The candlestick and the hanging man: Risk management through charting

Maxie Islam lights the way in the first in a new series of articles by using some imaginative charting techniques and appropriating the kind of tools the front office uses to aid proprietary trades

In the world of performance measurement and reporting, risk management appears very much a new kid on the block. Since 1995, I have been involved in risk management in one form or another across multiple markets including commodities, FX, fixed income and equities. In almost all of these asset classes, there is one underlying tool that some risk managers utilise: the power of charting. In its most elemental form, charting is used to determine a market’s trend and therefore conclude some form of analyses in order to control one’s risk appetite.
A deeper level analysis would lead to such charting techniques being analysed to determine entry and exit points of a market. In this article I shall attempt to introduce these charting techniques to a relatively new audience and perhaps demonstrate the kind of tools a front office uses in order to aid execution of proprietary trades.
Allow me to introduce to you the humble candlestick. It looks like a bar from any bar chart but in essence comprises of a body rather than a skeleton. Like on a bar, a candle shown to the right of Figure 1 (above) has open and close values and also high and low values are all depicted.





















So what’s the point of this you may be asking? Well, one major advantage of viewing a candle chart vs a bar chart is that it allows you at a glance to see whether a particular trading period has been bullish or bearish overall. Take a look at the following charts. The daily chart in Figure 2 (below) shows the FTSE 100 trending downwards — all very clear so far. But what is happening during each individual day? At a glance, the bar chart is not so clear and we have to identify which is the open and which is the close for each and any bar you choose to analyse.



















Candlesticks remove the need to do that. Look at Figure 3 (opposite), the equivalent candle chart. Immediately you’ll notice the latter chart provides a more visually interesting record of the price action; you can see what is happening at each individual trading period where it is either an uptick or a downtick. However, you will see two colours of candles in Figure 4 (opposite). One is black-bodied (bearish) and the other is white (bullish). Note how on the black candle, the open and close points are opposite to the white. (The blue candles in the FTSE charts are the black equivalents).

So now that we know candlesticks can be black or white, what else could they possibly tell us? It’s a little known fact that candlestick charting was first used by Japanese rice traders in the 18th century. In particular, candlesticks have more visible bullish/bearish reversal signs compared to bars 
and up until recently, this type of charting was a closely guarded secret by the Japanese until the West started utilising this method for its own 
trading activities.
So what is it we must look for to make us all wealthy? Ah, if life was only that simple...































Candlestick charting is an art rather than a science, so over the next couple of issues of PMCRR I will introduce to you the most common of the candlestick chart patterns and, more importantly, how to use these against other technical indicators.

























The hammer
Along with candlesticks, be prepared for the weird and wonderful names that come attached with them. Please 
meet the ‘hammer’. It takes on either 
of the following forms seen in Figure 5 (a) & (b) (below right). The hammer is a single candlestick with either a black or a white body and is a bullish reversal signal sometimes found at the troughs of a trending market. To qualify as a hammer, the tail of the candlestick must be at least twice as long as the body that hangs underneath it (often referred to as a ‘shadow’) — see 
Figure 5 (a) & (b) (right). A hammer usually means that the market cannot find any more lows and is now ready for an upturn in action. Have a look at the following charts on page 18 and verify the hammers:
Figure 6: Hammer example 1;
Figure 7: Hammer example 2;
Figure 8: Hammer example 3.
























Even though all these hammer formations have black bodies, 
they could have been white as well. 
There are other bullish reversal 
signals that we will discuss and these will be reserved for a future article.
A point to note here is that these reversal signals must never be looked at in isolation. A number of other factors (both technical and fundamental) must also be used before a decision is made on either entering or exiting a market. 
























The hanging man
You may be thinking if there is a candlestick that also tells of an impending downturn after a bullish run? You would be right. Allow me to introduce you to the ‘hanging man’ in Figure 9 (page 19). Hanging men can sometimes be found at the peaks of markets and usually foretells of a change in direction. Much like the hammer, the tail (or shadow) must be at least twice as long as the body in order to qualify as a reversal signal. Examine the following hanging man candle formations (opposite):
Figure 10: Bed, Bath & Beyond stock price;
Figure 11: FTSE100.
























Notice how each of the hanging men are close to the peaks of the markets before the impending downturn. A hanging man usually signifies that the market is close to its highs and is due a correction.
























The interested among you might think, ‘Well, I never knew about hammers and hanging men’. If so, I would encourage you to have a look at these the next time you are sitting in front of your Bloomberg terminal or Reuters screen. Instead of looking at bar charts, select the candlestick option and see if you can determine these patterns at their respective peaks and troughs. Have the candlestick signals worked each and every time?
























For the sceptics out there — and there will be quite a few who remain to be convinced — you may think I have selected a few carefully chosen charts to demonstrate the points I am making. Indeed, you would be right in thinking this. At this stage, these charts are only to demonstrate how candle patterns work and one should never use these signals in isolation, as I have said before.

























As the series progresses, I will show you how to use hanging men and hammers in conjunction with other analyses in order to form a more complete picture and one that tells a fuller story of what a market is doing (or not doing).
Once you have grasped a few of these patterns and they become familiar territory, I can assure you that you will automatically be looking for them in future. I first stumbled across candlesticks while completing my MBA at Durham during the summer of 1995 and started using them in a professional manner the following year. While candlestick charting is not part of my current work domain, they remain an interesting part of my personal investment analyses. For those who are not able to access any of the data vendors that include charting as part of their services, you can subscribe to a free forum called Interactive Investor (www.iii.co.uk) and the site will supply charts (albeit a few minutes delayed) in both bars and candles.
























But let’s continue with two formations that sound like they could have been taken from the recent volcanic ash headlines: ‘dark cloud cover’ and ‘engulfing patterns’.
























Dark cloud cover
Continuing with, what you might have thought as strange names, dark cloud cover is a two-candlestick pattern which can sometimes be found at market peaks. It is a bearish reversal signal and takes on the form seen in Figure 12 on page 20. For a true dark cloud cover, there must be a white candlestick immediately followed 
by a black candlestick as shown in Figure 13 (page 20).
The open of the black candlestick must be higher than the close of the white while at the same time, the close of the black candlestick must cut into the body of the white by at least 50 per cent, if not more. This is depicted in Figure 13. There is no consideration of the tails (shadows) in this formation like in hammers and hanging men. Just like the hanging man, the dark cloud cover usually signifies that the market is close to its highs and is due a correction.
Examine the dark cloud cover formations in the following stocks (overleaf):
Figure 14: White Electronic Designs;
Figure 15: Colgate.























In each of those stocks, the appearance of a dark cloud cover at the end of a bullish run have prompted the markets to adopt a bearish stance.

Piercing pattern
The converse of the dark cloud cover is called the piercing pattern. It takes on the formation seen in Figure 16 
(middle, right). As can be seen from 
this figure, there must be a white candlestick immediately following a black candlestick.
The white candle must open below the close of the back and also cut into at least 50 per cent of the body of the black as well. Piercing patterns can sometimes be found at the troughs of markets and usually inform of a downturn in trend. This is shown in Figure 17. We can therefore say that the piercing pattern usually signifies the market is close to its lows and is due 
a reversal.
























Examine the piercing pattern seen in Figure 18 (page 22) for General Electric. I have stated in the past that candlestick patterns should never be interpreted as the only sign of a reversal. I will now take the opportunity to combine the patterns so far discussed with some of the technical indicators I have used in the past in order to increase my chances of reading the market correctly.

























Oscillators
Quite like some scientific or even exercise machines, these are indicators which move up and down. I will introduce you to two of the more common oscillator signals that are used widespread in the markets: Relative Strength Index (RSI) and stochastics.

RSI is, in a nutshell, a measure of a markets’ state of being ‘overbought’ or ‘oversold’. It is represented by a percentage figure though most technical analysis practitioners opt to view a chart running concurrently with a candlechart. Take a look at the following example in Figure 19 (page 22). Study the candlechart. There are two sections — the top is the usual candle display; the bottom is the RSI output. At a glance, you may assume that the line loosely follows the price action of the chart. That is part of the story but did you know that during the lowest part of the RSI chart, the graph was telling the market is oversold? If you look again, you can see there are two horizontal lines near the top and bottom of the RSI output. These are marked at the 
30 per cent and 70 per cent levels. 
If the RSI goes below 30 per cent it could mean the market is oversold and is due for a reversal. You can see at this point, the price action from the candlesticks has caused the RSI to dip below the 30 per cent level. If you 
look at the corresponding candlestick, it is just a usual candlestick and does not conform to anything we have discussed previously.

However, if you look at the next candlestick, you will see that there is a hammer formation. So, we now have two indicators that suggest an impending upturn in the price action. The strategic advice here would be to exit all short positions and now look for an entry to get back into the market (ie, take on a long position). However from a personal viewpoint, even two indications that a market may begin to reverse its trend is not enough conviction — I would be looking for another sign.

Stochastics is one of my favourite technical indicators because it tells me at a glance what a market is about to do. It is very much like an RSI indicator but its appearance takes on a sinusoidal waveform. A rule of thumb when using stochastics is look to buy when the indicator says the market is oversold; sell when it’s overbought. It too is driven by mathematical formulae so can easily be charted in an Excel spreadsheet (like an RSI calculation).
Have a look at the following stochastic output from the Dow Jones Industrial Average in Figure 20 (page 22). This sinusoidal waveform is simply telling me that I should be looking for buying opportunities near the troughs of a market and selling opportunities near the peaks of a market. Stochastics always produce two lines; one is just a smoothing factor applied to the other which is the output of a mathematical calculation. On your data vendor in the charting section, switch on the stochastics function.
























What do you see?
Now, study the same chart as in Figure 19 but with the added stochastics information below in 
Figure 21 (top, right). The stochastic chart has been placed below the RSI chart for comparison purposes. The overbought and oversold limits are outlined at 75 per cent and 25 per cent respectively. Look at where the stochastic line has dipped below the oversold line (25 per cent) and see the corresponding candle in Figure 21 (dotted arrows line). The stochastic is telling me that the market is oversold and the downside is limited, however, I am not getting any specific candlestick signal. If I am short of the market, I would be looking to remain short or looking for some kind of exit signal to buy back and square up my position (ie, not hold anything). The next candlestick period is still bearish and the stochastic is still depressed.
However, the next candlestick period after that throws up a hammer which we know is a bullish reversal signal. My stochastic is still less than 25 per cent and my RSI is less than 
30 per cent. I am fairly confident now that I shall exit my short position and wait for the market to start rising. The following candlestick after the hammer is bullish and gives the confirmation I am looking for to buy; the RSI has started to rise and the two lines in the stochastic chart are at a crossover. My strategy here would now to be to buy small positions (reflecting my risk appetite and also the fact that the market can suddenly drop again). If the market continues to rise, then I would be more comfortable in adding to 
my long position especially so if I see 
the RSI and the stochastics indicator rising (in this example, they subsequently did).
In this article I have discussed examples of candlestick formations and also introduced to you the idea of using these in conjunction with some oscillator signals. I am guessing there are some sceptics among you out there? I am guessing these sceptics are saying, well this hocus pocus trickery/imagery may all well be nice and pretty but what about the fundamentals? 
Why have economic indicators been ignored here? Political and other 
socio-economic factors also play a huge part in the how a stock behaves but they seemed to have been forgotton — why?




































In the next article I shall discuss this and hope to reduce the sceptics to an even fewer number. I shall also build upon what has been covered so far and introduce you to yet more candlestick signals and technical indicators and, oh, perhaps some economic indicators too? In the meantime, if you have any questions before then, please do drop me a line via the editor of this magazine. I will welcome any form of constructive criticism/abuse or even a positive concensus. PMCRR

If you would like to comment on this 
article please contact Maxie Islam at: 
Maxie.Islam@BNYMellon.com