Many traders think that the simplest approach to trading is just as effective as is a more elaborate one that requires rigorous analysis. These traders will use Open/High/Low/Close (OHLC) price bars and/or Japanese candlesticks to gauge market sentiment, determine whether or not a trend is present, or determine whether the market is quiet and best avoided.
In the case of the OHLC price bar, the idea behind using it as an indicator for support/resistance is very basic.
1. Bars that are small, that is the high of the bar and the low the bar are very close together, indicate either a quiet market, a trend in either direction losing momentum, or the market testing old levels of support and resistance or creating new levels.
2. The open of the bar is the most significant clue the market will reveal. If the bar cannot move off its open to any significant extent, the market has reached a point of equilibrium where neither the bulls nor the bears can seize control. If a bar extends to the upside above its open, remains there and closes well above the open, this is a bullish buy signal. The inverse applies in identifying a bearish sell signal. If the bar opens, moves up quickly, reverses and goes down below its open to a degree equivalent to the distance it achieved above its open, then closes exactly at the open, the market has more volatility and either the bulls or the bears are about to gain the upper hand.
3. A close well below the open toward the bottom third of the price bar is bearish. The high of the bar can be considered as resistance.
4. A close well above the open, in the upper third of the bar, is bullish. The low of the bar forms support.
5. Bars that are large to the upside indicate that the bulls are in charge, but look for an approaching resistance level before buying.
6. Big bars to the downside show that the bears are winning. Check other time frames for lurking support prior to selling.
The application of Japanese candlestick price bars is similar. Candlesticks just look different because the price zone between the open and close is a given width, referred to as the “real body” of the candle. The price area either above or below the real body looks like the wick of a candle and is called the “shadow.”
Most trading platforms permit the user to display a candlestick where the closing price is higher than the opening price with either a solid black body or some other color, usually green, indicating that that particular price candle was positive. Where the closing price is below the opening price, the real body will be hollow, or red, indicating a negative price candle.
The advantage to this is that it allows the trader to very rapidly access the condition of the market.
Japanese candlesticks were first used by Japanese rice traders in the 19th century.
Their use in the stock, bond, option, futures and forex markets is a relatively recent innovation. A man named Steve Nison is credited, or at least takes the credit, for introducing candlesticks as a technical analysis tool to the modern financial markets. He has authored books on the subject for anyone interested in developing a solid foundation in the interpretation and application of Japanese candlesticks.
Reading any of these books, or spending some time on a website devoted to candlesticks, will at the very least introduce you to some colorful jargon for the names of the differently shaped candles, such as “dogi,” “shooting star,” “hammer,” and “hanging man,” among others. This jargon may make you irresistible to members of the opposite sex if you can figure out a way to work it into the conversation at your next cocktail party or social function.
There are are some major caveats to using OHLC bars or candlesticks for short-term technical analysis.
First, you must have the discipline as a trader to limit the duration of your trades to the one bar or candle under consideration. This is really hard to do, especially in instances where bars are small and you’ve lost the patience required to avoid a sideways market.
Second, you can use any time frame you prefer, but if you are using a long time frame, you must be certain your trading equity is adequate to sustain the type of draw down you can experience if it should turn out that your trade was the absolute worst it could possibly have been. You also must be willing to exit a short trade if the high for the period you’re trading is exceeded, a signal that resistance has been broken; or, in the case of a long trade, a new low is made, indicating that support has failed.