How candlestick analysis of stock prices works

Anatomy of a stock chart candlestick

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Candlestick charting is a kind of financial analysis used in what is known as technical analysis. Technical analysis of financial securities interprets charted or graphed price movements, patterns and trends of a financial product to help improve the results of financial activities such as stock trading. In candlestick analysis the candlestick chart or graph is the tool for  analysis, but the analysis of that chart is what provides financial utility. Moreover, as a form of technical analysis, candlestick charting reflects financial influences such as market psychology via product price patterns instead of the evaluating the product itself.

In the book 'Trading Applications of Japanese Candlestick Charting' by Gary Wagner and Bradley Matheny, the origins of candlestick charting are said to date back to the seventeenth century creation of an honorary samurai and futures trader named Sokyu Homma. According to Wagner and Matheny, Homma's candlestick patterns indicated commodity price direction when a series of three candlesticks in either an upward or downward pattern occur as 'gaps' in the opposite direction.

Patterns like those developed by Sokyu Homma are determined using candlestick charting through evaluation of key variables in a financial product's price including its opening price, highest price, lowest price and closing price. These price movements are represented as a pattern or series of chronological units such as a single day, with each unit graphed as a single rectangle or line known as a candlestick.

The appearance of candlesticks and wicks provide a lot of information about a financial product's price patterns for the period of time it is measuring. Essential aspects of the candlesticks are their color, length and the length of the 'wicks' or lines at the top and bottom of the candlestick's body. These candlesticks can vary in length and position on a candlestick chart depending on how the price of a particular price such as company price per share moves in a given time period. The top and bottom of the candlestick's body symbolize the opening and closing prices, and the top and bottom of the wicks represent the highest and lowest values reached during a trading period.

When a candlestick is black or red, a product's price has closed lower than its price when it opened at the beginning of trading. If the product's price closes higher than the opening price, the body of the candle is green or white. Long candlesticks and wicks represent a larger range of price movement than shorter candlesticks where the bottom wicks indicate the lowest price of the trading period and the top wick show the highest price. Sometimes no candlestick body is formed at all and this is called a 'doji'. Also per Wagner and Bradley, a Doji represents a trading period in which the opening price and closing price were very similar.

Once the appearance and location of a candlestick is understood, it is then interpreted for price evaluation and forecasting purposes. This is done by analyzing the form of the candles and their relationship to other candlesticks on the chart. For example, a series of black candlesticks each positioned lower than the next indicates a negative price trend such as a 'bearish hook reversal' and may mean confidence in a stock or commodity has been lost. Furthermore, if the majority of candlesticks on a chart are black with a visible downward trend, this can indicate a long term trend such as a market correction. A market correction is when a price moves lower to correct overly optimistic speculation regarding a specific product's value.

There are several candlestick chart patterns which a chartist is ideally familiar with. These patterns also have names such as 'spinning top', and 'marubozu' which help the chartist quickly interpret their meaning based on previous interpretations of the candlestick pattern. To illustrate, according to Minyanville Media Inc, an Emmy Award Winning business information provider, a 'spinning top' can serve as an indicator a price reversal is about to take place. Candlestick charting analysis, like most financial analysis in general is not definitive proof of where a financial product's price is heading. However, candlestick charts can serve as indicators of market indecisiveness, conviction and momentum; all of which in and of themselves influence the price of financial products.

How to pick lower risk stocks

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Picking lower risk stocks involves finding good returns on investment for low risk. Ideally low-risk stocks are as safe as a savings account insured by the Federal Deposit Insurance Corporation (FDIC). A good starting point in knowing how to pick conservative stocks is understanding how much stock to invest in, and for how long as even invested money in conservative stocks becomes risky if that investment may be needed in the short-term.

• Protect against risk

A 'conservative stock' that maintains or grows value during most parts of an economic cycle doesn’t necessarily mean it's conservative during a recession; this possibility makes the whole concept of conservative stock somewhat fallacious. That is to say, since market and economic conditions can change relatively quickly, unless one has picked conservative stocks able to withstand share price volatility, then the value of those shares can drop.

• Identify low-risk

If there is such a thing as a conservative stock, one’s chances of picking the right one might be somewhere between finding the holy grail and spotting a $1 bill in a parking lot. In other words, be prepared to do some research. An important step in performing due diligence on investments is defining low-risk. This could mean a number of things; high dividend, low beta, and consistent profit margin are what some might look for. Moreover, according to Investopedia, low beta measures the risk of volatility a stock's price experiences relative to movements in the broader market. 

• Forecast future risk

Just because a company is low risk in the present doesn’t mean it will be a conservative stock in the future. It is not impossible for a large, stable blue chip stock to take a turn for the worse. To illustrate how a blue chip stock can decline, according to Yahoo Finance.com, Merck & Co,. Inc. (MRK), the large pharmaceutical firm, dropped from an all time high over $80.00 per share in the early 2000’s, to the low $30s in 2011. A part of the risk for Merck might of included expiration of drug patents and not enough high demand patent protected drugs to grow revenue.

• Assess capital gains

To pick a conservative stock, the value of the company’s shares, or total investment in the stock, should also rise over time. The conditions for long-term capital gains are quite diverse and vary by industry, economy, and market conditions. An investor can increase the  chance of capital gains by locating a well managed company with strong financial statements. Companies that have a high percentage of market share and consistent product or service demand  have a potentially increased chance of consistent capital gains.

• Evaluate capital structure

The capital asset management of a business is also an indicator of how 'conservative' a stock is. This is because use of capital in part indicates how a company plans to grow, maintain revenue stream, and improve profit margin. Companies that invest in projects with high internal rates of return, and operate with low costs and efficient  cash conversion cycles are examples of potentially good capital structure.

Summary

Selecting conservative stocks is not really a fool proof endeavor as stocks themselves do not provide guaranteed returns nor are they insured financial instruments. For this reason, picking conservative stocks is more akin to choosing lower risk stocks. Lower risk stocks sometimes share a few characteristics, some of which include profitability under adverse conditions, strong and proven business models, and legacies of success that help ensure at least medium-term investment stability.

Predicting the Stock Market's Direction In 2012

Predicting the stock market's direction is no easy task, even for the best money managers on the planet. Peter Lynch recommends picking good companies and not trying to predict market direction. That does not mean it is not done, and Ken Fisher's Stock Market Advantage demonstrates why with reports on multiple investment group forecasts. 

Some of the results are surprising. For example the Bespoke Investment Group forecasts a 100 percent rise in the Standard & Poor's 500 Index in 2012. It is a surprise given dire economic news coming out of Europe, a slowing China, out of control U.S. national debt,  and a recent World Bank drop in global GDP expectation. These are evidently not of immediate concern to the S&P Index.

Jeremy Grantham echoes a more realistic sentiment in the GMO, LLC 12/2011 quarterly letter.  In it he recommends bias to 'safety' and investment in high-quality U.S. stocks with normal 'weighting' in global equities. In other words, pick strong companies that have investments outside the United States. Grantham also advises against long-term bonds, presumably U.S. Treasuries with low yields and recommends long-term accumulation of ground resources such as potash, and phosphorous which according to the Grantham Foundation for the Protection of the Environment will be scarce within 5-10 decades.

So far in 2012, U.S. markets have rallied considerably in a short-period of time. The San Francisco Chronicle quoting Bloomberg news reported today that the S&P 500 has already rallied 4 percent. That leaves 4.436 percent for the rest of the year after adjusting for inflation per Money Chimp if it's an average year. Grantham attributes this type of market movement to a combination of 'scarily' high-profit margins, low inflation and asset bubbles nursed by Federal Reserve monetary policy, but does not see it lasting indefinitely.  Moreover, Grantham sees a potential overreaction of the S&P 500 Index to as low as 800 points; a reflection of 1970's era market conditions hence, 'no market for young men'.