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Candlestick Chart Analysis as a Confirmation Tool

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They vastly aid in improving your timing, and help you get a jump on price changes.

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Candlesticks -- once a mysterious Eastern technique -- have become mainstream technical tools, indispensable in today's rapid and complex market. But these aren't just different expressions of price movement; specific candlestick formations serve as valuable confirmation tools for more traditional Western technical indicators.

For example, one well-known pattern used by technicians is the trendline. This is a straight line tracing rising support in an uptrend, or falling resistance in a downtrend. Technicians have observed that the trend begins to end once the trendline stops, meaning price moves below the rising support line or above the falling resistance line. This signals impending reversal.

Once prices fall below the rising support, or rise above the falling resistance level, the current trendline ends. This is a sign that the current short-trend is ending or at least pausing. As easy as this is to spot, though, it's always desirable to have a secondary confirmation of the apparent reversal. This is where some basic candlestick formation come in handy.

For example, check the chart for Caterpillar (CAT) for the three months ending March 18, 2010. The two lines drawn on the chart are trendlines, the first tracing a rising support and the second on a reversal, tracking the falling resistance.


(Chart courtesy of StockCharts.com)

Using just the trendlines as a basic technical tool, you can identify many easily spotted trends. However, to confirm these trends, candlestick formations provide very valuable additional tools. At the very top of the uptrend, you discover a prominent long white candle (white always shows up when prices move up for the day), followed by a smaller black candle (indicating a downward movement). The rectangle of the second day (called the "real body" resides completely within the real body of the previous day. This two-stick pattern is called harami, which is a Japanese word meaning "pregnant."

The white and then black harami is a bearish harami that not only predicts a reversal but also confirms the end of the rising trendline. The same confirmation occurs at the bottom of the downtrend. Note the downward gap and then the small white body candle with the long lower shadow (the line extending below the real body). This is the extent of trading for the day and shows a failed attempt by sellers to move price further downward. This formation is called a hammer and it predicts a bullish reversal. It also confirms the end of the second trendline.

Candlesticks come in many shapes and sizes. By themselves, they don't offer an alternative system for technical analysis; but they do work as excellent confirmation tools for what you discover in traditional Western price patterns. Used together, the Western and Eastern patterns and signs vastly improve technical analysis, helping you to spot reversal early. Nothing gives you a 100% system, but using candlesticks for confirmation improves your timing and helps you get a jump on price changes.
No positions in stocks mentioned.

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