Things You Didn’t Know About Candlestick Charts

Things You Didn’t Know About Candlestick Charts

February 9, 2019 0 By waxmurderer

If you are interested in trading, whether it be forex, stocks, even cryptocurrency, you might have seen a type of chart called candlestick. I’m excited that I finally have a chance to write about the candlestick charts. You might have already guessed where my name Wax Murderer came from. Yes, it came from candlestick charts. It is my bold statement that I will be conquering these charts and be successful as a trader. But first thing first, what are candlesticks anyway, and how is it different from other charts?

Visualising Data Over Time

In its essence, candlestick charts are to visualise data over a time period, so that we can see how it moves over time. Candlestick is not the only way to show data over time. The most famous and frequently used type of chart for this purpose is the line chart. We see it everywhere; newspaper articles, books, reports, etc. Line charts are drawn by plotting points on a grid, then connecting all the points with a line. Usually, the x-axis is for time and the y-axis is for quantitative value.

For example, if we google “Apple share price”, we will encounter the below line chart.

The above chart is showing how the price of Apple share has been moving within a day. We can see the last point is the data for 12:35. If you google it yourself and look at the chart, you will see the time interval is 5 mins. Each point is showing the price for a 5 minute time interval. But it’s not like the actual share price stays the same for 4 minutes 59.999… seconds and suddenly changes at every 5 minutes. Even within that 5 mins, there are price movements which are not displayed in the line chart.

In data visualisation, there is always a trade-off between simplicity and completeness. In the above line chart, by plotting just one point per 5 minutes, it makes it easier for viewers to digest the information, but at the same time, it loses the ability to give more granular information.

Tick Data

In the forex market, what is the most complete and granular data of a price? It is something called a tick. A tick is a minimum movement in the price. The movement in the price doesn’t come in regular interval. It might take 10 seconds from the last tick to the current tick sometimes, or when the market is very active, there might be more than 10 ticks within just 10 seconds. Also due to the characteristic of forex market which doesn’t have a centralised exchange, it may vary from broker to broker. Let’s take a look at a historical tick data from a broker.

The above data is a part of downloadable historical tick data provided by Pepperstone. I downloaded USD/JPY tick data for January 2016. It’s a zipped CSV file and if you try to open it with Excel, you will have to wait forever only to see the Excel freezes or crashes. Why? Because it has near 5 million rows. It is not a good idea to use Excel when your data has more than 1 million rows. I used a programming language Python, even with Python it took around 5 seconds to load the data (Trust me. 5 seconds in Python is considered quite long.)

Challenge of Visualising Tick Data

What we see in the above table is the first 9 rows of the data. In the first column, we see what currency pair it is. Time-wise, it is in millisecond (thousandth of a second) detail. And there are two different prices for Bid and Ask down to pipette detail. The bid price is selling price, and Ask price is buying price. The difference between these two prices is called spread. If you want to know what spread is or what pip or pipette is, take a look at my previous post, What is Forex, where I wrote about the very basic concepts of forex trading.

The reason why I’m showing the table is to show the irregular nature of tick data. For the first one second at 04/01/2016 00:00:00 there are only 2 rows of data, while for the next second at 04/01/2016 00:00:01 there are 6 rows of data. This irregular time intervals pose a difficult challenge when trying to visualise them. We have to make a decision somewhere on the simplicity-completeness spectrum. The Line chart that we saw above is normally created by plotting only the close prices and draw a line connecting them. It may give us an easy to digest overlook of the data, but it’s sacrificing a lot for simplicity’s sake.

The God of Trading: Homma Munehisa

Image courtesy of forum.hkgolden.com

In my opinion, the candlestick chart is a genius way of showing time series data with a good balance between simplicity and completeness. Before we take a look at how it is constructed and how to read them, let’s take a quick detour and understand its origin and history.

In Japan around the 18th century, there was a rice merchant called Homma Munehisa (本間宗久: can also be pronounced Homma Sokyu) later be called as “The God of Trading”. At the time, rice was like a second currency to Japan. Even though there was official currency Tokugawa coinage, use of this official coinage was still limited among aristocracy, elites and official governments. The majority of society still functioned based on a barter system, and rice was the most important of all. Taxes to feudal lords were paid in rice, samurais were also paid in rice.

The feudal lords in Edo Japan kept an extravagant lifestyle, and to support their lifestyles they need to not only sell rice they had but also sell rice from a future harvest. Coupons were used as a promise of rice delivery at a certain future time. This is thought to be the worlds’ first future market.

Homma Munehisa first saw an opportunity in rice trading when he visited Edo (now Tokyo) when he was 16. What he discovered was that even though the real value of rice doesn’t change that much over time, but there are granular price movements influenced by the sentiment of traders. He thought this difference between value and price can be used to make a prediction and an investment decision based on it. But when he tried to pursue his idea of trading, his father thought this was not the ideal way of a merchant, and didn’t allow Homma to follow his idea.

His father’s disapproval didn’t really discourage him though. After his father’s death, he started rice trading that he decided to pursue a long time ago. He started trading in his hometown Sakata’s rice market and later moved to Dojima market in Osaka. The profit he made through rice trading was equivalent to $10 billion in today’s dollars.

Candlestick chart was invented by this Homma Munehisa and helped him make fortunes in his lifetime. 

Candlestick Chart

Unlike line charts, candlesticks are telling us much more stories even with just one candlestick. There are two different types of candlesticks, one for bullish and the other for bearish. 

Image courtesy of Wikipedia

As we can see, there are four pieces of information that we can get from one candlestick; the price for open, close, the highest, and the lowest. Compared to line charts where only one piece of information is available for each given point, candlesticks give us a whole lot of information. Let’s see how the line chart is converted to a candlestick chart. Below is the line chart of average price of bid and ask for 5 minutes from 2016-01-04 00:00 to 2016-01-04 00:05. And I have drawn a candlestick to show how it is constructed.

The body of the candlestick represents open and close price, while the wigs of the candlestick represent high and low price. In the above chart, the close price is higher than the open price, so it is a bullish candlestick.

It is not still a complete picture of what happened during that 5 minutes, but at least it tells us about the movement of price within that time frame. Even if you already knew about how candlesticks are constructed, looking at candlesticks and being able to expand its story and imagine a chart that one candlestick might imply gives us a firm base when learning chart patterns. All those different chart patterns are not to be memorised blindly, but to be understood why a certain chart pattern means something.

Behind Candlesticks

Now we know a few things about candlestick charts, we know how it was invented, how it is constructed. Those are all useful knowledge but we still haven’t talked about the true essence of candlesticks. What is it in its true nature?

Movement of price is not some mechanical movements of a chart. Do you remember the price mechanism that you learned at school? What decides the price in the free market is after all interactions between buyers and sellers based on the law of supply and demand. Applying the same login to forex, when there are more people who want to buy than people who want to sell a certain currency pair, the price will rise, and vice versa. 

Think of it like this, in every currency pair in forex there are two teams, Buy team and Sell team. The Buy team of course buys and wants to see the price increases. On the other hand, the Sell team sells and hopes to see the price drops. Forex market is a constant battle between these two teams. What’s different from real wars or battles is that the team members are flexible. An investor can be in the Buy team for one moment, and can easily change to the Sell team the next moment.

Image courtesy of www.canstar.com

There are real people behind the candlesticks who might be excited, disappointed, happy, sad, laughing, crying at the movement of the price. What all chart patterns trying to predict is how people might react in certain situations. Also, the support line and resistance line are nothing but reference points for the two teams. When the price is dropping, there is a line that Buy team cannot afford to give away to the Sell team, and when the price is rising, Sell team also has a line in mind that they are not willing to give up. These lines become support and resistance, and they are fierce battlefields between the two teams.

Through this post, we have learned backgrounds of candlesticks and its true essence. For the next post, let’s take a look at the basics of technical analysis. Thank you for reading. If you have enjoyed the post, please do not hesitate to share. Sharing is caring 🙂