Candlestick charts have been around since the 1700s in Japan. They were found to provide a unique way of viewing supply and demand of the rice market. One of the most popular books on candlesticks is, Japanese Candlestick Charting Techniques A Contemporary Guide to the Ancient Investment Techniques of the Far East by Steve Nison.
A candlestick is made up of a “body” marked by the open and close values and wicks which note the high and low of the time period being charted. While I don’t use analysis on candlesticks on a daily basis, they are still something I pay attention to, notably certain patterns. My good friend, Adam Koos, CMT observed several weeks ago the bearish engulfing pattern on the weekly chart for the NASDAQ 100. I’ve written several times about the development of this bearish pattern in my weekly letter, Thrasher Analytics showing what type of price action historically follows this type of pattern.
Below I’m going to show one method I use when evaluating candlestick charts or really any type of analysis thats based on a recent observation within the market.
First, let’s take a look at the engulfing candle. It looks just like it sounds. The first candle is on an up day and followed by a candle exceeds the highs and lows (engulfing it) of the prior candle. Some traders also view candles that at least have the second candle engulf the body (open and close) of the prior candle. Below is the weekly chart of the NASDAQ 100 and you can see the two candles that make up the pattern in the circle.
How often do these patterns occur? They are actually pretty common. Below is the same chart as above going back to 2004 showing each bearish engulfing pattern with a red box. This alone doesn’t tell us a whole lot, at first glance it appears a little random, some occurring near highs and others near lows.
The next step is to observe the current bearish pattern occurred at a 52-week high in the NASDAQ 100. Do engulfing patterns at highs happen all the time? That’s what the next chart shows. This time we’re going back to 1985 to show that this unique pattern doesn’t happen all too often at 52-week highs, but it does in fact mark some significant turning points in market history.
The last step is looking for commonality in these patterns. What type of price action that led to downturns in the market commonly followed these engulfing patterns at 52-week highs? Is there anything that separates the reversals from the continuation price trends? I found that when the NASDAQ 100 undercut the engulfing candle’s low on a closing basis the next week, a potential sign of confirmation could be observed as sellers continued to hold control of the trend.
Since 1985, there’s only been two other times: 1991 and 2018. Both periods saw a notable move lower in the equity index. While many other of the engulfing pattern occurrences saw the low undercut a few weeks after it occurred, when it happened the very next week it was clearly the strongest evidence that the market dynamic had changed and sellers were working on holding control. This is what I wrote to Thrasher Analytics subscribers, highlighting the pattern and what type of price action could follow. That’s what we in fact saw play out today, the low of the engulfing pattern was taken out on a closing basis the next week and we then saw our third sample of what now can be observed as an extremely unique market study.
This process of narrowing down market history and looking for commonality can be an extremely useful exercise of analysis and one I do every week with different market developments. Not always will an insightful result be found or will the market continue to follow its past pattern, but I believe understanding market history through this type of lens is very beneficial.
Disclaimer: Do not construe anything written in this post or this blog in its entirety as a recommendation, research, or an offer to buy or sell any securities. Everything in this post is meant for educational and entertainment purposes only. I or my affiliates may hold positions in securities mentioned in the blog. Please see my Disclosure page for full disclaimer. Connect with Andrew on Google+, Twitter, and StockTwits.