The History & Truth Behind Japanese Candlestick Patterns by Mark Deaton

 

Japanese candlestick patterns, as the name indicates, were invented in Japan. They were developed for use as a form of technical analysis to increase profits in rice trading. This investment tool is known to have been widely used as far back as the 17th century; there are a few references that suggest it may have been in existence in some form before 1600. Legend has it that the creator of this type of chart lived some 500 years ago and used his system to become extremely wealthy.

The first detailed documentation of candlestick patterns can be traced back to an 18th century Japanese businessman from Sakata named Munehisa Homma. He used the system routinely to analyze the trading of rice contracts. Homma made huge contributions to the refinement of candlestick charting. His depiction of what was happening in the market brought some order and insight into a process that was normally extremely chaotic.

Japan's Trading Genius

Homma used his candlestick chart system to profit successfully from dozens of consecutive trades (some sources say over 100 in a row). In the process, he is rumored to have gained the equivalent of about $100 billion in today's dollars. This would make Homma the most successful businessman and trader in world history.

Obviously, Homma did a lot more than just trade along with the crowd. He found a way to accurately observe the behavior of the masses and manipulate them to his advantage. He tracked the opening and closing price along with the high and low of the day and placed them on a chart. This graphic representation was a series of columns that looked like candlesticks, hence the name.

In his descriptions, Homma compared the battle between buyers and sellers with wars waged on ancient Japanese battlefields. Many of his names for specific patterns come from military concepts. In the English speaking world, these are translated into pattern names like the Three Soldiers and the Belt Hold Line. Other patterns (such as the Doji and the Harami) retain their Japanese labels to this day. Homma's advances made candlestick charting look similar in many respects to the charts we use today. However, subsequent development has made it an even more accurate tool for modern traders.

Candlestick Charting in the Modern World

Despite being hugely successful in Japan, candlestick charts were not widely used in the West until about twenty five years ago. Today they are used as price prediction tools (and often simply for their graphic, eye pleasing appeal) all over the globe.

In 1989, Steve Nison published an article in Futures magazine concerning Japanese candlestick pattern analysis. This exposure did much to encourage adoption of the system in the U.S. Nison is still considered one of the foremost experts on the use of these charts for market analysis. Here's some recommended reading from among his works:

1. Strategies for Profiting with Japanese Candlestick Charts

2. Beyond Candlesticks: New Japanese Charting techniques Revealed

These books, along with Nison's continued trading success, have helped make candlestick pattern charts an integral part of western market analysis in recent years. This assimilation process has accelerated since 2000 with the prevalence of web based trading.

Candlestick Charts in the 21st Century

Candlestick pattern use has actually evolved rapidly since the advent of the internet. This process of dynamic innovation is driven by widespread information access and the blending of candlestick charts with other forms of analysis. One of the most interesting changes has been the fairly recent addition of colors. These color indicators can help you identify critical points or days on the chart that might indicate a future change in trend. In contrast, traditional Japanese candlestick patterns use only black and white to represent the trading ranges.

In some charts, the white candles (positive days) have now been replaced with candles that are hollow and contain no color. Red is often used for negative days and these candles are usually filled solid. You might also see a hollow red candle (red as just an outline). This indicates a complex situation such as a day when all of the following circumstances applied:

· The opening was lower than the previous day's close
· Trading was bullish despite this, however
· It didn't end trading above the previous day's close

A black filled candle would be a day of decision where there was a "gap" in trading in the other direction. For example, the day opened higher than the previous day's close and the current close was higher than the previous close. This modification introduces the concept of gap trading into candlestick charts. The idea is that all gaps in trading tend to be filled over time.

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