Candlestick charts mark the beginning of formal technical analysis, a discipline that has faced criticism from many traders. Today, some traders argue the new field of quantitative analysis should replace charts completely, while others vehemently defend the effectiveness of candlestick charts and their patterns. Technical analysis methods like candlesticks are based on an understanding of the psychology of market participants, a notoriously tricky subject that requires experience and flexibility to understand.
Whatever you think about technical analysis, candlestick charts have stood the test of time. Originally used in the rice market, they were developed by Japanese trader Honma Munehisa (1724 – 1803) over the course of a lifetime dealing in rice coupons, a forerunner of modern futures contracts.
From the late 1980s onwards, candlestick charts began to become popular in western markets. Now they are considered a standard part of any charting software, calculated automatically by trading programs, removing the need for laborious plotting by hand. Hundreds if not thousands of books have been published on the art of interpreting candlestick patterns, and they are used by both retail and professional traders worldwide.
The rice market
Rice markets formed a central role in the economy of feudal Japan. The ubiquity, ease of storage and stable value of this commodity meant that it acted as a sort of pseudo-currency, with the size of a feudal estate dictated by how much rice it could produce. Wages were often paid in rice, which was freely interchangeable with other commodities.
One of the most important innovations of this era was the ‘rice coupon’, which to all intents and purposes was an early form of futures contract. These coupons were also known as ‘empty rice’ – they were contracts for the purchase of rice that had not yet grown. By the eighteenth century, these coupons existed in far larger numbers than the total production of rice in Japan, a sign they were being used for speculation or as legal tender.
The rice market was centred on the rice exchange in Osaka, which accordingly became a major financial centre. Certain market participants made significant profits in speculation, observing seasonal trends, trading session abnormalities and using many other methods to turn a profit. Eventually, one trader began using the chart we now call the candlestick.
Candlestick charts become popular
The trader’s name was Honma Munehisa, and he soon became a legend in the rice market. After a successful career in which he became an advisor to the emperor and vastly wealthy he published a book, translated into English as The Fountain of Gold, in which he explained his method for producing candlestick charts.
These charts became a hit in his home country, and as other Japanese financial markets developed in later centuries the same method was applied to forex, equities and commodities markets. Candlesticks involve a plot per time period (originally, per trading session), with the highest price forming the top wick, a shaded body bounded by the open and close price, and a lower wick showing the lowest traded price in the session. Candles are coloured according to whether the market closed up or down on that particular session.
Candlestick charting holds a unique place in financial history because it is the first technical system to rely entirely on price data. Previous efforts, such as 16th century German trader Christopher Kurz’s system of price signals, mixed market data with astrological speculation. Honma Munehisa lived some distance from the markets he traded in, so he required a graphical representation of market psychology. The value of this wasn’t always obvious to traders: market psychology or ‘mood’ was immediately apparent in the days of open outcry trading, reducing the need for a chart to explain it.
These concerns notwithstanding, the theory behind candlestick charts is easy to justify using market psychology, and they represented a huge advance over earlier methods. Techniques such as point and figure charting share some of the same principles, but for versatility and accuracy there is no serious rival to candlestick charts (other than the classic price line).
From the late 1980s American traders working on Wall Street began to show an interest in using candlesticks in equities trading. This coincided with a renewed interest in technical analysis more generally, till then the preserve of a subset of speculators. As the method grew in popularity, public interest picked up, culminating in the 1991 publishing of Japanese Candlestick Charting Techniques by Steve Nison. This introduced candlesticks to the global retail market, and they have remained a top chart type ever since.
Why are candlesticks successful?
We have described the rise of this chart type from local commodities markets to globally recognised financial tool. There isn’t one single reason why this happened, but their ease of calculation was surely a key factor. Candlestick charts have several characteristics that make them particularly suited to pre-computerised trading:
- They are easy to calculate and plot: high, low, open and close is the only data required.
- They can be represented with a clear visual layout.
- They make patterns very clear when compared to retracements or moving averages.
It is true that the first point is of reduced importance in an age where computers can make complex calculations instantaneously, but traders still benefit from the second and third points. The visual, and slightly subjective, nature of candlesticks means they are not used by quantitative traders, some of who are quite sceptical about their accuracy.
Candlesticks and retail traders
Candlestick trading arrived just at the time when retail trading was taking off. Retail forex trading first became viable with the advent of computerised platforms in the 1990s, and the then-new candlestick became a much loved tool. Vast books detailing all the potential candlestick patterns soon appeared, and traders made (and lost) vast sums using them to predict market movements.
As with all visual technical strategies, it is difficult to confirm the efficacy of candlestick charts. Because traders need to make a judgement call on the existence of a pattern, experienced traders will often respond to charts very differently to novices. This has frustrated attempts to prove or disprove their effectiveness. Quantitatively-minded traders tend to avoid them for this reason, but they remain extremely popular with both retail and professional investors.
When using candlestick charts, it makes sense to confirm any patterns using another indicator. For example, classic reversal patterns such as the head and shoulders can be confirmed using an oscillator, and it is common practice to describe emergent patterns in the context of moving average intersections. Finding a pattern forming that is supported by other technical signals produces a more reliable trade entry than using charts alone.
Conclusion
Candlestick charts are so ubiquitous that it sometimes feels you can’t trade forex without them. Many trading platforms use candlestick charts as their default view, and the most famous patterns are household names. Nevertheless, they are not loved universally. Algorithmic traders struggle to input this kind of signal into their trading systems, and graphical trading more generally is no longer viewed as the most sophisticated system.
That said, there are real reasons, rooted in market psychology, why candlestick patterns can and do work. The problem for retail traders is knowing how to identify these instances, and avoid dud or partially formed patterns. One simple strategy is to only trade absolutely perfect patterns. Some traders argue slanted head and shoulders or other variant patterns carry extra information, but this is a murkier area and it is often safer to avoid such situations.
However you trade candlesticks, the same risk management principles apply. Avoiding psychological errors like overexuberance – which can make you see patterns where there are none – and using well-placed stops and take profit levels, will enhance your returns. Additionally, confirming any potential patterns by checking other technical indicators and underlying fundamental drivers will help you separate good opportunities from false ones.
How Rakuten can help
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