Candlestick charts are widely used by traders to predict short-term trends. In trading price signal are very important. They are useful for the buying and selling process.
A basic understanding of candlestick charts is essential. Interpretation of support and resistance is also possible with candlestick charts.
Candlestick Charts have a variety of patterns that can be used to predict the future price turning points. But first, let us what the candlestick actually represents and what the patterns formed by a series of them mean.
Candlestick Charts – Introduction
Homma, a legendary Japanese rice trader used a primitive form of this technique during the 1700s. Eventually, this technique evolved into the candlestick techniques that analysts used on the Japanese stock market. Steve Nison with his book, Japanese Candlestick Charting Techniques introduced these techniques to the western world.
The most useful feature of this technique is its ability to give earlier and more reliable reversal signals. The reference period can be chosen accordingly. It can be hourly, daily or even weekly.
The x-axis represents the reference period which is daily. The y-axis represents the price. Each candlestick has a body and probably a shadow above and below it. When on a particular day, the closing price is more than the opening price we have a rising candle. A raising candle can be represented in green or white. The shadows represent the highest and lowest price reached during the reference period. The shadow hence gives the highest range of values. When the closing price is lower than the opening price, we have a falling candle.
In figure 1.2, we see four possible shape of a candlestick.
Candle with label 1 has a long body and a long shadow on the top and a short shadow at the bottom. A large green body represents a very positive trend. A big shadow above is a negative sign and indicates weakness.
Candle with label 2 has a normal body. It has a normal upper shadow and a long lower shadow. A big shadow below is a positive sign and indicates strength.
Candle with label 3 has a short body. It has no lower shadow and has a short upper shadow. A small body means that buyers and sellers are trying to take power.
Candle with label 4 has opening & closing price at almost the same price level. Referred to as a doji, it can signal a reversal trend. A doji at a top or bottom often is the first signal of a price reversal.
Meaning of these shapes
Every candlestick inherently bears meaning. As shown in figure 1.3, a candle body without shadows represents stability. So it represents a steady rising/falling power. Hence, it is an example of a clear signal.
We have an upper shadow attached to a green body, the highest price it reached could not be cemented and hence it signals a weakening rising power. In the case of an upper body attached to a red body, it represents an increasing falling power because the closing price has ended up lower than both the opening and the highest price.
A lower shadow attached to a green body signals a bullish trend. As the closing price is greater than the lowest price, it represents an increasing rising power. In the same way, a lower shadow attached to a falling power is a signal that there can be a recovery. And when the recover of the price is too much as in the case of them the lower shadow is large, we can expect a price reversal.
Single Candlestick patterns
Figure 1.4 and 1.5 represent candlestick patterns formed by single candles alone. As previously mentioned, each candle bears some meaning but meaningful conclusions can be drawn only when the candles are read together. Patterns are essential for price forecast.
(Bulls mean buyers and bears mean sellers)
- Long green candlesticks indicate that the Bulls controlled the trading for the most part.
- Long red candlesticks indicate that the Bears controlled the trading for the most part.
- Short bodies imply very little buying or selling activity.
- A marubozu (candlestick without shadows) indicates balance and hence represents no direction for the price movement.
- A large marubozu indicates a very strong sentiment. Positive when green, negative when red.
- A long upper and lower shadow indicates that the both the Bears and the Bulls had their moments, but neither could put the other away, resulting in a standoff.
- Long lower shadow represents medium positive or negative sentiment.
- A green body with Long lower shadow would indicate a medium positive price movement.
- A red body with Long lower shadow would indicate a medium negative price movement.
- Long upper shadow indicates strong bullish sentiment when the body is green and bearish sentiment when the body is red.
It is important to note that as the body decreases neither the buyers nor the seller seem to dominate. Shooting star, hammer, spinning top are some of the single candle patterns with short bodies.
Hammer and Hanging man
The hammer forms during a downtrend and signals a bullish reversal pattern. The downtrend is hammered at the bottom. So, now probably price will start rising again. The long lower shadow indicates that buyers were able to overcome the selling pressure. There is little or no upper shadow.
A confirmation would be required after the formation of the hammer. Generally when there is a green candlestick that has a closing price above the open to the right side of the hammer.
Hammer candle is very effective when found after a short retracement in a major trend. Hammer can be bullish or bearish in its formation. A bearish or red colored hammer also indicates strength but a green or bullish hammer indicates more strength and more possibility to reverse into an uptrend.
The hanging man forms during a uptrend and signals a bearish reversal pattern. It can also indicate a strong resistance zone. When price is rising, the formation of a hanging man indicates that there are more sellers than buyers.
The long lower shadow shows that sellers pushed prices lower during the session. Buyers were able to push the price back up some but only near the open.Soon, no buyers are left to provide the necessary momentum to keep raising the price.
The hanging man is a bearish reversal candle but its reliability is not as strong as a shooting star. However, a red colored or bearish hanging man has a greater impact on price than a green colored or bullish one.
Inverted Hammer and Shooting Star
The inverted hammer occurs during a downtrend. It signals a possible bullish reversal pattern. Its long upper shadow shows that buyers are willing to buy at an higher price. Soon the sellers can catch up to that and we have a bullish trend as long as buyers are willing to buy.
The shooting star is a bearish reversal pattern that looks identical to the inverted hammer but occurs when price has been rising. Its shape indicates that the price opened at its low, rallied, but pulled back to the bottom. This means that buyers attempted to push the price up, but sellers came in and overpowered them. This is a definite bearish sign since there are no more buyers left because they’ve all been murdered.
Shooting Star pattern is found at the top of an uptrend.. It signals a bearish reversal pattern. The long upper shadow indicates the strong sell pressure.
Generally, this pattern is reliable, but it becomes stronger when a red colored shooting star found at the top of an uptrend. This pattern usually presents itself as a sign of a short term correction rather than a more potent reversal signal. The shooting star is basically telling us that the markets rally could not be sustained.
Note: The longer the tail is on a shooting star or a hammer the more likely it is that price will reverse direction.
Japanese candlesticks with a long upper shadow, long lower shadow and small real bodies are called spinning tops. The pattern indicates the indecision between the buyers and sellers. Hence it is a neutral candlestick pattern.
- If a spinning top forms during an uptrend, this usually means there aren’t many buyers left and a possible reversal in direction could occur.
- If a spinning top forms during a downtrend, this usually means there aren’t many sellers left and a possible reversal in direction could occur.
Doji are essentially neutral candlestick patterns. A doji candle forms when the open price is at the same point or price. It indicates indecision between buyers and sellers. The price can go any way and hence it is better to wait it out.
Long Legged Doji
A long legged doji candle has long upper and lower shadow. The shadows are almost equal in length. This doji reflect a great amount of indecision in the market.
A dragonfly doji has long lower shadow and no or little upper shadow. Dragon fly doji indicates a bear dominated trading. By the end of the session, bullish trend pushed prices back to the opening level and also to the session high.
A gravestone doji candle has long upper shadow and no lower shadow. Basically, it is a shooting star with virtually no real body. This formation is more powerful than the typical shooting star signals a more serious reversal.
Check out the article, Japanese Candlestick Patterns 102 for a detailed list of multi-candle patterns.
Here is a good source for more information.