What is a candlestick chart?
Are you looking for a better way to spot trends while trading in financial markets? Whether you’re trading stocks, commodities, or even forex, your best friend is going to be your chart. After all, short-term trading is the process of analyzing historic price trends and technical indicators to determine whether there’s buying or selling pressure on an asset that will push its price up or down.
No matter what you trade, a quality chart will largely dictate the amount of profits you cash in at the end of the trading day.
If you haven’t started using one yet, it’s time to look into candlestick charts. These charts consist of multiple bars that look like candlesticks with wicks on both sides. Candlestick charts make it possible to quickly visualize and identify key trends.
What Is a Candlestick Chart?
Candlestick charts were around well before financial markets were established in the United States. The first candlestick chart was developed by Munehisa Homma, a Japanese rice trader who made a connection between the price of rice and trader emotions.
Homma theorized that trader emotions led to changes in supply and demand, ultimately resulting in price movement. By using his candlestick chart to quickly see the open, close, high, and low prices in any given trading day, he could predict when reversals were likely to occur; these were perfect times to buy or sell rice.
The Japanese candlestick chart was so successful at mapping emotions and pointing to trend reversals that it was picked up across a wide range of financial markets, starting with commodities and working their way into forex and equities.
Dissecting the Candlestick
The candlestick chart got its name because of the appearance of each entry on the chart. Each “candlestick” has a body and two wicks, which offer four crucial pieces of information at a glance. Here’s the anatomy of the candlestick:
Color or Fill
There are two different types of candles that you’ll find on a candlestick chart. A bullish candlestick represents a time period in which the value of the asset closed higher than the opening price. A bearish candlestick represents a time period in which the value of the asset closed below its opening price.
Most of these charts are color coded with green candles representing bullish movements and red candles representing bearish ones. In some cases, when candlestick charts are displayed in black and white, white shaded candles are bullish candles and those shaded in black are bearish.
The real body of a candlestick is the fat rectangle found between the two wicks. The length of the body represents the difference between the session’s opening price and closing price. Candles with long bodies represent a bigger change in price than short-bodied candles.
On bullish candles, the bottom of the real body is the opening price of the day and the top of the body is the closing price. On bearish candles, the opposite is true, with the top of the body representing the opening price and the bottom of the body representing the close.
Upper Shadow “Wick”
The upper shadow of the candle, also commonly referred to as the upper wick, represents the highest price the asset traded at during the time period.
For example, if a stock opened at $100 per share, moved up to $105 midday, and closed at $104, the candle body would cover the range between $100 and $104, with an upper wick from $104 to $105.
Because the high price of an asset is often viewed as resistance, drawing a line that connects the top of the wicks on a chart outlines a theoretical boundary where the price of an asset will likely face resistance to further gains.
Lower Shadow “Wick”
The lower shadow of the candlestick, also known as the lower wick, represents the lowest price the asset traded for during the time period.
For example, if a stock opened at $100 per share, dropped to $93 midday, and bounced back to $98 by the close, the candle body would cover the range between $98 and $100, with a long lower wick from $93 to $98.
Because the low price of an asset is often considered a point of support — a point at which the price of an asset is likely to bounce back and start heading in a positive direction — drawing a line connecting the lower wicks on the chart will produce a support line.
Why Traders Use Candlestick Charts Rather Than Traditional Charts
Candlestick charts for a stock provide the same information that can be presented on bar charts and line graphs. So why do so many traders consult the candlestick chart?
These charts are a perfect fit for a fast-paced technical trading strategy.
The color coding of candlesticks within a chart makes it easy to quickly determine whether the value of an asset is trending up or down. Moreover, the layout of the candlesticks on the chart makes interpreting data faster and easier.
In financial markets, whether you’re trading rice, stocks, or Bitcoin, time is money. The ability to spot trends visually and absorb data at a glance gives a trader the upper hand in a market where quick decisions count.
Common Candlestick Patterns That Traders Use
Candlestick charting was designed as a way to track supply and demand led by trader emotions. This gives traders a method of predicting future price movements based on chart patterns.
As you can imagine, with a charting system that was created centuries ago, countless types of patterns have been spotted and exploited for profits. The most popular patterns to look for when candlestick trading include:
Bullish Engulfing Pattern
A bullish engulfing pattern generally takes place at the end of a bearish run. Essentially, when the sellers run out of steam and buyers begin to take over, you’ll notice a red- or black-shaded candlestick with a relatively small body. The small-bodied candlestick will be followed by a bullish candlestick that’s much larger than the small bearish candlestick before it.
As the name of the pattern suggests, the pattern suggests buyers are engulfing, or taking over, sellers. In general, this is when a downward trend reverses and becomes an uptrend.
Bearish Engulfing Pattern
The bearish engulfing pattern is similar to the bullish engulfing pattern. The only difference is the direction of the reversal. This pattern starts with a bullish candlestick with a relatively small body. The small body signifies that buying interest is beginning to slow.
Following the bullish candlestick with a small body will be a large bearish candlestick. This pattern suggests sellers are beginning to overtake buyers and a bearish reversal is on the horizon.
Bearish Evening Star
The bearish evening star pattern is one that suggests downward movement is likely on the horizon. This pattern happens when the last candlestick in the pattern opens below a previous candlestick with a small body. This opening will usually be deep into the bottom of the candlestick from two days prior but not below the bottom of the body of this candlestick.
This pattern shows that buyers are beginning to become indecisive and sellers are taking over. As a result, a downtrend generally commences following an evening star pattern.
Bullish Morning Star
The morning star pattern works just like the evening star pattern, but in reverse. The pattern is formed using three candlesticks. The middle of the three candlesticks will be very small with the last of the three opening well above the body of the middle candlestick.
Moreover, the last of the three candlesticks will generally open well into the real body range of the first candlestick in the sequence. This pattern shows that sellers are beginning to lose interest and buyers are starting to take over, signifying a coming uptrend.
Bearish Shooting Star
Shooting stars are exciting to see in real life, but as a candlestick pattern, they’re a sign that declines are coming. The pattern is formed when an asset opens the trading session and shoots higher before falling substantially and landing near its opening price.
When this happens, the body of the candlestick will be very small with a long upper wick and little to no lower wick. Generally, the price of the asset begins a downtrend following a shooting star event.
Bullish Rising Three
The rising three pattern is a bullish pattern that’s mapped out using five candlesticks, each representing a single trading day.
The pattern starts out with a bullish candlestick that has a large body. Following the bullish candle, you’ll see three sequential bearish candles, each of them relatively small, and each staying within the range of the large bullish day the pattern started with. Finally, the fifth day is a bullish day represented by a large green or white candle at the end of the pattern.
This pattern suggests that the price of the asset is going to begin trending upward.
Bearish Falling Three
The falling three is just like the rising three but is the version of the pattern that suggests a downtrend on the horizon.
It starts with a long red or black candle signifying a relatively steep drop in the price of the asset during the first trading session. The long bearish candle is followed by three small bullish candles, with the fifth candle in the sequence representing yet another long, downward day.
This pattern signifies that a downward trend is likely on the horizon.
The bullish harami takes place during a downward trend in which at least three days of downward movement have taken place. At the end of the trend, you’ll find the last candle, which will be a relatively small green or white candle.
This is a reversal pattern signifying that the downtrend is coming to an end and the buyers are beginning to take control. As a result, an upward trend is likely on the horizon.
The bearish harami follows along the same lines as its bullish counterpart. The difference is that this harami takes place following at least three sessions of upward movement. The last candle in the pattern will be relatively small with a red or black body.
This pattern signifies that the upward trend may be coming to an end and a downtrend is on the horizon.
Bearish Hanging Man
The hanging man is a bearish signal signified by a small candle body with a very long lower wick. The lower wick should be at least double the length of the candle’s body. The candle suggests that the stock started at one price and quickly fell before recovering some of the losses to close near the open price.
In general, when this type of price action takes place, the trend following is a downward one.
The gravestone doji is another bearish pattern that signifies declines to come. The pattern is formed when a financial asset shoots up in value from its opening price only to fall back down, closing near its original price for the trading session. This is often a sign of further declines to come.
Candlestick charts are incredibly useful tools for traders looking to make fast-paced moves in the market because the layout of these charts makes quickly analyzing price movements a breeze.
However, when you start to use these types of charts, or technical analysis in general, it’s important to remember that historic trends aren’t always indicative of future movements. So, even if you find a pattern that seems to be a sure win, you should never risk more than 5% of your total portfolio’s value on a single trade.
Moreover, many of the patterns found in candlesticks and any other chart form over the course of several trading sessions. Coupling your technical analysis with fundamental research will help to ensure success as you trade.