Quick Lesson on a Japanese Candlestick Formation Using SPY

Tom Gentile

Posted in
Technical Analysis

By: Tom Gentile
May 12th, 2023

4 mins read

In our ongoing quest to assess directional bias on the major market indices we see many patterns that give an indication the markets could trade higher, lower.  We also see at times patterns or technical indicators that give an indication a market may continue or reverse their current trend.

In the world of technical analysis, the types of charts one uses can vary.  One can use what’s called Open, High, Low or Close (OHLC) bars.  Or they use a popular type of chart that are comprised of Japanese Candlesticks.  There are other types of charts as well, like Line charts or Point and Figure charts) but for this article we will focus on Japanese Candlestick Charts.

Basic Construction of a Candlestick

The candlestick is formed giving data for a period of time.  A candle can be a one-day candle, or it can represent a week or monthly candle.  For this article we are going to use a candles that are 1-day candles.

The body of the candle in Tom’s Tools (www.tomsoptiontools.com) charts show red or green candle bodies.  A red body is for a bearish day and green is for a bullish day.

Figure 1: 2023-05-10 and 11 Candle Days for SPY
Figure 1: 2023-05-10 and 11 Candle Days for SPY

What we are seeing is a one-candle signal. Look for the following characteristics:

  1. The candle itself either a slightly bullish or bearish body.
  2. That candlestick must have a long lower tail. More specifically, the lower shadow should comprise two-thirds or more of the total range of the candlestick bottom of the wick to top of the wick.

You see this in figure 1 regardless of the length of the total day’s range of either or both day’s ranges.

This is an indication of the battle between the bulls and the bears.

If the price of a candle period and again we are speaking and showing one day candles; if the price on the day dips lower than the days open price it is at that point showing the bears have the control on price action for the day thus far.

Sometime in the day of trade bulls take back control and push the price higher off the lows of the day to where it either closes slightly bearish, but significantly higher off the lows or bullish for the day. And it works in the reverse as well.

In the case where the long shadow is below the candle body we would look for the candle body to be green or bullish, (but sometimes the candle body can be slightly red/bearish).

The Long Lower Shadow candlestick is typically considered to be a bullish signal, but it is quite weak in this capacity. In addition, when the market is oversold or at support, the Long Lower Shadow candlestick tends to be more significant.

The Long Lower Shadow candlestick is typically considered to be a bullish signal and may signal a reversal to the upside or a continuation of an existing bullish trend.

The fact it is a one-day or one-period session but know that one-day patterns do not have the impact that a two- or three-day (period) has.

Where a Candle Pattern Happens is Just as Important as the Formation Itself

If a bullish reversal pattern happens at the end of a trend or down-leg or at a support.

Figure 2 is showing the SPY chart over the past 100 days of trade.

There is no long-term down trend on this chart to emphasize in relation to the long-legged shadow days of trade the prior two.

If one wants to consider 410 as a price support that is being generous and may be forcing one to want to think that is the case, but we are not seeing 410 as that major of a support.

The day of trade is not over yet, and it is yet to be seen how the candle looks at the close.

To see prices bought up off the low forming a long lower shadow would be consistent with the two trading days prior to today, but no guarantee it will happen.  If it does that would have us leaning a bit bullish.  If not, it will look like another day of consolidation in this sideways morass of trading which sees SPY trading in a range between 405-415.

Figure 2: 100-day Candle Chart on SPY
Figure 2: 100-day Candle Chart on SPY

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