Candlestick charts have a crucial role to play in technical analysis and are particularly important in assessing whether existing trends are sustainable or whether they are becoming over-extended and vulnerable to a reversal.

“It’s not that candlesticks offer any new or different data than the traditional bar charts that technicians have used for years – they show the same open, high, low and close prices – but they present the information in a more enlightening way, giving traders a better idea at a glance of market strength or weakness,” says Robert Colby, CMT, a consulting analyst at www.TradingEducation.com and author of The Encyclopedia of Technical Market Indicators, Second Edition.

Dollar/Yen Background

The behavior and trading patterns for the U.S. dollar and Japanese yen (USD/JPY) illustrate how candlestick analysis has been an important tool during sharp swings in currency direction. The dollar/yen market is particularly sensitive to candlestick analysis, given that Japan runs a substantial basic balance of payments surplus. Although short-term capital outflows tend to weaken the Japanese currency, any drop in these flows can result in rapid yen gains reflecting an underlying over-supply of dollars in the market. There is the potential for extended dollar rallies punctuated by very sharp corrections.

The dollar remained under pressure in early 2005 as confidence in the U.S. currency remained very weak and the Bank of Japan intervened to curb yen gains towards the 100.0 level against the U.S. currency. During the year, however, the U.S. Federal Reserve increased interest rates at successive meetings of the Federal Open Market Committee while the Japanese central bank left interest rates effectively at zero to combat deflationary pressure in the economy.

Although U.S. interest rates were kept at 1.0%, the dollar was a clear target for short sellers as the yield cost was limited, even with short-term Japanese interest rates at zero. The equation, however, continued to change gradually during 2005 as the yield gap widened with U.S. short-term rates rising to 4.25% by the end of the year.

Changing Currents

The dollar became much less attractive as a global funding currency while there were increasing temptations to sell the yen on yield grounds as the Japanese currency became the focus of attention as a global funding instrument. There were further outflows of capital into higher-yield instruments such as Uridashi bonds issued in New Zealand dollars.

The domestic evidence during the fourth quarter of 2005 was generally optimistic about the Japanese economy with gains for production and employment while there was evidence of a slow emergence from deflation. The capital account data recorded strong inflows into Japanese equity markets while the speculative positioning evidence suggested an increasing short yen position.

The U.S. dollar pushed to highs around 114.0 during the third quarter before weakening back to near 110.0 as the Japanese yen was boosted initially by the Chinese Yuan revaluation in July. The dollar also hit short-term selling pressure after Hurricane Katrina hit the U.S. Gulf Coast in late August. The dollar recovered quickly, however, and pushed above the 115.0 level.

Yen losses against the dollar accelerated during the fourth quarter as widening interest rate spreads encouraged further dollar buying, and the dollar pushed to levels above 120.0 by the beginning of December. Candlestick signals were generally dollar bullish during November, but a closer look at the USD/JPY chart shows some warning signs.

< Insert Chart Dollar-yen chart.bmp >

Figure 1 - USD/JPY
Source: VantagePoint Intermarket Analysis Software (www.TraderTech.com)

Following the Candles

A "dark cloud cover" (1) marked one period of congestion. A little over a week later "shooting stars" with long upper shadows (2) suggested the market was beginning to reject higher levels. A couple of long black candlesticks or "bearish engulfing patterns" (3) also indicated weakness as the market opened at or above the previous close, then closed below the previous day's high-low range, completely engulfing the previous candlestick.

The dollar survived this scare and rallied to highs above the 121.0 level. From early December, however, the candlestick patterns started to issue more serious warnings about the dollar, potentially signalling a trend reversal.

Long upper shadows again suggested that the market was attempting to push the price higher but was failing to hold the elevated levels reached during the day and retreating lower by the close, forming a "spinning top" (4) and another shooting star (5). The shooting star was followed by a "gravestone doji" with the open and close at the same price at the low of the daily range and another spinning top. The candlestick clues were mounting up that underlying market selling pressure was starting to increase.

Another bearish engulfing pattern (6) provided stronger evidence that sellers were starting to dominate the market. The dollar did manage to close just above the 120.0 level, but within the next week the dollar had fallen rapidly to lows near 115.0.

A "piercing line" (7) on Dec. 19 started a dollar bounce back as the market opened lower than the previous close but then closed well up into the body of the previous candlestick, followed by another strong white candlestick. The dollar rallied back to 118.0 against the yen, but the rally attempt wasn't very convincing as spinning tops and a doji (8) hinted the up move was probably a short-lived correction.

Moving into the first week of January 2006, the dollar weakened sharply again with a low close at 113.5 as dollar confidence deteriorated sharply. Price action on January 12 provided evidence of a long lower shadow on the daily charts, forming a "hammer." This suggested that dollar buyers were starting to gain the upper hand again, supported by several strong white candlesticks and then a "bullish harami" (10), an inside day in Western technical analysis terms in which the range of the entire day is within the body of the previous candlestick. From there the dollar was off on another run higher, waiting for the next candlestick pattern that might signal price direction.

Although each candlestick has a story to tell about the price action during that period and a succession of candlesticks can reveal the pattern of price direction and market momentum, candlesticks aren't perfect trend indicators. Like most aspects of technical analysis, they produce their share of false signals and fakeout moves. But if you keep in mind the candlestick pattern's position within overall market action, candlestick charts can provide quick visual clues about trends and trend reversals, especially in trending markets like the currencies.