Clarifying Candles

From the Market Misbehavior mailbag:

“Dave, how do you think about candles?  Specifically, weekly and monthly vs. daily candles?  What if the signals conflict?”

That’s a great question and the short answer is I pay attention to weekly and daily candles because I feel they are good representation of investor behavior during a well-defined period of time.

The somewhat longer answer is as follows.

For those of you that are not familiar, candlestick analysis is a traditional Japanese form of charting that illustrates the open-high-low-close of each period using a “stem” and “real body.”  The stem indicates the high/low range, just like in a traditional bar chart.  The real body indicates the open and close for each session, with open candles indicating a close above the open and closed candles showing the close below the open.

A candle chart of Facebook, where each candle represents the open-high-low-close for one trading day

In my years as a technical analyst, I have seen FX traders looking at one-minute candle patterns on cross rates.  I have seen swing traders focusing on daily and hourly candles to identify short-term price swings in equities.  I have talked with long-term investors that swear by weekly and monthly candles as a gauge of long-term sentiment. 

I have even seen an analyst use yearly candles to identify key support and resistance levels over the course of decades.

Some inventive traders have even experimented with non-traditional settings such as a 65-minute candle (so each trading day has seven evenly-spaced candles) or a 13-minute candle (inspired by the Fibonacci sequence).

I think of charts and technical analysis as a way to illustrate and quantify investor behavior.  I only use techniques that I feel are a) consistently effective, b) justifiable using the concepts of behavioral finance, and c) relatively easy to explain to others.

From my perspective, candle patterns fulfill all three requirements.  They are designed to tell you about the next couple price bars, and they do pretty well at identifying short-term price swings.  They are a pure illustration of short-term investor dynamics and are often some of the best ways to illustrate concepts like herding and overconfidence.  Finally, they are easy to understand as they are just a different way to represent historical prices.

So which time frames are most effective for candle patterns?

I would argue that candles are best on clearly defined time frames.  A daily candle shows you the opening trade of the day, the closing trade of the day, then all the volatility that happened between those two points.  The open and close of each day have meaning, and there is a period of rest between each observation.

Weekly candles are similar in that you’re taking the first trade of Monday morning and last trade of Friday evening (given no holidays) and then viewing the extremes of price action between those two points.

I’m less excited about intraday candles because they don’t deal with clearly-delineated time frames.  For example, a 5-minute candle means 10:00-10:05 is one period, then 10:05-10:10 is the next, and so on.  But 10:05am isn’t really a special time.  There was no “break in the action” to reset expectations or digest overnight news.  It’s just another minute within a trading day.

So while I do think intraday charts are helpful in  understanding how trading evolves during the day, I don’t see intraday candles as adding much incremental value vs. traditional bar charts.

The same could be said for monthly/quarterly/yearly candles.  While yes, quarters and years are indeed meaningful time frames to consider, I would argue that the quarter often ends in the middle of the trading week.   I would much rather look at the weekly candles around quarter end to understand the short-term dynamics at play.

A yearly candle does indeed capture all the trading in one year, which is a meaningful period of time.  But I wouldn’t bet on the next 2-3 years using a price chart based purely on a candle representing an entire year.  I would much rather use other inputs to make an evaluation on that sort of time frame.

A bullish engulfing pattern at price support? I’m listening…

So what if the candle signals conflict?

I would say this goes back to the value of considering charts using different time frames.

If I’m looking out for the next couple days to weeks, I’m using a one-year daily chart.

If I’m interested in the next couple months to a year, I’m using a five-year weekly chart.

If I want to see how the short-term tactical view fits into the long-term structural view, then I’m using both the daily and weekly charts together.

So it’s completely possible to have a bullish weekly candle then a bearish daily candle.  This would simply suggest that the next couple weeks are leaning positive (because of the weekly candle) but the next couple days will likely pull back a bit (due to the bearish daily candle).

It’s also worth noting that one of the biggest benefits of candle charts is that they fit in beautifully with traditional technical analysis tools.  Whenever I see a bullish engulfing pattern or hammer candle at the 200-day moving average, I pay special attention.

Candle guru Steve Nison once told me that the context of the candle is what’s most important.  So a candle on its own has limited value.  A candle pattern within the context of the overall trend?  That’s where the real value lies.


Disclaimer: This blog is for educational purposes only and should not be construed as financial advice. Please see the Disclaimer page for full details.