Candlestick Close-up: Three White Soldiers

Candlestick charts offer a quick, at-a-glance summation of a day's worth of trading information, which many investors prefer to the standard bar chart. Figure 1 illustrates how candlestick bodies highlight the opening and closing price and the stock's direction for the day. The overall movement of the stock is easily visible on a chart; more closed bodies (colored red or black) means the stock is headed down, and more open bodies (colored white or green) means the stock is moving up. When the candlesticks display formations or patterns, they can help stock analysts gauge market sentiment, which can be used to anticipate short-term movements in the stock price.

FIGURE 1: THE PARTS OF A CANDLESTICK. An open candlestick body is drawn when the close is higher than the open. When the close is lower than the open, you get a closed candlestick.

There are literally dozens of candlestick patterns to choose from, and that number increases exponentially if you take all the variations into account. A few patterns, however, tend to be more significant because they occur less frequently and are more reliable than other patterns. One such pattern is called the three white soldiers. It makes a beautiful indicator, signaling some change in a downward trend. What that change might be is uncertain. It doesn't necessarily mean the trend is reversing and prices are going to rise -- they could move sideways -- but it does mean that the stock price is going to stop declining.

The white soldiers pattern is easy to recognize; it even jumps out on yearly charts. Look for three long white candlestick bodies marching upward like stairsteps. The classic formation, shown in Figure 2, follows these rules:

1 There should be three consecutive long, white bodies, each with a higher close.
2 Each successive candlestick should open within, and preferably above, the halfway mark of the previous day's body.
3 Short or nonexistent upper wicks, meaning they have closed at or near the highest price of the day.

WHAT DOES IT MEAN?

The soldiers formation suggests that a stock is rallying, but not necessarily that the rally will continue. The overlap of the three bodies -- opening at a lower price than the price at which they closed -- is considered a healthy sign for an uptrend; not a fast one, but one that shows the possibility of a strong move upward. The overlapping candlestick bodies imply that there is some profit-taking from the recent price rise -- a positive sign. When the candlestick bodies are too long or gap upward (that is, they open at a price higher than the closing price of the previous day), showing no selloff, analysts look at the stock with suspicion because the chart may indicate the quick, unsustainable climb rather than a change in the overall trend.

EXCEPTIONS TO THE RULES

Once you are able to recognize the classic formation and the significance of its various components, you can move on to recognizing variations of it. The classic formation occurs infrequently, so you are more likely to identify one of the several variations:

• Variation 1 -- The second and third candlesticks have short bodies.
• Variation 2 -- The second or third candlestick opens above the previous day's close, creating an opening-day gap.
• Variation 3 -- The pattern occurs in an uptrend or nontrending market. In order to predict a trend reversal, the stock should be trending in the correct direction.

FIGURE 2 illustrates the variations of the three white soldiers, as well as some useful exit formations.

APPLYING IT

If you follow a particular stock for any length of time, you will be able to get a feel for its behavior. You will be able to:

1 Determine whether the stock moves in step with the major indexes, such as the Dow Jones Industrial Average (DJIA), the Nasdaq Composite, and the Standard & Poor's 500.
2 Recognize areas where the price tends to hover.
3 Know the average number of shares that are traded daily.

With all this information in hand, you can get a good picture of the strength of a candlestick formation relative to the stock's overall character. The possibility of flipping or clicking through charts on the Internet eliminates the need to draw these charts by hand. You can also quickly scan huge amounts of data to look for white soldiers.

In Greg Morris's CandlePower, he rated the effectiveness of candlestick formations for three-, five-, and seven-day intervals. He found a whopping 75% average effectiveness rate on the classic three white soldiers formation, and the three black crows formation was not far behind. This is an amazing statistic, if hard to believe, in an arena where any indicator above 50% accuracy is considered tradable, thus placing these two formations in the high end of reliability.

THE PACKAGE: ENTRIES AND EXITS

If you want to take advantage of the candlestick formations on more than an opportunistic level, you can combine them with a second indicator. I use the second indicator for the long term, and the candlestick, whose formations are considered to be very short term (a three-day formation can predict the next three to seven days' stock movement), as the actual entry signal.

I started by pulling up a chart of a target stock in which I'm interested -- in this case, a one-year chart of America Online (AOL). First, I opened the bar chart, then converted it to candlesticks (see sidebar "How to get a custom chart on BigCharts.com"). I noticed several white soldier formations seemed to be occurring at the right places -- points of uncertainty during market activity (Figure 3). Great! Although white soldiers are a bottom trend-reversal signal and work best when a stock is trending down, they can still signal a strong entry when a stock is going sideways or trading within a price range. White soldiers that are formed when there is no clear downtrend need to be watched carefully.

FIGURE 3: ONE-YEAR CHART OF AOL. Look over the initial chart to see if it uses certain candlestick patterns more than others, and if they are forming in the right places.

I applied a second indicator to use for the long term. The moving average convergence/divergence (MACD) indicator is an oscillator that swings above and below a mean value. It is made up of two lines, the MACD line and the trigger line. For our purposes here, the application of MACD will be limited to the crossovers of the two lines. When the MACD line crosses above the trigger line, it indicates a buy. Conversely, when the MACD line crosses under the trigger line, it indicates a sell signal. (For more information on MACD, keep an eye out for the upcoming article in the June 2001 issue of Working Money.)

In Figure 3, you can see that the MACD and white soldiers are giving buy signals at about the same time on two occasions. For entry and exit signals using the MACD, see sidebar "In... and out."

Exits are important, too. Based on previous chart patterns, I have found the three black crows and hanging man patterns to be reliable exit signals:

• Three black crows -- This formation is the mirror image of three white soldiers. It consists of:

1 Three descending long, black candlesticks, each closing at or near their low (no lower wicks) for the day.
2 Each succeeding candlestick opening within the prior candlestick's real body.
3 The first black crow under the previous candlestick's real body. The previous candlestick should have a white body.


• Identical three black crows -- This formation is a bearish variation. In addition to the rules for three black crows, the second and third candlesticks open at or near the close of the previous day. This is particularly bearish because no one is buying on the previous day's declines, meaning the general sentiment is that this stock, for whatever reason, will continue to go lower.

• Hanging man -- This formation consists of:

1 A short body with a long, lower wick that extends to at least twice the length of the body.
2 An occurrence near the top of an upward trend.
3 The body of the candlestick either open or closed.
4 No upper shadow.
5 The longer the lower shadow and the shorter the body, the more significant the formation.

The long lower wick indicates a sharp selloff, followed by a rally that closes near the day's high. It's considered slightly more bearish if the body is closed, indicating that the rally failed to rise to the opening price. The actual signal I got in the example in the sidebar "In... and out" was the advance block, a variation of the three white soldiers. When the stock dropped and two black crows appeared, I didn't wait for the third one. I sold my stock.

MARCHING TO THE BEAT

Using candlesticks can be as simple or as complex as you care to make it. Candlesticks are a marvelous way to initiate yourself into the world of stock market charting. By themselves, candlesticks take advantage of stock market formations and market sentiment and introduce the use of trends, rallies, reversals, and entry and exit points. In conjunction with a second indicator, they can become a powerful tool to increase and protect your investments. And that, after all, really is the name of the game, whether in old-time Japanese or modern English.

IN. . .

Pick a stock and pull up its five-year chart
Program the chart to display candlesticks and the MACD indicator. For this example I'm using BigCharts, but other websites and companies will work just as well. (See the sidebar "How to get custom charts on BigCharts.com" for instruction on custom charting.)

Look for a buy signal from the MACD indicator
The MACD indicator on the bottom of the chart gave a buy signal when the blue MACD line crossed the red trigger line in October. At this point, I go to the three-month chart and analyze the candlestick formations, looking for a good time to buy.

Pull up a three-month chart and look for three white soldiers
I pulled up a three-month chart of AOL when I got the crossover signal in October. Upon examining the chart, I saw the three white soldiers had appeared on September 28, 1999. Keep in mind that the MACD is a lagging indicator and the candlesticks are not, so the candlestick formation that you want may have already occurred right before the MACD gave its signal, which is what happened in this case. I bought in at 50.

. . . AND OUT

Back to the five-year chart
Now I wait for the MACD to cross over, signaling a possible trend reversal. This occurred only a few months later at the beginning of 2000. Next step, back to the three-month chart.

Looking for an exit
Already I see several exit signals, and the three-month MACD gave an exit signal simultaneously with the candlestick's advance block formation in mid-December.

CONCLUSION

The big picture
I decided to sell at 75. By the end of January, the stock dropped down to 60, so I was happy with my system. The only thing I'd like to change is rather than waiting for the two lines to actually meet, I'd prefer to start checking the daily price charts when the MACD indicator got close to crossing. The MACD is a lagging indicator and it seems to work well with AOL, so I have the confidence to go ahead and anticipate its next move.

How to get a custom chart on BigCharts.com

Put in your ticker symbol, then click on Interactive Charting to get the menu seen on the left.

1 Start with time settings and select five years.
2 Set the frequency to weekly.
3 Bottom indicator is MACD.
4 Set price display to candlesticks.

Sharon Yamanaka can be reached at SYamanaka@Traders.com.

REFERENCES

Morris, Gregory L. [1992]. CandlePower, Probus Publishing Co.

Nison, Steve [1991]. Japanese Candlestick Charting Techniques: A Contemporary Guide To The Ancient Investment Technique Of The Far East, New York Institute Of Finance.