Candlesticks
Overview
In the 1600s, the Japanese developed a method of technical analysis to analyze the price of rice contracts. This technique is called candlestick charting. Steven Nison is credited with popularizing candlestick charting and has become recognized as the leading expert on their interpretation.
Candlestick charts display the open, high, low, and closing prices in a more visually appealing format compared to the traditional bar chart. Moreover, they are colored in such a way that they reveal more easily the market dynamics of the security.
Each candlestick shows the fluctuations of price in any given time period (e.g., day) of data. Candlesticks can be used in any time frame, from one minute to one year. Figure 1 displays the elements of a candle.
Interpretation
Each candlestick can give us information on the market participants’ behavior. A relatively long body with short shadows, for example, normally means that the buyers or the sellers are very strong and can push price way up or down, while the opposing participants were unable to stop them. So, the size of the candlestick alone is an indication of the traders’ willingness and enthusiasm.
A short body, on the other hand, indicates that neither party is strong enough. When combined with long upper and lower shadows, it is a sign of indecision, as it means that the fight between the bulls and the bears didn’t have a clear winner.
The shadows can also give us useful clues. A long upper shadow and a short lower one usually means that the bulls tried to push the price up, but the bears reacted and brought the price down again. The opposite is true for a long lower shadow and a short upper one. The bears managed at first to lower the price till the bulls reacted and pushed price up. So, in general, we can interpret a long upper shadow as a bearish sign and a long lower shadow as a bullish one.
Of course, as with all the other tools we use, candlesticks are far from infallible and as a result, they should not be used in isolation and out of context. We should combine the signs candlesticks give us with the other indicators such as RSI or MACD.
Even more important, we must learn to evaluate the significance of candlesticks by looking at them into context, that is, by taking into account their position in relation to support and resistance lines, moving averages and the Bollinger Bands. In other words, the information candlesticks give us should be confirmed by the wider condition and dynamics of the trading terrain.
The above are the basic principles candlesticks are based on. Before spending the time to memorize tens of candlesticks and candlestick combinations, we should remember these principles and always study candlesticks in their context in increase their validity and usefulness.
For your convenience, we provide a list of the most common and useful candlesticks and candlestick combinations, with their description and interpretation.
The interpretation of candlestick charts is based primarily on patterns. The most popular patterns are explained below.
BULLISH PATTERNS
Long white (empty) body. This is a bullish candlestick. It occurs when prices open near the low and close significantly higher near the period's high.
Hammer. This is a bullish candlestick if it occurs after a significant downtrend.
If the candlestick occurs after a significant uptrend, it is called a Hanging Man.
A Hammer is identified by a small real body (i.e., a small range between the open and closing prices) and a long lower tail(i.e., the low is significantly lower than the open, high, and close). The body can be empty or filled-in.
Piercing candlestick. This is a bullish pattern and the opposite of a dark cloud cover.
The first candlestick is a long black candlestick and the second candlestick is a long white candlestick.
The second candlestick opens lower than the first candlestick's low, but it closes more than halfway above the first candlestick's real body.
Bullish engulfing pattern. This pattern is strongly bullish if it occurs after a significant downtrend (i.e., it acts as a reversal pattern). It occurs when a small bearish (filled-in) candlestick is engulfed by a large bullish (empty) candlestick.
Morning star. This is a bullish pattern signifying a potential bottom. The "star" indicates a possible reversal and the bullish (empty) candlestick confirms this. The star can be empty or filled-in.
Bullish doji star. A "star" indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. You should wait for a confirmation (e.g., as in the morning star, above) before trading a doji star. The first candlestick can be empty or filled in.
BEARISH PATTERNS
Long black (filled-in) candlestick.
This is a bearish candlestick. It occurs when prices open near the high and close significantly lower near the period's low.
Hanging Man. These candlesticks are bearish if they occur after a significant uptrend. If this pattern occurs after a significant downtrend, it is called a Hammer. They are identified by small real bodies (i.e., a small range between the open and closing prices) and a long lower shadow (i.e., the low was significantly lower than the open, high, and close). The bodies can be empty or filled-in.
Dark cloud cover. This is a bearish pattern. The pattern is more significant if the second candlestick's body is below the center of the previous candlestick's body (as illustrated).
Bearish engulfing candlesticks. This pattern is strongly bearish if it occurs after a significant up-trend (i.e., it acts as a reversal pattern). It occurs when a small bullish (empty) candlestick is engulfed by a large bearish (filled-in) candlestick.
Evening star. This is a bearish pattern signifying a potential top. The "star" indicates a possible reversal and the bearish (filled-in) candlestick confirms this. The star can be empty or filled-in.
Doji star. A star indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. You should wait for a confirmation (e.g., as in the evening star illustration) before trading a doji star.
Shooting star. This pattern suggests a minor reversal when it appears after a rally. The star's body must appear near the low price and the candlestick should have a long upper shadow.
REVERSAL PATTERNS
Long-legged doji. This candlestick often signifies a turning point. It occurs when the open and close are the same, and the range between the high and low is relatively large
Dragon-fly doji. This candlestick also signifies a turning point. It occurs when the open and close are the same, and the low is significantly lower than the open, high, and closing prices.
Gravestone doji. This candlestick also signifies a turning point. It occurs when the open, close, and low are the same, and the high is significantly higher than the open, low, and closing prices.
Star. Stars indicate reversals. A star is a candlestick with a small real body that occurs after a candlestick with a much larger real body, where the real bodies do not overlap. The shadows may overlap.
Doji star. A star indicates a reversal and a doji indicates indecision. Thus, this pattern usually indicates a reversal following an indecisive period. You should wait for a confirmation (e.g., as in the evening star illustration) before trading a doji star.
NEUTRAL PATTERNS
Spinning tops. These are neutral candlesticks. They occur when the distance between the high and low, and the distance between the open and close, are relatively small.
Doji. This candlestick implies indecision. The security opened and closed at the same price. These candlesticks can appear in several different patterns.
Double doji candlesticks (two adjacent doji candlesticks) imply that a forceful move will follow a breakout from the current indecision.
Harami ("pregnant" in English). This pattern indicates a decrease in momentum. It occurs when a candlestick with a small body falls within the area of a larger body.
In this example, a bullish (empty) candlestick with a long body is followed by a weak bearish (filled-in) candlestick. This implies a decrease in the bullish momentum.
Harami cross. This pattern also indicates a decrease in momentum. The pattern is similar to a harami, except the second candlestick is a doji (signifying indecision).