The meanings of the symbols

The upper and lower surfaces of the candle rectangle represent the opening and closing price of the stock on any particular day. If the rectangle is white, then the price rose from the lower (opening) value to the upper (closing) value. If the rectangle is black, then the price fell, and it is the upper surface of the candle that is the opening value. The highest point on the upper wick represents the peak price, the lowest point on the lower wick, the minimum price. In this way, the symbol encodes all four crucial pieces of information (opening, peak, low and closing price).

Each day on a candlestick chart is represented by a symbol resembling a small candle (hence the name): a vertical rectangle that can be black or white with a small vertical line sticking out of the top, the “shadow” (or “wick” to persist with the candlestick metaphor). Unlike real candles, there is another vertical line or wick sticking out of the base as well! The vertical axis on a candlestick chart represents share price, so the tops and bottoms of the rectangle and wicks represent price values.

The four elements represented on a Candlestick Chart

The stock starts each day at a particular price, called the opening value, and ends each day at a (possibly) different value, the closing value. During the day it may reach a peak price above the opening value or drop to a minimum price below the closing value, the high and low values respectively. These are the four elements represented by each candlestick on a candlestick chart.

What are Candlestick Charts?

Candlestick charts are a graphical way of expressing the movement of share prices from day to day. Each entry in the chart represents a single day but encodes information about the behaviour of the price on that day. They are sometimes known as Japanese Candlestick Charts because they are supposed to have been developed in Japan during the nineteenth century as a way of tracking rice prices.

Technical Analysis does have its critics – those economists who say it is nothing more than a pseudoscience, one that has no basis in fact. Investors such as Warren Buffett and Peter Lynch say that there is precious little evidence that Technical Analysis works. However, various academic studies have shown that technical analysis, particularly when carried out by neural networks, can produce statistically significant returns, and many investors have made fortunes through the application of its principles. It is therefore unfair to dismiss it as mere nonsense, and one ignores it at one’s peril!

Computer software lends itself readily to the processing of massive amounts of data, and they are ideal tools to use in Technical Analysis. There are two broad approaches to the automatic prediction of shares: those that use rule-based prediction (where the computer program is fed certain predetermined rules about how shares generally behave and when to buy or sell) and those that use neural networks (software based on networks of brain cells). Neural networks are trained by example on sets of data and which hone their prediction abilities as they accumulate experience.

One of the tenets of Technical Analysis is that prices follow trends, either upwards, downwards or sideways (when the price is generally holding steady – a “flat” price). If investors spot an upward trend in a share, they may well try to jump on the band-wagon and buy that share, hoping to benefit from its rise, and thereby driving its price up further. Similarly, a downward trend may cause investors to dump shares on the market, causing a further fall in the price. This can cause the price to “zig-zag” – rise and fall several times in line with investor confidence.

Technical analysis covers two areas of the stock market, its sentiment (sometimes termed its “psych”) and the analysis of supply and demand. The sentiment of the market is the general feeling of investors. This is rather intangible, but does show itself in overall share movements. For instance, if investors are feeling generally optimistic (as in a bull market), share prices will tend to rise. The supply and demand aspect of the stock market is a measure of how much money there is available to invest in shares: If an investor has little spare money, for example, this restricts his or her ability to invest in shares and drive the market higher.

Any stock market produces vast amounts of data on a daily basis, far too much for anyone to cope with in its raw form. You only have to look at the share price pages in the Financial Times to get some idea of the quantities of figures that make up just one day’s trading. To make any sense of this deluge, we must apply various statistical measures that turn the raw data into meaningful information. There are several measures in common use, and different technical analysts tend to prefer different measures. These measures all have one thing in common – they reduce the amount of noise present on the data and help to reveal any underlying pattern.

The Purpose of Technical Analysis

Inevitably, the ultimate aim of Technical Analysis is to make money. The secret of successful share trading, boiled down to one sentence, is to buy when the share price is low and to sell when it is high. As the share prices rise and fall, there will be times when one makes the correct judgement and makes a profit, and times when one gets it wrong and makes a loss. With successful technical analysis, the accumulated profits will outweigh the total losses.