Using candlestick patterns is an effective trading strategy for technical analysts. A candlestick chart reveals many insights using well-known Japanese candlestick formations and can be a leading indicator of market activity. Although many people are aware of Candlestick analysis, few actually understand how or why it actually works. Understanding candlesticks can improve trader’s investment profitability.
How to Read Candlestick Charts
What is the difference between candlestick charts and bar charts?
Once you start using candlestick charts, you will realize that bar charts do not provide the same clarity. A vertical line, as shown in the below picture, represents the daily price movement on a bar chart. The bottom of the line is the low of the day while the top of the line is the high of the day. A notch to the right side shows the closing price while a notch to the left side shows the opening price.
In a candlestick chart, the horizontal lines represent the open and close. They form a box, called the real body. If the close is higher than the open, the body is green. If the close is lower than the open, the body is red. The lines extending from the body represent the extremes of the daily price movement. These are called upper and lower shadows.
The contrasting colors of the bodies give us rapid visual interpretations. For example, when there is a series of declining red candles followed by an appearance of a green candle, we would notice that immediately. That may not be something we notice right away when looking at conventional bar charts. These colors are for illustration only. Some charts will use white instead of green and black instead of red.
Also, keep in mind that a green body does not mean that price was up from previous day and a red body does not mean that the price was down from the previous day. The body color only indicates where the close was compared to the open.
Candlesticks give us clues to price action and the market’s mood. For example, bullish candles form when a stock opens, moves lower, tests support, and then bounces back to close at a high.
Candlesticks may be created for any time period – monthly, weekly, hourly, and even a minute. However, they should not be judged in isolation. Traders should see if there is a follow-up action to confirm the buy or sell signal.
Top Candlestick Patterns
There are more than 100 candlesticks and candlestick patterns. This may seem daunting, but rest assured, we will focus on the candlestick patterns that are most popular and useful.
Each candle formation has a unique name. Some have English names and some have Japanese names. Let’s learn about the most common candlestick patterns.
A doji candle is one of the most important Candlestick signals. It is a single-candle pattern that occurs when the stock opens and closes right at or near the opening price, forming a horizontal line. The lengths of the shadows can vary. The longer the shadows are, the more significant the Doji becomes. A doji represents uncertainty, indecision, and equilibrium between supply and demand. Neither the bulls nor bears are winning. Traders should not make decisions based solely on the doji. They should wait for the next candlestick to make an appropriate trade.
Bullish engulfing is one of the most well-known candlestick patterns and occurs when the price of a stock moves past the high and low of the previous day range. This pattern consists of two opposite colored candles and is easy to identify. The first candle is a narrow range that closes down for the day followed by a wide range candle that “engulfs” the body of the first candle and closes near the top of the range.
This is the opposite of bullish engulfing candlestick pattern. A bearish engulfing candlestick pattern composes of two candles, where the first one is a narrow bullish candle followed by a large bearish candle that “engulfs” the body of the first candle.
The Haramai pattern comprises of a two-candle formation in a downtrend. In a Bullish Harami pattern, the body of the first candle is long and is the same color as the current trend. This is followed by a narrow range candle that closes up for the day. The open and close occur inside the open and close of the first candle. This pattern signals that the momentum preceding it has stopped and the trend is over.
The Bearish Harami pattern is the exact opposite of the Bullish Harami pattern. It occurs when two candles form in an uptrend, where the first candle is long and is the same color as the current trend. The second candle is narrow and closes down for the day. The candle opens and closes inside the open and close of the previous candle. This pattern indicates that the trend is over.
The Hammer pattern consists of one candle that has a small body and a lower shadow at least two times greater than the body. It tends to appear in the shape of a hammer, hence the name “hammer.” It is found at the bottom of a downtrend and signals that the bulls started to step in. The color of the body is insignificant; however a green candle has slightly more bullish implications than a red candle. A positive day is required the next day in order to confirm this signal.
The Inverted Hammer candlestick pattern is the reverse of the Hammer candlestick pattern. It also has a small body, where the open, close, and low are near the low of the candlestick and the upper shadow is at least two times greater than the body. This pattern is found at the bottom of a downtrend.
The Shooting Star has the same shape as Inverted Hammer, consisting of one candle with a small body and an upper shadow at least two times greater than the body. The difference is that the shooting star is found at the top of an uptrend. This pattern looks like a shooting star falling from the sky with the tail trailing it, hence the name “shooting star.”
The Hanging Man has the same shape as Hammer, consisting of one candle with a small body and a lower shadow at least two times greater than the body. The difference is that the hanging man is found at the top of an uptrend. This pattern looks like a head with the feet dangling down, hence the name “hanging man.”a
Dark Cloud Cover
The Dark Cloud Cover pattern consists of a two-candle formation in an uptrend. The first candle is green, a continuation of the existing trend, and is followed by a red candle. The red candle’s open is higher than the high of the previous day. It closes more than half way down the first candle.