How Candlestick Double Tops in May Predicted a Major Decline in the Dow

Hundreds of years ago, a rice trader in Japan developed a system of recording the ups and downs of daily prices as rice was bought and sold in the wholesale market – a system which recorded in picture form the underlying psychological inputs which impelled traders to buy and to sell at any particular time. This was a significant improvement over a simple “line” recordation of prices, which showed only the opening price, the closing price, and the high and low of the day. What he did was to “fatten out” the line into a cylinder which left the indications of the high and low extremes in place, but which marked the opening and closing prices within the cylinder rather than simply as points on a vertical line. If the closing price of the day was higher than the opening price, he left the cylinder vacant, or “white.” If the closing price of the day was lower than the opening price, he filled in the cylinder, or made it “black.” This presentation made it easy to see at a glance the thrust and mood of the traders during that time period. It is said that he became very wealthy by following his new recording system.

This method of display came to be known as “Japanese Candlesticks.” The fattened-out bars can indeed look like candles, with “wicks” (sometimes called “shadows”) extending from the tops and bottoms of the white or black cylinders to the upper and lower ranges of prices. Candlestick charting was introduced to the United States 25 or so years ago, and is now gaining new acceptance every day. In time, it may well become the standard form of price presentation.

One of the great advantages of Candlestick display is that it does not attempt to usurp or to override any of the “Western” indicators to which we have become accustomed. Rather, it works in great harmony with them; and, if anything, it tends to enhance their value.

More and more, Candlestick technical analysis has come to be the foundation of many an investment newsletter, trading chat room, and educational forum, the subject of which is the pattern and formation development which is characteristic of this method of price display.

The Candlesticks are sometimes uncanny in their ability to foretell major reversals of trend. A fine example is found in the price action of the Dow Industrials Index during May 2008. The Weekly charts of the Dow for the weeks of May 2 and May 8 showed a clear “double top” (in “Western” terms) together with two strong “Bearish Engulfing” patterns in a row. Closer investigation by use of the Daily charts reveals a second double top, which was formed by the price bars of May 2 and May 19, together with (again) strong Bearish Engulfing patterns formed by the next day’s trading. These two sets of signals, together, were powerful predictors of a meaningful price decline to follow. In fact, the prediction was amply fulfilled, as prices fell from a high of about 13,125 on May 19 to a low of about 10,823 on July 15 – a drop of 17.5%.

This is an excellent example of mutual reinforcement of the signals which are given off by “Western” indicators and by Japanese Candlesticks. When used together, they can be a powerful tool in every investor’s and trader’s approach to the markets.