Investing made easy: Understanding Candlestick Charts basics for Stock Trading

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Introduction

Chart analysis has become more popular than ever. One of the reasons for that is the availability of highly sophisticated, yet in-expensive, charting software. The average trader today has greater computer power than major institutions had just a couple of decades ago. Another reason for the popularity of charting is the Internet. Easy access to Internet charting has produced a great democratization of technical information. Anyone can log onto the Internet today and see a dazzling array of visual market information. Much of that information is free or available at very low cost.

Another revolutionary development for traders is the availability of live market data. With the increased speed of market trends in recent years, and the popularity of short-term trading methods, easy access to live market data has become an indispensable weapon in the hands of technically oriented traders. Day-traders live and die with that minute-to-minute price data. And, it goes without saying, that the ability to spot and profit from those short-term market swings is one of the strong points of chart analysis.

Charts can be used by themselves or in conjunction with fundamental analysis. Charts can be used to time entry and exit points by themselves or in the implementation of fundamental strategies. Charts can also be used as an alerting device to warn the trader that something may be changing in a market’s underlying fundamentals. Whichever way you choose to employ them, charts can be an extremely valuable tool—if you know how to use them.

History of Candlesticks

If you are trading or thinking of getting into trading, Technical Analysis or TA is a very important part of the process. With out looking into Technical Analysis and understanding TA, it would be very difficult to be profitable in your trading sessions.

Technical Analysis is made up of a whole load of tools, including analyzing charts of the movement of price of a given stock over a period of time. Using these charts to predict the future price of that stock is what technical analysis is all about.

There are various methods of representing the price and time data on these charts such as lines, bars etc. But a new method, called the “Candlesticks Charting”, based on a Japanese system, was brought to the west in the 1900 by Charles Dow.

Over 150 years ago, a Japanese rice trader names Homma Munehisa is credited to have come up with a system of charting that used candlesticks giving an overview of open, high, low, and close market prices of rice over a certain period. Until about 1710, only physical rice was traded but then a futures market emerged where coupons, promising delivery of rice at a future time, began to be issued. From this, a secondary market of coupon trading emerged in which Munehisa flourished. Stories claim that he established a personal network of men about every 6 km between Sakata and Osaka (a distance of some 600 km) to communicate market prices.

The system that Homma created to help him analyze the price movements of rice back in the 18th century became popular in the 1990s, largely thanks to Steve Nison, who tracked down and translated a huge collection of Japanese texts that described the Candlestick charting method. Today, almost every one knows about the candlestick charting method and almost all trading and analysis software display candlesticks and even name and explain the candlestick patterns and formations.

Candlestick Shapes

Basic candlestick anatomy

Whenever you look at a price chart, you will select a timeframe for that chart – perhaps it’s a minute or an hour or a day. Rather than simply plotting the open or close price for that time frame, the candlestick gives you information about what went on during that period of time. Having all this extra information, gives you a heads-up about market sentiment and can offer invaluable clues about the way the market will move.

Having all this extra information, gives you a heads-up about market sentiment and can offer invaluable clues about the way the market will move.

What Candlesticks Don't Tell You

Candlesticks do not reflect the sequence of events between the open and close, only the relationship between the open and the close. The high and the low are obvious and indisputable, but candlesticks (and bar charts) cannot tell us which came first.

Types of Candlesticks

The Doji

The Doji is a candlestick where the opening and closing prices are the same (or almost the same). It can take many forms, as shown here, depending on what the trading activity was in that period.

What’s key with a doji is that neither the bears nor the bulls have gained control, and that the price has ended where it began. It’s a sign of indecision in the market, and could (in conjunction with other indicators) signal a change in market direction.

Applying doji candlesticks: a good trick is to look out for a doji near the edge of a price channel (i.e., if a doji appears at the top of a channel it could indicate a bearish correction.)

The Marubozu

The text-book marubozu is a long candle, which implies that the day’s trading range has been large. And it should have no upper or lower wick (“marubozu” in Japanese means “shaved”).

A green (or white) marubozu signals strong conviction among buyers, while a red (or black) marubozu indicates that sellers hare eager to flee.

In practice, when you’re looking at charts, a marubozu will often have a short wick at the top or the bottom.

The Harami (Bullish & Bearish)

The harami is one of the most common candlestick patterns you’ll come across, so it’s important to recognize it – to understand what it means, and to understand its limitations.

A harami is a two-session reversal pattern – i.e. it’s made up of two candlesticks and implies that the price is about to turn. It is indicated by a small body of the opposite colour, completely contained by the body of the previous session. It is not essential for the two candles to be opposite colours, but this tends to give a more reliable signal.

As you can see here, the body of the small black candle is completely within the confines of the body of the previous white candle. This indicates that the upward trend is running out of steam.

Here are a couple of examples:

This bullish harami shows the sellers beginning to dominate as they come back into the market:

This bearish harami has a shadow that extends beyond the body of the previous candle – some traders wouldn’t regard this as a “true” harami. However, it’s body is entirely within the previous green candle, and a reversal follows.

A harami doesn’t always live up to its hype. While it is touted as a “reversal indicator” – you may find yourself disappointed by its reliability. The psychology behind a harami is that a possible change in sentiment may be happening. The small candle does not necessarily mean a strong reversal is coming. Often with a harami pattern, several days of tight range trading, referred to as “congestion” or “consolidation,” will follow.

A harami on its own says “the chart MIGHT reverse.” It is best to look for confirmation and to combine the harami with other longer-term patterns.

The Hammer (bullish) & The Hanging Man (bearish)

This is one of the best-known reversal indicators …

It is a candlestick pattern that consists of just one candle (although with candlesticks it is always best to view them in context of the candlesticks around them – in particular the candle that follows immediately after).

The hammer or hanging man candle has a long lower wick, short body, and little or no upper wick. Strictly speaking, the lower wick should be at least two times longer than the body – the longer, the better. And depending on where you find it on a chart, it is called either a hammer or a hanging man.

A hammer: is found in a downtrend, and signals a bullish reversal. The long lower wick shows a period in which sellers where in control, but the body shows buyers coming back in. From this we can tell that there is strong buying by bulls as the period of sell-off declines.

As with all single candlestick patterns, we should wait for next candle to confirm that buyers are in control.

Note how the strong selling action and increased volume (indicated by the long lower wick) on the candlestick is reversed as buyers come back in, and that this coincides with an oversold indicator on Stochastics. The green candlestick opening above the body of the hammer confirms the bullish trend.

A hanging man: is the same shape as hammer, but found in an uptrend. We don’t expect to see strong selling pressure (seen in the long lower wick on the candle) in an uptrend, so here it suggests a change of market sentiment and a reversal to downside.

In this case, the hanging man shape coincides with the Stochastics showing the price to be overbought, and the next candle confirms the move.

There's no hard and fast rule about what colour a hammer or a hanging man should be – the fact that they have a short body already means that there's indecision coming into the market. However, a green (or white) hammer and a red (or black hanging man) are stronger indicators.

Inverted Hammer (bullish) & Shooting Star (bearish)

This candlestick is, as you would expect – a hammer turned on its head …

It is a candle with a small body and long upward wick, signally a possible reversal. Where it appears in a chart affects whether it’s an inverted hammer or a shooting star.

An inverted hammer forms after a downtrend or at the bottom of a period of consolidation. The reversal isn’t confirmed until you have a bullish candle in the next period.

A shooting star forms after an uptrend or at the top of a period of consolidation.

Inverted hammers and shooting stars can have green or red bodies – what’s important here is that the body size is small, that the upper wick is at least twice the length of the body, and the lower wick is negligible.

Engulfing (Bullish & Bearish)

An engulfing pattern signals a reversal, and can be bullish or bearish. It comprises two candles. The body of the second must engulf the body of the first, and must be the opposite colour to the first.

For a bullish engulfing candle, we have a smaller red candlestick, followed by a green candlestick, the body of which is greater in size that the previous candle.

For a bearish engulfing candle, the first candlestick is smaller and green, followed by a red candlestick, the body of which engulfs the previous candle.

In this example of a bearish engulfing pattern, we have a clear uptrend, where the final candle has a red body, which engulfs the body of the previous candle. This suggests that strong selling pressure has come into the market, and could indicate a reversal or period of stagnation.

Conclusion

Candlestick charts provide more information than other types of charts because they combine the open, high, low and close prices into one graph. The variety of different chart patterns that can be analyzed on candlestick charts is extensive and beneficial to learn.

Candlestick patterns are very useful - and they get stronger when combined with various other technical studies. For example, combining candlestick patterns with support/resistance, oscillators or Fibonacci can lead to really good setups.

Importantly, you need to learn how to read candlestick patterns properly to improve your trading skills and find your edge in the markets.