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How to Read Candlestick Charts
How to read candlestick charts will introduce you the powerful chart patterns that professional traders use to swing trade and day trade stocks.
Candlestick charts show the open, high, low, and close prices. Many swing traders use candlestick charts because its contrasting colors provide fast visual interpretations.
Why Candlestick Patterns
Traders find candlestick patterns visually appealing and easier to interpret compared to traditional bar charts. After learning how to analyze candlestick charts, you will see that they offer valuable information that a traditional bar chart does not.
For example, candlesticks reveal emotions surrounding a stock, and investors' emotions have a major impact on a stock's movement. This type of data can help traders give better predictions on where a stock might be headed.
Candlestick Pattern Formation
The above chart shows how a candlestick pattern looks like. Candlesticks give us clues to price action and the market's mood.
The open and close prices are represented by horizontal lines and they form a box, called the body (also referred to as the "real body").
White candles form when the close price is higher than the open price and black candles form when the open price is higher than the close price.
The long thin lines extending from the body are called shadows, or wicks, and represent the high and low range.
The high is marked by the top of the upper shadow while the low is marked by the bottom of the lower shadow. These are important because they show the extremes in price for the trading period.
How Candlestick Patterns Work
Short shadows show that prices confined near the open and close. Long shadows show that prices traded well past the open and close.
If the open or the close was the highest price during the trading period, then there will be no upper shadow. If the open or the close was the lowest price
during the trading period, then there will be no lower shadow.
For example, bullish candles form when a stock opens, moves lower, tests support, and then bounces back to close at a high.
Bearish candles form when a stock opens, moves higher, tests resistance and then falls to close at a low.
The trader sets the time frame of each candle. For example, if you want to see the high, low, open, and close price over a 30 minute period, the trader sets the time frame of the candlestick chart to 30 minutes. Then, every 30 minutes, a new candlestick is created and it takes 30 minutes for it to complete before another one forms.
Below is a daily candlestick chart of Apple Inc.
When the close is higher than the open, a white hollow candlestick is formed, indicating buying pressure. Long white candlesticks mean that the close was significantly higher than the open and buyers were aggressive.
Although these are typically bullish, it also depends on the trend. After a long downtrend, a long white candlestick can indicate a potential reversal or support level. If it shows up after a long uptrend, it can indicate excessive bullishness.
It is important to note that a white body does not mean that the price went up from the previous day's close. It simply means that the close was higher than the open.
When the close is lower than the open, a black filled candlestick is formed, indicating selling pressure. Long black candlesticks mean that the close was significantly lower than the open and sellers were aggressive.
After a long uptrend, a long black candlestick can indicate a potential reversal or resistance level. If a long black candlestick shows up after a long downtrend, it can indicate panic.
A black body does not mean that the price went down from the previous day's close. The body color of the candlesticks only indicates where the close was compared to the open.
Long white candlesticks indicate that the bulls controlled the trading and long black candlesticks indicate that the bears controlled the trading. Generally, the longer the candlestick body is, the more intense the buying or selling pressure is.
Short candlesticks mean that neither the bulls nor the bears took control. They finished not far from where they started. Short candlesticks indicate little price movement.
Marubozu candles do not have upper or lower shadows. A White Marubozu forms when the open is the low and the close is the high. This indicates that buyers had control starting from the first trade.
A Black Marubozu forms when the open is the high and the close is the low. This indicates that the sellers had control starting from the first trade.
Spinning Top Candlestick
Spinning top candlesticks are those with a long upper shadow, a long lower shadow and a small real body. Spinning tops signal indecision.
The small body, whether hollow or filled, shows that there is not much difference between the open and close even though the prices moved significantly higher and lower during the day. Neither the bulls nor the bears were able to take over.
If a spinning top appears after a long white candlestick or after a long rally, it shows weakness among the bulls and a possible change in the trend. If a spinning top appears after a long black candlestick or after a long decline, it shows weakness among the bears and a possible change in the trend.
Doji candles are amongst the most important candlesticks. It forms when the stock opens and closes at or near the opening price, forming a horizontal line. The length of the shadows varies, but the longer they are, the more significant the Doji is.
Overall, a doji candlestick looks like a cross or plus sign. It represents uncertainty and indecision between the bears and bulls. Doji alone are neutral patterns and trading decisions should not be made on it solely without any confirmation.
The importance of a doji depends on the preceding price action. If a doji appears after a long white candlestick or after a long rally, it signals that the bulls are starting to weaken and that the uptrend could be coming to an end.
If a doji appears after a long black candlestick or after a long decline, it signals that the bears are starting to weaken and the downtrend may be coming to an end. Doji represents an equilibrium between supply and demand and signals that a change in trend may be near.
A doji alone is not enough to signal a reversal. There are different types of doji, such as the neutral doji, long-legged doji, gravestone doji, and dragonfly doji. Learn more about the different types of doji and how to trade doji candlesticks.
The length of the candlestick shadows is significant. A long lower shadow signals that bears took control but bulls made a comeback in the end. A long upper shadow shows that bulls took control but the bears made a comeback in the end.
If the upper and lower shadow are both long, it shows that the bears and bulls both took control at some point in the day, but neither was able to take control in the end.
Top Candlestick Patterns
Following is a list of the top candlestick patterns
Many swing traders make their trading decisions based on candlestick patterns, such as the engulfing candlestick pattern.
Bullish engulfing is one of the most popular candlestick patterns and forms after a downtrend. This pattern consists of two opposite colored candles, where the second candle "engulfs" the body of the first candle.
This means that the open price of the second candle is lower than the previous day's close and the close price is higher than the previous day's open.
Bearish engulfing pattern also consists of two opposite colored candles, where the second candle "engulfs" the body of the first candle. The difference is that this forms after an uptrend. Read about the engulfing trading strategy.
Another common candlestick pattern is the Harami pattern. The Harami pattern consists of two opposite colored candles, where the open and close of the second candlestick occurs inside the first candle.
The shadows of the second candlestick do not have to be inside the first candle, but it is better if they are. Bullish Harami occurs after a downtrend and the first body of the candle is black, followed by a white candle.
This pattern indicates that the downtrend momentum has slowed and the trend is coming to an end. Bearish Harami occurs after an uptrend, where the first candle is white, followed by a black candle.
Hammer and Hanging Man
Both the Hammer patternand Hanging Man pattern have a candlestick with a small body (black or white) and a long lower shadow. The upper shadow is either short or does not exist.
The difference between these two patterns is that the Hammer forms after a decline and is a bullish reversal pattern but the Hanging Man forms after a rally and is a bearish reversal pattern. Both patterns require confirmation before action.
In a Hammer pattern, the long lower shadow signals that sellers drove prices lower during but buyers took control by the end of the trading session.
Wait for confirmation such as a gap up or long white candlestick, preferably on expanding volume. In a Hanging Man pattern, the long lower shadow signals the appearance of selling pressure.
Even though the bulls regained control by the end of the trading session, it is an important signal that selling pressure is starting to increase. Wait for confirmation such as a gap down or a long black candlestick, preferably on high volume.
Inverted Hammer and Shooting Star
Both the Inverted Hammer pattern and Shooting Star pattern have a candlestick with a small body (black or white) and a long upper shadow. The lower shadow is either short or does not exist.
The difference between these two patterns is that the Inverted Hammer forms after a decline and is a bullish reversal pattern but the Shooting Star forms after a rally and is a bearish reversal pattern. Both patterns require confirmation before action.
In a Shooting Star pattern, the long upper shadow signals that buyers drove prices higher but sellers were able to force prices back down. This marks a potential trend reversal. Wait for bearish confirmation such as a gap down or long black candlestick on high volume.
An upper shadow that is at least 2 times the length of the body can signal a substantial reversal.
In an Inverted Hammer pattern, the upper shadow signals that the buyers stepped in but were not able to sustain the buying pressure.
At the end of the trading session, the bears took control and prices closed well off their highs. Due to this failure, bullish confirmation such as a gap up or long white candlestick with high volume is needed before making a trading decision.
To learn more about How to Read Candlestick Charts, read the best candlestick patterns and candlestick trading strategy.
To screen for candlestick patterns, use the Candlestick Screener.
You can also read the book Profitable Candlestick Trading which introduces you to every pattern and how to use them to trade stocks.
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Top 10 Candlestick Patterns
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How to Trade the Inverted Hammer Candlestick Pattern
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