The Joy of Looking: Unearthing New Japanese Candlestick Reversal Patterns

Everybody’s different, but everybody enjoys the satisfaction of finding something of perceived value while on a treasure hunt; or of landing that “big one;” or of “rejoicing upon finding the drachma that was lost.” 

We think also of the medical technician, skilled in chemistry and in medicine, who labors year after year in a quest for a drug which will cure or prevent cancer or the onset of heart disease or polio or blindness, who at last succeeds in finding the miracle medicine which turns out to be successful worldwide.  How fulfilling it must be, not merely the hope or realization of material reward, but also that all of his or her hard work resulted in a substantial payoff for humanity.

It’s all about achievement.

We can think, too, of the professional athlete who trains day after day, six or seven days a week, taking care of his body while listening to the good counsel of skilled professionals as well as to the rhythms of his own nature.  Names come readily to mind: Roger Federer; Lance Armstrong; Al Oerter, four-time Olympic Gold Medalist in Discus Throw; Tiger Woods; Oscar Pistorius, who runs competitively on prosthetic legs and feet; Tim Tebow, the Gators quarterback and Heisman Trophy winner; Usain Bolt, who keeps on breaking his own records here in August 2009.  You could think of dozens of others.

All of them are fine examples of winning in the physical world in which we live.  That world is governed by natural laws and constraints which apply universally.  They never change.  We are amazed if we will just stop for a moment to think of the majesty of the spiral, which is the most dynamic form in the natural world.  The spiral design of the tiniest sea creature’s shell – an eighth the size of your smallest fingernail – is identical to the spiral design of the sunflower seed pod, the pine cone, the tail of the sea horse, the whirlpool, the hurricane, and the spiral galaxy.  The mathematics are identical; it’s only a question of degree.  The same rules apply everywhere, all the time.

However, we live in another world too, a world which we cannot see – the world of human emotion, which is not reducible to numbers.  It cannot be quantified.  The comfortable predictability of the physical world does not apply in this instance.  The rules of the two worlds are different; they parallel each other; but the lines never cross.

There comes to mind the memory of Long Term Capital Management, a hedge fund of ten years or so ago, which specialized in extracting profit from the expected convergence or divergence of the value of Russian sovereign bonds compared to the value of other financial instruments.  Two of the firm’s backers were Nobel prize-winning economists who had developed a mathematical (i.e., physical) algorithm for the pricing of options on financial instruments.  It worked like a charm for a while.  The company became so successful in its trading with the Nobelists’ system that it made larger and larger bets, into the millions and then into the billions of dollars, spreading the risks around Wall Street so that no one outside the company could know the extent of the gamble.  Difficulty arose when a human event intervened upon the process – one which the algorithm did not account for – namely, the human decision on the part of leaders in Moscow to “take the necessary medicine” and default on Russian bonds.  The result was that, instead of the expected narrowing of the spread, it widened and widened to the point at which the company was on the verge of collapse; and its trades were so large and so spidery that the impending default of the company nearly brought down the entire financial system of the country and, arguably, of the world.  It was only through the active (but quiet) intervention and arm-twisting of the New York Federal Reserve Bank that widespread disaster was averted.  Author Roger Lowenstein has captured the entire sequence in his great little book entitled “When Genius Failed.”

The moral of the story is that the world of finance is a world of human emotion in which the rules of the physical world do not apply.

In that world of human emotion, the best measuring-stick ever devised is the stock market.  There, it all comes together in the mass emotions of the herd.  Investors and traders, as a group, are truly members of a herd; the term should not be used or considered loosely, because it does apply factually.  We all know that investors will often jump on a particular stock because it’s “hot;” and it’s “hot” because members of the herd have a natural instinct to run with the crowd.  When the price of a stock goes up, its desirability goes up; contrarywise, when the price of a steak goes up, its desirability goes down.  This is one more proof that the physical world and the world of finance operate under different rules.

It is possible to track human emotion as it operates in the stock market, and reasonably to predict its outcome based upon past evidence.  Human emotion leaves clues in its wake.  Those clues are to be found in the record of price action in the stock market, in the many individual stocks and, more generally, in the major Indexes such as the Dow Industrials, the S&P 500 and 100, the NASDAQ 100 and Composite, and in the Russell 2000.

The style of those clues was devised hundreds of years ago in the Japanese rice trade.  One trader, in particular, discovered that if he were to keep a written record of prices on a given trading day, characterized by a vertical line (drawn against a price scale) which showed the total price range of the day with the line (or “candle”) “ballooned out” between the opening and closing prices and the balloon filled in or blackened if the closing price were lower than the opening price, he would get a sense of the mood, or psychology, of the traders and could plan better for the next day.  He also discovered that not only did one day’s price bar possess predictive capacity, but also that a pattern of several days in a row gave him the ability to see reversals of trend in the making.  It was such a simple system, and yet so revealing.

Today, not surprisingly, we know that trader’s system as “Japanese Candlesticks.”  It was brought to this country 20 or 25 years ago, and over time has gained increasing acceptance because of its ability, when properly interpreted, to predict reversals of trend.

Obviously, if the “balloon” portion of the Candlestick price bar is not filled in, i.e., left “white,” traders as a group were positive on the day; and if the balloon is filled in, or left “black,” the mood was negative.  The exercise really comes to life in the present day in real-time price presentation on the computer, where changes in traders’ mood can be observed as they are happening.

Much valuable information can be gleaned from observing the color of an individual Candlestick (whether black or white), by the size of it, by the degree of spread between the price on opening and the price on closing, by the size of the difference between opening and closing (which is known as the “real body” of the candle, by the location of the real body within the total range of the day’s trading, and by its relationship to the candles which preceded it.

Even the price bar which is represented by a lone Candlestick can contain valuable information.  For example, if at the top of a long-standing trend there appears a large black candle which menacingly overshadows a white candle which immediately precedes it, that is known as a “Dark Cloud Cover” and is considered to be a bearish omen and a predictor of a possible reversal of trend to the downside.  Some reversal patterns consist of single bars; some of them consist of two, or three, or even four bars.

Therein lies the greatest advantage of the Candlesticks: they can give advance warning of the development of a reversal.  An adept trader may not wait for completion of a multi-bar reversal pattern; he may elect to take a modest risk by seizing upon the early warning and enter a trade.  Many traders like to establish a trade early in a possible trend reversal, on the theory that an entry early in the game offers the best possibility of making a profit.

The Candlesticks come into full flower as predictors of trend reversal when a particular multi-bar pattern forms.  For example, there is the “Morning Star,” a bullish pattern, which consists of three Candlesticks in a row:  first there will be a tall black bar; next a bar (which is called the “Star”) which will have a small real body near the bottom of the tall black bar; and then a tall white bar.  What is the significance of all of this?  First, the tall black bar was evidence that traders were in a negative mood that day, driving prices down; then there was something of a “panic stop” when traders decided to halt in order to survey the landscape before committing very much one way or the other; and finally, the tall white bar showed that the underlying psychology of the traders had changed dramatically to the upside by their vigorous buying.  Frequently, the Morning Star will be followed by a powerful and long rise in prices.

The Candlestick reversal patterns operate the same in all time frames, from one minute to ten minutes to daily to weekly to annually.  Many of them which appear at the top or at the bottom of established trends have mirror images of themselves at the other end of a trend.  As one might expect, the mirror image of the Morning Star is the Evening Star.

The basic Candlestick reversal patterns were given names a long time ago.  Some of their names recall physical features which we see in nature, such as the “Shooting Star,” which surely looks to the eye very much like a real shooting star.  Almost nothing has been written about variations on the patterns to which we have become accustomed, other than the fact that there are such things.  Until lately, little has been said about the possibility that there is more to it than just the standard patterns.

While other folks have a great time searching for buried treasure, or hunting, or fishing, I find that the joy of looking for variations on the well-known Candlestick patterns is very satisfying.  It is quite a positive experience to discover a variation, to follow it along, to discover whether it possesses some of the same characteristics as its parent, and – if it does – to giving it a name of its own.  It’s the pleasure of discovering something new or different.

Here are some great examples.  On March 6, 2009, I noticed one particular Candlestick bar at the bottom of a long downtrend.  It was the first indication of a possible price reversal.  Sure enough, a weekend and a day later a complete pattern emerged in the Dow Industrials Index which looked for all the world like the bullish “Morning Star,” except that it didn’t have just one “Star” between the tall black candle and the tall white candle – it had two.  I wondered whether it might have the same bullish characteristics as the “standard” Morning Star.  The result was clearly positive: prices rose dramatically over the next several days, and eventually became a the Great Rally of 2009, which will be long remembered.  The necessary conclusion was that, indeed, this was a powerful reversal pattern, a variation on the Morning Star to be sure, but that it deserved recognition as a separate pattern in its own right, and its own name.  I named it the “Tokyo Express.”

It eventually petered out, and the trend reversed to the downside; but  believing that the rally was not yet complete, I continued to watch for another upside reversal pattern.  It came in July, at the tail end of an intermediate downtrend.  Once again, I spotted what appeared to be a variation on the Morning Star, except this time it contained three Stars situated between the tall black candlestick and the tall white candlestick.  It was so finely formed that I felt that it had the potential to be strongly bullish.  Prices rocketed up in a repeat performance of the March experience, and prices were driven to a new high point in August (which, as this is being written, is proving to be a remarkably strong day in the market).

The pattern had obviously proven itself.  Once again, I concluded that it was so obviously a valid bullish predictor that it is deserving of recognition, not just as a variation of the Morning Star but as a legitimate Candlestick bullish reversal pattern.  One could consider it to be either a variation on the basic Morning Star or as a variation on the “Tokyo Express.”  Either way will suffice; “fielder’s choice.”  I chose to give it a name all its own: the “Kobe Cruiser.”

The “joy of looking” has produced two winners in a row.  This has been an immensely gratifying experience.  I hope and intend that it not be the last of its kind.  I’m delighted that I was able to spot these two hitherto unheralded Candlestick reversal patterns soon enough to understand their possible significance, and that, hopefully, the body of existing knowledge about the subject has been expanded.  As their discoverer and namer, I assert that the “Tokyo Express” and the “Kobe Cruiser” deserve to be recognized as true bullish Japanese Candlestick reversal patterns in their own right.

William Kurtz

August 21, 2009