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II Candlestick

Basic concepts

Candlestick charts are thought to have been developed in the 18th century by Munehisa Homma, a Japanese rice trader of financial instruments (Morris, 2006). They were introduced to the Western world by Steve Nison (Nison, 1991) in his book, Japanese Candlestick Charting Techniques.

A candlestick is a graphical representation of price movements for a given period of time. It is commonly formed by the opening, high, low, and closing prices of a financial instrument.

A typical candlestick chart is usually composed of the real body and shadows: the area between the open and the close is called the real body, price excursions above and below the real body are called shadows. The real body illustrates the opening and closing trades. If the security closed higher than it opened, the body is white or unfilled, with the opening price at the bottom of the body and the closing price at the top. If the security closed lower than it opened, the body is black, with the opening price at the top and the closing price at the bottom. The shadow illustrates the highest and lowest traded prices of a security during the time interval represented. The shadow above the real body is called upper shadow and the shadow below the real body is known as lower shadow. Accordingly, the peak of the upper shadow is the highest price and the bottom of the lower shadow is the lowest price. Figure 3.1 presents the plot of a typical candlestick. Figure 3.2 presents what the black and white candlesticks look like.

In this book we define real body, upper and lower shadows as follows:

Real body: real body in candlestick is defined as the absolute difference between opening price and closing price. In this book the real body is defined as the natural logarithmic difference.


where RB, is the real body and ln(x) is the natural logarithm of .v.

A typical candlestick

Figure 3.1 A typical candlestick

Upper shadow: upper shadow is the price excursions above the real body. In this book, the upper shadow is defined as


where US, is the upper shadow, O, and C, are, respectively opening and closing prices.

Lower shadow: lower shadow is the price excursions below the real body. In a similar way, the lower shadow is defined as


where LS, is the lower shadow.

From the concepts of real body, upper and lower shadows, we can construct the Parkinson range (Parkinson, 1980).

Basic concepts 17

Black (left) and white (right) candlesticks

Figure 3.2 Black (left) and white (right) candlesticks

Parkinson range: Parkinson range is defined as the difference between the log highest price and the log lowest price

where PR, is the Parkinson range. Assuming that the asset price follows a simple diffusion model without a drift term, Parkinson (1980) proved that this range is a very efficient volatility estimator

where rf, is the volatility estimator.

It is clear that the Parkinson range is the sum of upper shadow, real body and lower shadow

if (), > Cn and

if c>o,.

Similar to Parkinson range, the difference between the highest price and the lowest price is known as the technical range.

Technical range: technical range gauges the variability of price movement, which also is a direct indicator of price uncertainty, or risk: the larger is the technical range the more risk the investors are facing.

where H, and L, are, respectively, the highest and lowest prices over a specified time period. TR, is the technical range. Technical range is equivalent to the length of the candlestick chart.

Candlestick charts are a group of candlesticks, serving as a cornerstone of technical analysis. As can be observed from the drawing of the candlestick that candlestick charts usually convey more information than other forms of charts, such as the moving average charts which use only the closing price information. The candlestick charts not only display the absolute values of the open, high, low, and closing price for a given period but also show how those prices are relative to the prior periods’ prices. For example, when the candlestick is white and high relative to other time periods, it means buyers are very bullish. The opposite is true for a black candlestick.

In practice, the candlestick charts are always used with the combination of the other technical indicators, such as the moving average. There are many candlestick chart patterns. This section is only a brief introduction to the construction of candlestick. Readers who are interested in more details about candlestick charts and candlestick trading techniques are advised to refer to Nison (1991) and Morris (2006).

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