• October 12, 2010

Japanese Candlesticks Exit Signals

by Donald Harder

The two most difficult junctures in a trade are when to enter and when to exit.  This is particularly important when trading breakout stocks where it is even more difficult to decide when and where to take a profit.

Japanese candlestick charting can be one of the best tools for predicting a reversal.  According to candlestick theory, you can see a picture of who is in charge, the bulls or the bears, by looking at the opening, closing, and intraday prices of a stock.  For example, when a stock is going up, the bulls are in charge and this can be determined by looking at the candlestick for that day.  The candlestick is essentially a map of all price movements that occurred during that particular day.

What we want to determine is when the bulls are starting to lose grip, or have lost grip, and when the bears have taken over.  There are a few ways to do this, but we are going to address two of the most common Japanese candlestick exit signals.

The Doji Exit Signal

A doji is formed when the opening price and the closing price are the same.  The common doji looks like a plus symbol (+), but it can also have a longer top or longer bottom, no top, or no bottom, or both.  What is important is its meaning.  The doji represents indecision.  If the price has been in an uptrend for a while and a doji appears, this may be signaling time to exit, so you need to take notice.  This means that while the bulls have been in charge, the bears finally caught up causing indecision on the direction of the stock.  Some books recommend selling immediately when this occurs.  We have found, however, that lately this signal requires confirmation.

Japanese Candlestick Shadows:

Shadows are those price movements that exist outside of the opening and closing prices on a candle.  They would be the wick of the candle, but can occur on either side, like so:

When a stock has been in a strong uptrend and then suddenly closes with a long shadow on top, this should make you take notice.  It means that while the bulls were in charge early in the day, the bears stepped in and sold the price down giving up much of the gains made that day, the longer the shadow, the more dramatic the reversal.

VITX provided us with a good example a while back:

Notice how after VITX ran from .60 to above 1.40, that it began to sell off midday during the  last two days on the chart leaving a long shadow on the top of the candle for the day.  This was a major sell signal.  The next day, when the price opened at $1.30, amateurs got excited thinking that the price would continue up.  The pros, however, knew that sentiment had reversed from bullish to bearish mid day the day before and sold to amateur traders who were hoping for more.  This pushed the price even lower.

Also take note that using the shadows on a candlestick to predict reversals works both ways.  Notice that after VITX sold off a few weeks ago the shadows started to appear a few days later on the bottom of the candle.  Since this was obviously occurring at the bottom of a down ward spiral, it indicated that buyers were stepping in and that the price was due for a reversal.

The Hangman Exit Signal

The hangman exit signal is the reverse of the hammer entry signal.  It appears at the top of a trend instead of the bottom.  The concept of why the hangman indicates a reversal in price is about to occur.  It has similarities to the shadow that appears on top of a trend.  With a hangman, the price actually closes near the high for the day, but the intraday price dropped down below the opening price leaving a shadow on the bottom of the candle like so:

When a hangman appears after a trend up has been in effect, it tells us that during intraday trading the bears were able to pull the price down, but that the bulls rallied into the close.  The indication is that the bulls have used up most of their resources but that though they were able to muster enough strength to close toward the daily high.

Refer back to the VITX chart and notice that a hangman appeared just 4 days prior to the crash.  Heeding this signal would have saved investors and traders alike a huge amount of pain.



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