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Advanced Technical

Analysis
Basic Charting

Despite all the technological


breakthroughs, charting remains more
of an art than a science. Yet the more
refined traders become, the better is
their forecasting performance.
Cornelius Luca

Section 2 of 8

Advanced Technical Analysis

Basic Charting

KEY CONCEPTS

1. Candlestick and bar charts


show he past price movement of
individual trading periods. Line
charts do not.
2. Each candlestick is composed of
an opening, high, low and closing
price for the trading period.
3. White candlesticks indicate a
bullish trading period in which the
stock price closed higher than it
opened.
4. Black candlesticks indicate a
bearish trading period in which the
stock price closed lower than it
opened.
5. Individual candlesticks indicate
market sentiment, but they are
not trading signals in and of
themselves.

Before you dive into the complexities of various technical


indicators and their interactions with the markets, you need
to understand the basics and functionality of a technical chart.
You should familiarize yourself with the Interactive Chart in
the Investor Toolbox. Experiment with the functionality of the
Interactive Chart as outlined in the Appendix.
Chart Time Frames
Technicians live by the mantra The trend is your friend.
Trading with the trend can keep you out of many dangerous or
risky situations. Technicians often use multiple time frames to
confirm their trading strategies. For example, if you are trading
the daily charts using the stochastics indicator and you have a buy
signal, you can check the weekly or monthly charts to make sure
you are trading with the longer-term trend.

Using the Investor Toolbox

You can adjust the time frame on your chart by using the toolbar at the top of
the Interactive Chart. To adjust the time span of the chart, click on the second
drop-down menu from the left (see Figure 2.1).

Figure 2.1Time Frame Options

To adjust the time span of each bar on the chart, click on the third drop-down
menu from the left (see Figure 2.2).

Figure 2.2Trading Period Options

Try adjusting your chart from a 1-year daily chart to a 5-year weekly chart.
This same principle of looking to the next time frame for trend confirmation
can be used with the hourly and daily charts, the daily and weekly charts and
even the weekly and monthly charts for a longer-term trader. The principles of
technical analysis apply equally to each of these time frames.

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Section 2: Basic Charting

Basic Charts

Technicians use many different types of charts. The oldest and


most popular chart type is the Japanese candlestick chart. We will
discuss candlestick analysis later in this section. Another popular
chart type is the bar chart. Bar charts are a Western invention
and have provided a profitable blueprint for investors for more
than 100 years. Another less popular chart type is the line chart.
Line charts, however, can provide valuable information in specific
situations. Other chart types include volume bar charts, pivot
point charts and the oldest Western chart typecreated by
Charles Dow of the Dow Jones Industrial Averagethe pointand-figure chart.

AT A GLANCE

Basic Charts
Bar charts
Line charts
Japanese candlestick charts

Using the Investor Toolbox

You can adjust the chart type by using the toolbar at the top of
the Interactive Chart. To adjust the chart type, click on the first
drop-down menu from the left (see Figure 2.3).

Figure 2.3Chart Type Options

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Advanced Technical Analysis

Figure 2.4Bar Chart

Bar Charts
A bar chart is a commonly used Western
method of charting price movement. The long
vertical linethe barrepresents each periods
trading range, including the high price for the
day and the low price for the day. The horizontal
line on the left side of the bar represents the
opening price for the day. The horizontal line on
the right side of the bar represents the closing
price for the day (see Figure 2.4).

Technicians using this type of chart have the obvious advantage


of being able to see at a glance whether the market was rising or
falling during a particular trading period (see Figure 2.5).

Figure 2.5Bar Chart (IBM)

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Line Charts
A line chart does not plot the price movement for a given period.
It only plots the closing price for each period. The chart then
connects the closing prices with a single linehence the name
line chart. At first glance, this chart type seems inferior to the
bar chart because it displays less information. However, some
technicians like this view because it usually shows support and
resistance more clearly than a bar chart does (see Figure 2.6).

INVESTOR TIP

Line charts provide clear support and


resistance levels.

Figure 2.6Bar Chart (IBM)

Japanese Candlestick Charts


In 1989 Steven Nison brought Japanese candlestick charts to the
Western trading world. Japanese candlesticks have been used by
the Japanese in the rice markets since the 1700s. We will be using
candlesticks as the primary method of illustrating the technical
formations in this program. Candlesticks are also the first
technical analysis method we will discuss.

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Advanced Technical Analysis

Candlestick Charts

Candlestick Construction
INVESTOR TIP

Each candlestick is composed of a


body and an upper and lower shadow.

Like a bar chart, a candlestick chart shows three things: the


opening price, the trading range and the closing price. The range
for the period is shown with a vertical line. The opening and
closing prices are shown by horizontal lines crossing the vertical
line. The distance between the opening and closing prices forms
a box called the body of the candlestick. The range of prices
above or below the body of the
candlestick, represented by the
vertical line, is called the shadow.
If the closing price is higher than
the opening price, the body of the
candlestick will be left empty, or
white. If the closing price is lower
than the opening price, the body of
the candlestick will be filled in, or
black (see Figure 2.7).

Figure 2.7Candlesticks

Figure 2.8Candlestick Chart (IBM)

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Section 2: Basic Charting

Candlestick charts are preferred by most technicians because they


are generally easier to read. The up days and down days stand out
from each other without losing any of the detail of the bar charts
(see Figure 2.8).
In this course, we will be looking at the most common and
reliable candlestick formations used by technicians. Although
candlestick formations can be traded by themselves, they are
much more reliable when combined with Western techniques.
Once we have covered the basic candlestick formations, we
will combine them with other Western methods in subsequent
sections.
Following are a few basic types of candlesticks. You will use these
basic candlestick types in each of the formations discussed in this
course.
White Candlesticks
The white candlestick has a long
body that may or may not have
an upper or a lower shadow (see
Figure 2.9). The long white body
of this candlestick type indicates
strong buying interest. Yet a white
candlestick is not a stand-alone signal
to buy or sell.
Figure 2.9White Candlestick

Black Candlesticks
The black candlestick has a long
body that may or may not have
an upper or a lower shadow (see
Figure 2.10). The long black body
of this candlestick type indicates
strong selling interest. Yet a black
candlestick is not a stand-alone signal
to buy or sell.

Figure 2.10Black Candlestick

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INVESTOR TIP

Both spinning tops and dojis indicate a


trading period in which the buyers and
sellers are relatively balanced.

Spinning Tops
A spinning top is a candlestick with
both an upper and a lower shadow
and a relatively small body (see
Figure 2.11). The color of the body
is not important. While a candlestick
with a long body indicates strong
Figure 2.11Spinning Tops
buying or selling interest, the small
body of a spinning top indicates a slow market with a relative
balance between buyers and sellers. Yet a spinning top is not a
stand-alone signal to buy or sell.
Dojis
A doji is a candlestick with an upper shadow, a lower shadow
or both, and a flat body (see Figure 2.12). Dojis occur when
the stock closes at a price
equal to or almost equal to its
opening price. Dojis do not
have an elongated body, just a
horizontal line indicating the
opening and closing prices.
Like the spinning top, a doji is
not a stand-alone signal to buy Figure 2.12Dojis
or sell.
A doji is essentially a neutral indicator because
it represents a balance between buyers and
sellers. There are, however, two types of dojis
that are not neutral.
The first non-neutral doji is called the
tombstone doji (see Figure 2.13). As its name
might suggest, it usually kills an uptrend
Figure 2.13
and is generally bearish. A tombstone doji
Tombstone Doji
represents a trading period in which the price
opened near the low for the period, experienced an unsuccessful
rally and then closed near the low for the period.

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Section 2: Basic Charting

Figure 2.14Dragonfly
Doji

The second non-neutral doji is called the


dragonfly doji (see Figure 2.14). It usually
flies upward and is generally bullish. A
dragonfly doji represents a trading period
in which the price opened near the high
for the period, experienced an unsuccessful
sell off and then closed near the high for
the period.

Candlestick Formations

Candlestick formations provide technicians with both buy and


sell signals. There are many different candlestick formations, some
of which fall outside the scope of this course. We will discuss only
those formations that are central to generally accepted technical
analysis methodologies.
Hammers
A hammer is a common formation
that occurs only in a downtrendit
is bullish and signals a reversal of
the current trend. Hammers are
similar to the dragonfly doji; they
have little or no upper shadow, a
small body and a lower shadow that
is at least twice the length of the
body (see Figure 2.15). The color
of the body of the hammer is not
important.
The hammer represents a trading
period in which the price opened
Figure 2.15Hammer
near the high for the period,
experienced an unsuccessful sell off and then closed near the high
for the period. The market is often described as hammering out
a bottom when this formation appears.

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Advanced Technical Analysis

Figure 2.16Hammer on IBM

As you can see in the IBM (IBM) chart shown in Figure 2.16,
the stock price forms a hammer on 5/12 that is followed by a
confirmation on 5/19 when the stock price closes above the
hammer.
As with most technical signals, the hammer is not a stand-alone
signalanother signal must confirm the bullish action. A buy
confirmation for a hammer occurs when a subsequent candlestick
closes above the body of the hammer candlestick.
The Hanging Man
A hanging man is similar in form to the hammer, but the
implications of this candlestick are quite different. A hanging
man occurs only during an uptrendit is bearish and signals a
reversal of the current trend. A hanging man has little or no upper
shadow, a small body and a lower shadow that is at least twice the
length of the body (see Figure 2.17). The color of the body of the
hanging man is not important.

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Section 2: Basic Charting

The hanging man represents a trading


period in which the price opened near
the high for the period, experienced an
unsuccessful sell off and then closed
near the high for the period. Although
the bulls may have rallied prices back
up near the high for the period, a
hanging man indicates the market is
running out of steam.

INVESTOR TIP

Both a hammer and a hanging man


have short bodies and long lower
shadows. They each indicate a
potential change in their respective
trends.

As you can see on the S&P 100


Index (OEX) chart shown in Figure
2.18, the stock price formed a hanging man on 4/06 that was followed
Figure 2.17Hanging Man
by a confirmation on 4/07 when the
stock price closed below the hanging man. Also note the hammer on 5/12 that was followed by a confirmation on 5/25.
The hanging man is not a stand-alone sell signalanother
signal must confirm the bearish action. A buy confirmation for a
hanging man occurs when a subsequent candlestick closes below
the body of the hanging man candlestick.

Figure 2.18Hanging Man on the OEX

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The hanging man and hammer formations are important


technical signals as they represent major shifts in market
sentiment. Here are four important things to remember about the
hanging man and hammer:
Trend. The hanging man occurs only during an uptrend.
The hammer occurs only during a downtrend. The
longer and more dramatic the previous trend, the more
important the signal will be.
Body size. The lower shadow must be at least twice as
long as the body. The longer the shadow is compared to
the body, the more valid the signal is.
Upper shadow. The hammer and hanging man should
have little or no upper shadow.
Confirmation. The hammer is confirmed by a
subsequent candlestick closing above the body of the
hammer. The hanging man is confirmed by a subsequent
candlestick closing below the body of the hanging man.

INVESTOR TIP

Both an inverted hammer and a


shooting star have short bodies and
long upper shadows. They both
indicate a potential change in their
respective trends.

Figure 2.19Inverted Hammer

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Inverted Hammers
The inverted hammer is a
common formation that occurs
only in a downtrendit is
bullish and signals a reversal of
the current trend. The inverted
hammer, like the hammer, is
similar to the tombstone doji.
Inverted hammers have little or
no lower shadow, a small body
and an upper shadow that is at
least twice the length of the body
(see Figure 2.19). The color
of the inverted hammer is not
important.

Section 2: Basic Charting

Figure 2.20Inverted Hammer on the OEX

The inverted hammer represents a trading period in which


the price opened near the low for the period, experienced an
unsuccessful rally and then closed near the low for the period.
The market can also be seen as hammering out a bottom when
an inverted hammer appears.
As you can see on the S&P 100 Index (OEX) chart shown in
Figure 2.20, the stock price formed an inverted hammer on 5/19
that was followed by a confirmation on 5/21. The combination
of the hammer and the inverted hammer during this period
increases the strength of the signal.
As with most technical signals, the inverted hammer is not a
stand-alone signalanother signal must confirm the bullish
action. A buy confirmation for an inverted hammer occurs when
a subsequent candlestick closes above the body of the inverted
hammer candlestick.

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Figure 2.21Shooting Star

Shooting Stars
The shooting star formation is similar
to that of the hanging man. You
can see how the name shooting star
came about because it looks like a
meteor with a tail falling to earth.
The shooting star occurs only during
an uptrendit is bearish and signals
a reversal of the current trend. A
shooting star has little or no lower
shadow, a small body and an upper
shadow that is at least twice the length
of the body (see Figure 2.21). The
color of the body of the shooting star is
not important.

The shooting star represents a trading period in which the price


opened near the low for the period, experienced an unsuccessful
rally and then closed near the low for the period. A shooting star
indicates the market is running out of steam.
As you can see in the Intel (INTC) chart shown in Figure 2.22,
the stock price formed a shooting star on 1/09 that was followed
by a confirmation on 1/13 when the stock price closed below the
shooting star.

Figure 2.22Shooting Star on INTC

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Section 2: Basic Charting

The shooting star is not a stand-alone buy signalanother signal


must confirm bearish action. A sell confirmation for a shooting
star occurs when a subsequent candlestick closes below the body
of the shooting star candlestick.
The inverted hammer and shooting star formations are important
technical signals as they represent major shifts in market
sentiment. Here are four important things to remember about the
inverted hammer and shooting star:

Trend. The shooting star occurs only during an


uptrend. The inverted hammer occurs only during a
downtrend. The longer and more dramatic the trend is,
the more important the signal.

Body size. The upper shadow must be at least twice the


length of the body. The longer the shadow is compared
to the body size, the more valid the signal.

Lower shadow. The inverted hammer and shooting star


should have little or no lower shadow.

Confirmation. The inverted hammer is confirmed by


a subsequent candlestick closing above the body of the
inverted hammer. The shooting star is confirmed by a
subsequent candlestick closing below the body of the
shooting star.

Engulfing Formations

An engulfing formation is more common than a hammer,


hanging man, inverted hammer or shooting star. Unlike in those
formations, the color of the candlestick in an engulfing formation
is important and must appear in specific sequential combinations
of two or more candlesticks.

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Figure 2.23Bullish Engulfing


Formation

Bullish Engulfing Formations


A bullish engulfing formation occurs
when a black candlestick is followed
by a longer white candlestick during
a downtrend. The white candlestick
must have an opening price below
the closing price of the previous black
candlestick and a closing price above
the opening price of the previous
black candlestick (see Figure 2.23).
This indicates a critical change in
market sentiment. The bulls are
literally overpowering the bears.

The bullish, or white, candlestick


does not have to encompass the black
candlesticks shadows. Only the body of the black candlestick has
to be surrounded by the white candlestick.

Figure 2.24Bullish Engulfing Formation on EBAY

As you can see in the eBAY (EBAY) chart shown in Figure 2.24,
the stock price formed a bullish engulfing formation on 6/21 and
6/22. This signaled a change in the trend of the stock and was the
beginning of a 9 percent increase in the stock price.
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Section 2: Basic Charting

Bearish Engulfing Formations


A bearish engulfing formation occurs
when a white candlestick is followed
by a longer black candlestick during
an uptrend. The black candlestick
must have an opening price above the
closing price of the previous white
candlestick and a closing price below
the opening price of the previous
white candlestick (see Figure 2.25).
This indicates a critical change in
market sentiment. The bears are
beating down the bulls.

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Engulfing formations occur when a


candlestick engulfs the previous
candlestickmeaning you could fit the
body of the first candlestick within the
body of the second candlestick.

The bearish, or black, candlestick


does not have to encompass the white
candlesticks shadows. Only the body of the white candlestick has
to be surrounded by the black candlestick.
Figure 2.25Bearish Engulfing
Formation

Figure 2.26Bearish Engulfing Formation on YHOO

As you can see on the YAHOO (YHOO) chart shown in Figure


2.26, the stock price formed a bearish engulfing formation on
4/27 and 4/28. Note that this formation followed another bearish
engulfing formation on 4/19 and 4/20.

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The bullish and bearish engulfing formations are important


technical signals as they represent major shifts in market
sentiment. Here are three important things to remember to
ensure that you are recognizing the right engulfing formation at
the right time:
Trend. The bearish engulfing formation occurs during an
uptrend and a bullish engulfing formation occurs during
a downtrend. Both indicate a potential change in trend.
Body size. The second candlesticks body must
completely engulf the body of the first candlestick in
both formations.
Color. In the bearish engulfing formation, the first
candlestick must be white and the second candlestick
must be black. In the bullish engulfing formation, the
first candlestick must be black and the second candlestick
must be white. The two candlesticks in each formation
are always opposite colors.

Harami Formations

INVESTOR TIP

Harami formations are the opposite of


engulfing formations. With a harami
formation, you should be able to fit the
body of the second candlestick within
the body of the first candlestick.

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A harami formation is similar to


an engulfing formation and has
similar implications, but differs
in three ways. First, in a harami
formation the body of the first
candlestick must encompass the
body of the second candlestick
instead of the other way around.
Second, the colors of the two
candlesticks do not have to be
different from each other. Lastly,
Figure 2.27Harami
the second candlestick should be
much smaller than the first candlestick (see Figure 2.27).

Section 2: Basic Charting

Figure 2.28Harami on GE (1)

Like many other candlestick formations, the harami has a Western


bar chart equivalentknown as an inside day. Both haramis
and inside days can occur in positive or negative trends. Haramis
that occur in an uptrend indicate a bearish reversal signal, while
those that appear in a downtrend indicate bullish reversal signals.
When a harami formation occurs at the top of the trend, it tends
to be more valid than when it occurs at the bottom of a trend.
Remember, the greater the difference between the sizes of the two
candlesticks, the more valid the signal becomes. In fact, the ideal
harami would include an unusually large first candlestick and a
doji for the second candlestick.
As you can see in the General Electric (GE) chart shown in
Figure 2.28, the stock price formed a bearish harami formation
on 6/23 and 6/24. Note that both candlesticks are white. A
harami formation does not need to have candlesticks with
opposite colors.

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Figure 2.29Harami on GE (2)

As you can see on the General Electric (GE) chart shown in


Figure 2.29, the stock price formed a bullish harami formation
on 3/24 and 3/25.
Haramis are important technical signals, as they represent major
shifts in market sentiment. Here are three important things to
remember to ensure you are recognizing haramis at the right time:
Trend. Haramis occur during both uptrends and
downtrends.
Body size. The first candlesticks body must completely
engulf the body of the second candlestick.
Color. In haramis, the color of the candlesticks is not
important.

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Section 2: Basic Charting

Dark Cloud Covers and Piercing Lines

The final formations we will examine are also trend reversal


signals. A dark cloud cover is a bearish signal, while a piercing line
is a bullish signal. Although these signals are new concepts, they
are not dissimilar to the bearish and bullish engulfing formations
already discussed.
Dark Cloud Covers
The dark cloud cover formation is a bearish signal that includes
both a white and a black candlestick. Although the formation is
normally associated with trend tops, it can also be used to identify
the peaks of congestion zonesareas in which the stock trades in
a narrow range.
A dark cloud cover formation
is composed of a long white
candlestick followed by a black
candlestick that opens above the
white candlesticks closing price
and closes deep within the body of
the previous white candlestick (see
Figure 2.30).
To be considered a dark cloud cover
formation, the formation must meet
the following requirements:

Figure 2.30Dark Cloud Cover

The first candlestick must


be both longer than usual and
white

The second candlestick must be black and have an


opening price that is higher than the previous candlesticks
closing price
The black candlesticks closing price must be below
the halfway point of the body of the previous white
candlestick

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Figure 2.31Dark Cloud Cover on YHOO

As you can see on the Yahoo (YHOO) chart shown in Figure


2.31, the stock price formed a dark cloud cover formation on
1/12 and 1/13. Note the bearish haramis on 2/11 and 2/12 and
the hammer on 12/17.

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Piercing Lines
The piercing line formation is the
exact opposite of the dark cloud
cover formation. A piercing line is a
bullish reversal signal that occurs at
the bottom of a downtrend or the
valley of a congestion zone.
Piercing line formations consist of
a long black candlestick followed
by a white candlestick that opens
below the closing price of the black
candlestick and closes deep within
the body of the previous black
candlestick (see Figure 2.32).
Figure 2.32Piercing Line

To be considered a piercing line


formation, the formation must meet the following requirements:
The first candlestick must be both longer than usual and
black
The second candlestick must be white and have an
opening price that is lower than the previous candlesticks
closing price
The white candlesticks closing price must be above the
halfway point of the body of the previous black candlestick

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Figure 2.33Piercing Line on HD

As you can see on the Home Depot (HD) chart shown in Figure
2.33, the stock price formed a piercing line formation on 5/07
and 5/10. This formation was followed by a very profitable
uptrend.
Dark cloud cover and piercing line formations are important
technical signals, as they represent major shifts in market
sentiment. Here are three important things to remember to
ensure you are recognizing the right formation at the right time:
Trend. The dark cloud cover formation occurs during an
uptrend, while a piercing line formation occurs during a
downtrend. Both indicate a potential change in trend.
Body size. The second candlesticks body must
penetrate through more than half of the body of the first
candlestick in both formations.
Color. The first candlestick in the dark cloud cover
formation must be white and the second candlestick
must be black. The first candlestick in the piercing line
formation must be black and the second candlestick must
be white. The two candlesticks are always opposite colors.

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Section 2: Basic Charting

Candlestick analysis is an important component of modern


technical analysis. The formations we have discussed are the most
popular reversal formations in current practicethey are not
comprehensive of all candlestick formations available. They do,
however, represent a great way to get started with some common
and reliable formations.
Practice identifying market tops and bottoms on a stock of your
choice using candlesticks. Try to track the reliability of those
signals and compare your results with a buy-and-hold strategy
over the same time period. We will use candlesticks in each of the
following sections. Make sure you feel comfortable identifying
those formations we have discussed so far.

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