The 300-Year-Old Tool That Runs Modern Day Trading

The water streaming over Niagara Falls every second is nothing compared to the stock market, which is awash in more information every moment than a person could digest in a lifetime.

A lot of that information is what the stock market just did: “The Dow had its worst showing in nearly five months”, “GM misses analysts’ earnings estimates”…and so on. Then there’s no end to guessing what the market will do: “China’s throttling of magnet supply likely to depress industrial sector….”

Meanwhile, here’s the plain truth: The place where day trading money is made, and lost, is not in reports about the past, or in the talking heads’ predictions — it’s in knowing what’s happening right now, this very moment. The rubber meets the road where buyers meet sellers. And the way day traders keep their fingers on the pulse of what’s happening right this moment is through the lowly candlestick chart.

I say “lowly” because the multi-trillion-dollar world of high finance is comfortable using a method developed by a rice trader in Japan 300 years ago. Candlestick charts are alive and well centuries later because they compactly deliver five crucial bits of information.

Look at any of the green and red candles above. Each candle represents an interval of time. Though a longer-term investor may have each candle represent one day, it’s typical for day traders to focus primarily on one-minute intervals (though we’ll have screens open for other intervals as short as ten seconds). For the one-minute chart, a new candle is displayed every minute that the market is open.

The fat part of the candle shows where the stock opened and closed. The next two pieces of information are the skinny wicks that many (but not all) candles have; those indicate the high and low for that interval. The fifth bit of information is the color of the candle. If it’s red, that means the price opened at the top of the fat portion of the candle and closed at the bottom of it.

It’s easy to have information overload the first time you watch these candles being formed on a stock you’re following. Wait, so the long, skinny wick at the top means the price went way up during that minute? But then it closed about where it opened because there’s no fat part of the candle? Huh? And every minute (or 30 seconds or even 10 seconds) I’m supposed to make sense of the latest one?

Yup, that’s your amazing brain at work. The first time you got behind the wheel of a car, it was crazy information overload, but now it’s automatic. I think of candlesticks like letters of the alphabet. There are a variety of shapes you will encounter. Once you learn the letters, you can focus on how they come together to make words. With enough exposure and experience, those words combine to say things like: “Buy now” or “Get out!”

Candlesticks are also similar to chess in the sense that the rules are relatively easy to learn, but real mastery takes a while. When you’re a day trader, you do not have the luxury of sitting back to nurse your latté for an hour, contemplating whether it’s an appropriate time to take a position in a stock. You have a few minutes at most, and often a few seconds.

Here’s where the fun begins:

• When you see a sequence of fat green candles, but each one is a little shorter than the last, it may indicate that buyers are still there, but thinning out.
• Maybe you see a few candles with only the thin wicks, and almost no fat part of the candle. It’s called a “Doji” candle, and it indicates a battle going on: The opening and closing prices for that interval didn’t move much, but there were strong upward and downward swings in that period. This often means that sentiment is changing.

Sometimes the candle shapes unambiguously shout their meaning, but often they suggest something. It’s up to you to test that message by looking at the context. You do that in three ways:

1. You look at more of the price action leading up to this moment. If you’re focused on the one-minute chart, then the last 20 or so minutes may yield clues;

2. You consider certain technical indicators. Day traders can choose from dozens of averages and ratios, most of which I’ve found to be inconclusive or downright distracting. Some, like relative volume, are critical. For example, if you see green candles on lots of volume, and red candles on weak volume, that may help to support the case for buying.

3. You use your experience. The pattern recognition that your brain’s so good at will only get more finely tuned with practice.

There’s also what you could consider a window into the immediate future — it’s called “Level 2.” It doesn’t just display the “bid” and “ask” prices that everyone’s familiar with; it shows the depth of interest of buyers and sellers by listing the open orders waiting to be executed, with different prices and share sizes. It’s not a perfect system, but I find it invaluable; it’s like going from a grainy snapshot of prices to a 3D view of the marketplace at this very moment.

Though all the day traders I know use candlestick charts, they can be used for any asset: Forex, crypto, futures — you name it.

It’s impossible to overstate the importance of candlesticks to day trading. They’re not a crystal ball, but they are a window into what a stock is doing, and what other traders around the world are thinking about that stock. When you combine candlesticks with technical indicators and a healthy dose of practice and experience, you have a solid foundation for taking that next trade.

The water streaming over Niagara Falls every second is nothing compared to the stock market, which is awash in more information every moment than a person could digest in a lifetime.

A lot of that information is what the stock market just did: “The Dow had its worst showing in nearly five months”, “GM misses analysts’ earnings estimates”…and so on. Then there’s no end to guessing what the market will do: “China’s throttling of magnet supply likely to depress industrial sector….”