40

21 CANDLESTICKS EVERY TRADER SHOULD KNOW

When day trading, I always pay attention to round numbers. A stock
may rise from say $41.20 at the
open to $42.10 intraday. But before
I jump on board, I will always want
to make sure this penetration of
$42 is going to last.

the next day by a large white candle

that bullishly engulfed the trading
range of the previous 9 days and
the rally was on. Several days later,
the Dow reached a peak of 10696.
That level is marked 1 on the
chart in Figure 22.

In gauging round number resistance with the major averages,

some slight leeway is necessary. In
the example below, I am going to
analyze the 10700-price level that
stalled the Dow Jones Industrial
average for several months. One
would not expect the Dow Jones,
for example, to hit 10700 exactly
on each day it tested that level.
On some occasions it might fail at
10690 and at others penetrate 10700
and climb as high as 10750 intraday. Occasionally, it might even
close above 10700, although it is
difficult for the index to sustain this
altitude for more than a day or two.

At this time, there were few technical reasons to believe the Dow
would not blow through 10700 and
perhaps challenge 11000, a previous resistance level. But the very
next candle (marked 2) dashed
those hopes. Can you see why?
Because it was bearish engulfing. It suggested that traders who
bought between 10175 and 10500
were more than happy to nail
down strong near Dow 10700.

The Dow Jones chart that I referred

to is on the next page. In early
July, the index hit a low of 10175
and rebounded sharply intra day.
By the end of the session, the Dow
had rebounded to close near 10300
and formed an enormous hangman
candle. That candle was followed

For the next several days, the Dow

waffled in a very narrow trading
range. It found support in the
10560 zone, a level that had provided buying interest earlier in the
month. Note how the two lateral
lines drawn on the chart mark the
bounds of a very narrow trading zone. This very constricted
rectangle formation contained the
Dow for several trading days as
it vacillated between support and
resistance.

Figure 22 - Dow Jones Industrial Average ($INDU)

Source: StockCharts.com

Near the end of the month, the

Dow again pressed up against
resistance. At 3 for the first time,
it closed above 10700 for the first
time in this move, finishing the
session at 10705.55. Again the bulls
no doubt entertained hopes of a

page 41

breakout and higher prices ahead.

Once more, at 4, their hopes were
dashed. Again, can you say why?
The next candle was dark cloud
cover as it opened slightly above
the previous days close and closed
very near the low for the day.

But the Dow bulls were not yet

ready to be deterred. Early the next
month they again tested the 10700
level. This time a hangman candle
formed at 5. Bears, or those looking to pin down profits, should
have been watching the next day
carefully. A hangman, after all, is a
major reversal candle, and it played
its role to perfection. The next
trading day at 6, a large bearish
engulfing occurred, and that led
to a sell-off that brought the Dow
back to key moving average support near 10525.

stochastics and CCI indicators had

deteriorated markedly since the
Dow had first probed 10700 several
weeks earlier. Typically there will
be bearish divergence after a long
period of sideways action, a decline, and then the probing of old
resistance. Traders should learn
to be skeptical of the price action
during these times. The technical maxim is momentum precedes
prices, and it pays to be extra patient at these times before entering
a trade on the long side.

As you may remember, bearish

momentum divergence forms
when price hits a new or equivalent
high, but the momentum indicator makes a lower high. Both the

what happened. After two large

white candles, the Dow stalled. It
formed a near-doji candle at Dow
10700, a clear signal that the strong
advance from the 10175 level was

running out of steam. The next

week, a second doji-like candle appeared. This one was slightly more
ominous than the first. Why? It
was dark and just about bearishly
engulfed the first.

Note also the message of the two

momentum indicators immediately after the two dojis. Both gave
sells signals. Stochastics said sell
as %K crossed below %D above
the overbought 80 level, and CCI
echoed this message when it fell
from above +100 to below +100.

Figure 23 - Dow Jones Industrial Average ($INDU)

At many junctures such as the one

I have been describing, it always
But the Dow bulls were not yet
exhausted. Two trading days later, pays to look at as many technical
factors as possible. Even for those
the index made one last probe of
with a short-term trading focus, a
the 10700 during this period. Except for the small lower shadow, the look at the weekly chart in addicandle formed at 7, a near-perfect tion to the daily is always instrucshooting star, another major rever- tive. In this case the weekly chart
provides the trader with a great
sal signal. Although the next day
was a positive white candle, techni- deal of additional insight.
cians should have been very suspiThe chart in Figure 23 is comcious because there was extreme
prised of exactly the same data
bearish momentum divergence.
and indicators as the daily. Note

Source: StockCharts.com

page 42

Therefore, the final probe for this

period should, based on almost all
the technical evidence, have been
regarded with great suspicion.
First, on the weekly chart a very
large upper shadow was left, similar to the daily shooting star. Next,
there was strong momentum divergence on the daily chart. Finally,
the probe of 10700 occurred while
both weekly CCI and stochastics
were on sell signals.
Alert technicians recognized these
signals in real time, and the Dow
retreated sharply over the next
several weeks. A combination of
using candlesticks, indicators, and
round number resistance would
have saved the trader from buying
at the wrong time or given back
a large percentage of previously
earned profits.
Lets return to the daily Dow chart.
The index hesitated at 10500 for
several days, finding support both
near its 50- and 200-day moving
averages and also at an important
round number. From there it declined to just below 10350 where it
scored a significant bottom.
Can you spot some of the technical factors that may have given the

buyers confidence? First, the Dow

had gone from one end of the Bollinger band to the other end. Second, note at point 8 how it made
a near tweezers bottom on the
last two days of the month scoring lows of 10321.42 and 10329.15.
Third, note the long lower shadows
on each of the three candles suggesting that buyers at these levels
thought they were buying at bargain levels. Note also how both
stochastics and CCI had become
oversold and soon gave buy signals after the three long-shadowed
candles. A small uptrend line also
can be drawn under the second
two candles, and even though there
is not much data on which to base
this trendline, it will often have
predictive power.
From there, the Dow rallied back
to just above 10700 at point 9.
This rapid advance left the Dow
overbought on both stochastics and
CCI and again brought it back to
the top of the Bollinger band. A
long white candle was followed by
a doji, and then a large dark candle
that implied 10700 resistance was
not to be overcome anytime soon.
If the doji had been more star-like,
the three-candle formation would

have been a classic evening star formation, again signaling an important reversal.
The Dow again retreated and found
short-term support (point 10)
right around the 10350 level just
where the previous decline had
halted. Soon the Dow was advancing, although it peaked below
10700 resistance.
Traders should note how during
this period the 50- and 200-day
moving averages were both flat
and very tightly bunched. This
configuration occurs when the
market enters a prolonged and near
trendless sideways consolidation
phase. During these periods where
the bulls and bears are engaged in
a tug of war but neither side can
win, there can be intense volatility within the trading range. One
of the few ways to make money
during this kind of period is to
recognize reversal signals virtually
as soon as they occur. Combining
candlesticks, indicators, support,
and resistance should give you
some of the essential tools to survive and even thrive in this kind of
choppy market environment.

page 43

Figure 24 - Aladin Knowledge Systems Ltd. (aLDN) Nasdaq

Lesson 4
GAPS FROM
A JAPANESE
CANDLESTICK
VIEWPOINT
What is a gap?

gap is a hole in the chart. It occurs because on a

particular day a stock opens or closes much higher
or lower than on the previous session. The cause
of a gap can be varied. Some common reasons for gaps are
earnings announcements, important corporate news, or
even large moves in the overall market at the opening of
trading.

THE FOUR TYPES OF GAPS

The trader should be able to identify four different types
of gaps: area (common), breakaway, continuation (measuring), and exhaustion.

An area gap occurs within a trading pattern such as a

triangle, rectangle, or base. Typically, the area gap is of little

significance. Since area gaps often are filled quickly, they
conform to traditional wisdom that gaps are filled. The

Source: StockCharts.com

stock Aladin Knowledge Systems (ALDN) shows two examples of area

gaps. In both cases, these gaps were filled quickly.

A breakaway gap is an entirely different matter. The breakaway gap

ends a consolidation pattern and happens as prices break out. Often, a

breakaway gap occurs on very large volume, as the supply available within
the consolidation pattern has been consumed and bidders who want to
enter the stock must pay up for it. A genuine breakaway gap often will not
be filled for weeks or months (if ever).
The chart of Conagra (CAG) shows a breakaway gap that occurred on
enormous volume.
Note how the stock tried to rally back toward resistance at $25.44 on the
end of the gap. It failed right below that level and left an enormous upper
page 44

A fascinating example of a continuation gap occurs in the chart of Brinter

Intl. (EAT), a restaurant chain. The stock peaked just shy of the $40 level
in March and hit a low of $33.19 in late April. After a snappy recovery,
the stock closed at $36.95 on June 8. Note the move from $33.19 to $36.95
was $3.76.

Figure 25 - Conagra, Inc. (CAG) NYSE

The next day EAT gapped up on news that the company was boosting
both its quarterly and full year earnings outlook. The stock opened at
$39.25, backed off to $38.65, and closed over round number resistance
at $40. A continuation gap typically takes place approximately halfway
through the move. If you add the prior move of $3.76 to the low of the
Figure 26 - Brinter Intl, Inc. (EAT) NYSE

Source: StockCharts.com

shadow. Volume on that day was about 350% higher than normal levels.
If the stock were to approach $25.44 again, it would face very strong resistance as all the buyers who had the chance to get out at close to breakeven would be tempted to do so.

A continuation gap occurs within a rapid straight-up movement. This

type of gap is also known as a measuring gap because it usually occurs

approximately halfway through the move. Continuation gaps may eventually be filled, but it should take some time to do so as the stock needs to
first peak, reverse, and finally trend in the opposite direction.
Source: StockCharts.com

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An exhaustion gap occurs at the end of a price move. If there have been

In mid-June, however, note that BHP made an unusual number of gaps

in a row, even for this stock. The third gap formed a doji, and the stock
reversed, filling the top and middle gap, but finding support at the bottom one. With gaps I often find that the three strikes and youre out
rule applies. The third gap often is the final one.

BHP Billiton is an Australian mining stock that trades on the New York
Stock Exchange. The company tends to form many gaps because the
trading that takes place in Australia before the NYSE opens influences
BHPs performance dramatically on that day.

When a trader sees a gap, he or she should immediately ask, What kind
of gap am I witnessing? Often it will take some time to come to a final
conclusion. What seems to be a breakaway gap, for example, may over the
next several weeks be filled, and that filling may be an important catalyst
to take trading action in the opposite direction.

gap day, $38.65, the target becomes $42.41. The stock hit $42.40 several
trading days later!
two or more gaps before it, then this kind of gap should be regarded very
skeptically. A genuine exhaustion gap is filled within a few days to a week.

Figure 27 - BHP Billiton Ltd. (BHP) NYSE

CANDLESTICK THEORY ON GAPS

Candlestick theory, while less detailed about gaps, provides some important additional insights. Japanese theory does not distinguish between
the types of gaps. Nor does it even use this term. Instead a gap is called
a window. Whereas a great deal of emphasis in candlesticks is given to
reversal patterns, a window is considered a continuation pattern. In other
words, trading is highly probable to continue in the same direction after
the window as it did before it.
In his work on candlesticks, Steve Nison advises traders that typically
they should trade in the direction of the window. If a particular stock
is declining when the window occurs, then it is highly probable that the
decline will continue. If the stock is rising when the window occurs, then
it should continue to rally.
Once a window has occurred, the pattern often forms into an important
support and resistance area. If the window occurred in a downtrend, then
on any subsequent rally the upper end of the window should turn back
prices. If the window was created in an uptrend, then when prices rally
the bottom edge of the window should be the lowest point of decline. Further, candle theory holds that the test of all open windows is likely. The
key thing to examine is what happens on this test.
Source: StockCharts.com

page 46

When the alert swing trader spots a

window in a rising trend, he or she
should expect, for a time, that the
price will continue higher. Eventually, however, prices will reverse and
will test the open window. On this
test, prices should hold at the lower
edge of the window, which is now
important support. If, however, this
support level is violated and selling
pressure persists, then it is likely
that the trend has reversed. The
swing trader should now go short
in the same way he or she would if
a horizontal support level had been
breached.
In a downtrend, the opposite is true.
After the initial window, the decline
should continue. Eventually resistance, which is at the upper edge
of the window, should be tested. If
buying pressure persists and is able
to move prices beyond this upper
window, then swing traders should
go long in the same way they would
if a resistance level were overcome.

SYNTHESIS OF
WESTERN WISDOM AND
EASTERN INSIGHT

ombining Western wisdom and Eastern insight on gaps, what then are some key trading tactics
you can take away? The principles below should be applied within the context of other chart
messages such as moving averages, trendlines, and stochastics. That said, here are several trading principles based on gaps:
1. On spotting a gap in a daily chart, immediately question yourself as to which of the four kinds
of gaps it is.
2. Generally, short-term trades should be in the direction of the gap. The larger the gap and the
stronger the volume, the more likely it is prices will continue to trend in that direction.
3. If an area gap is identified, then the swing trader should look for a short-term peak. When prices
begin to move back toward the gap, a trade may be placed anticipating the gap will be filled.
4. Upon identifying a continuation gap the trader should, other factors considered, buy quickly.
The trader should then use the measuring principle, which applies to this gap, to identify the
short-term target.
5. A breakaway gap also provides an immediate buy point, particularly when it is confirmed by
heavy volume.
6. The third upside gap raises the possibility an exhaustion gap has occurred. Swing traders should
look for the gap to be filled in approximately one trading week. If the gap or window is filled
and selling pressure persists, then that issue should be shorted. If the gap is the third one to the
downside, then traders should be alert for a buy signal.

page 47

Although gaps are powerful analytical tools, generally they should not
be acted on in isolation. View the
gap within the context of the other
technical messages given by the
chart. For a complete system of gap
analysis, traders should apply both
Western and Eastern concepts of gap
analysis. Hopefully, this summary
of gaps has filled in some holes in
your knowledge of how to apply this
technical analysis concept.

A CONCLUDING
CHALLENGE

ow that you have read 21 Candlesticks, I have a challenge for you. Take a sheet of paper and
see how many of the candlesticks you can name from memory. After youve done that, review
the ones you missed until you can name all 21 by heart.

Next, go back and draw the candlestick diagrams next to the text. Again, see how many you can draw
from memory. Go back and check your results against the earlier chapters of this book. Repeat this
exercise until you can name and draw all 21 candles.
The benefit of this exercise will be that you will be able to recognize the 21 candles when they occur in
trading situations. If you are a short term trader, this will help you immeasurably to pick up on key
continuation and reversal patterns. If you trade intraday, you will be much more sensitive to changes in
the ebb and flow of supply and demand as signaled by candles.
Good luck and good trading!

page 48

ABOUT THE AUTHOR

r. Melvin Pasternak has studied and traded the stock

market for more than 40 years, having made his first
trade in 1961. For more than a decade he taught classes
in technical analysis for TD Waterhouse and also instructed stock
market classes at the college level for many years.
Dr. Pasternak holds both Ph.D. and M.B.A. degrees and writes a
trading oriented newsletter called the Swing Trader at www.streetauthority.com.
Dr. Pasternak is a regular technical analysis commentator for CBC
radio, Canadas national radio station. His stock-picking methods
have been profiled in several newspaper articles.
He actively trades his own account where the methods described in
this book form a key part of his decision making. In his best year,
Dr. Pasternak multiplied his account several hundred percent and
completed more than 80% of his trades profitably.

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