If you are starting to get into the rabbit hole of investing and trading, then you have probably seen the green and red bars shown above. In the financial markets, we call these stock market bars "candlesticks." And no, we're not talking about scented candles here!
- Technical analysts typically use candlesticks to gauge market sentiment and make trading decisions.
- Understanding candlestick patterns allows you to easily read price action, identify trends, and conduct market analysis to make forecasts.
- We will briefly go over commonly used candlestick patterns and charts you can leverage in your trading strategies to make money.
History of Candlesticks
Candlestick charting techniques originate from 18th century Japan, according to Steve Nison, who is credited as the leader of modern candlestick charting. Nison traced the origin to Munehisa Homma, a Japanese rice businessman who developed the candlestick charting to track the price of rice coupons (rice supply receipts for the next harvest) while trading in the rice exchanges of Sakata, Osaka, and Edo (present-day Tokyo).
When rice coupons were first introduced in 1710, Homma noticed that aside from fundamental factors such as weather, volume, and harvest, something else affected the supply and demand of rice - trader sentiment. To more accurately track people's emotions, he developed a method of charting price movements for each trading session.
Homma's technique did not gain traction until the 1850s as more rice traders started using this early version of technical analysis. But, over two centuries later, we continue to use his system of candlestick charting, though there have likely been many iterations since then.
What is a Candlestick?
Candlesticks are a popular tool used in technical analysis. They are a visually appealing way to show price movements during specified periods. Each candle represents a certain amount of time that passes or the number of trades completed. The timeframe or the number of trades selected is completely up to your discretion.
They are commonly used to gauge market sentiment and enable traders to interpret information easily. Investors and traders often use candlesticks to make trading decisions and forecast the price direction of securities.
A candlestick shows four data points - the opening price, high, low, and closing price of a security within a defined timeframe. Popular timeframes used for day trading are the one-minute and five-minute timeframes, which give traders insights into real-time price movements.
Structurally, there are three basic features of a candlestick:
- Upper shadow (wick)
- Real body
- Lower shadow (wick)
The body is the price range between the open and close price of a security. It represents how much its price was gained or lost in a specified period. The wicks give you a visual aid of the price levels and whether they have risen or fallen. Candlesticks are color-coded based on the direction that prices move. When a security's price rises, the movement upward is represented by a green (or white) candlestick. When its price falls, the movement downward is represented by a red (or black) candlestick.
Candlesticks can appear on different timeframes, ranging from minutes to hours to days. If you cannot make sense of a pattern, move the timeframe up. For example, if you are looking at candlesticks from a one-hour timeframe and cannot identify any patterns, move the time up to two hours.
While candlestick patterns are a popular form of technical analysis, they should not get used in isolation as they do not tell the entire story. Other indicators should be used simultaneously, such as VWAP, moving average crossovers, and MACD.
The Main Benefits of Using Candlesticks
Easily Read Price Action
Candlesticks are easy to interpret because they are color-coded. If a candlestick is green (or white), then you'll know there is bullish sentiment. If a candlestick is red (or black), then there is bearish sentiment.
You should also pay attention to the wick, body, and size of the wick compared to the body. This information can tell you whether the buyers or sellers are in control and whether there is strong or weak price rejection.
In the example on the left, you can see that the candle has a long upper wick and a short body. That indicates that there is a strong price rejection by sellers and weak buyers in control.
Over some time, individual candlesticks will form patterns that allow you to read price charts. Once investors and traders identify candlestick patterns, they can approximate support and resistance levels, which act as price ceilings and floors. Once the support and resistance levels are pinpointed, they can find good entry or exit points for their positions.
Candlestick patterns tell us what is currently happening in the markets and what happened in the past. We can interpret this information to forecast what might happen in the future. For example, if we see a series of red candlesticks in the price of a biotech stock, we can infer that something bad happened, such as regulatory setbacks or a failed clinical trial.
5 Common Candlestick Patterns
We will cover 5 common candlestick patterns to look out for below. This is by no means an exhaustive list, but use it as a starting point to get a general understanding of patterns.
1. Engulfing Pattern
Engulfing patterns help you see market reversals. When there is a bullish engulfing pattern, the buyers (or bulls) are pushing the sellers (or bears) out. When there is a bearish engulfing pattern, the sellers are pushing prices down. As you can see in the image, the name stems from either a bullish or bearish candle "engulfing" the previous candle.
2. Hammer and Shooting Star
A hammer candlestick pattern has a short body, little to no upper wick, and a long lower wick. It shows that sellers were trying to push the price down at one point, but the buyers pushed back and drove the price up. A hammer represents the rejection of low prices and can usually be found at the bottom of a downward trend.
A shooting star candlestick pattern has a short body, long upper wick, and little to no lower wick. It shows that buyers tried to push the price up at one point, but the sellers fought back and pushed the prices back down. A shooting star is a rejection of high prices.
3. Dragonfly and Gravestone Doji
A dragonfly doji is a sign of strength and represents a rejection of lower prices. A gravestone doji is a sign of indecision in the market and represents a rejection of higher prices. Both have a long wick towards one direction, but no body.
4. Morning and Evening Star
With a morning star candlestick pattern, the sellers start out in control, followed by a doji (indecision), and then the buyers take over. It is a bullish reversal pattern.
With an evening star candlestick pattern, the buyers start out in control, followed by a doji (indecision), and then the sellers take control. It is a bearish reversal pattern.
5. Tweezer Bottom and Top
The tweezer bottom formation is a bullish reversal pattern. Sellers tried to push the price down, but the buyers pushed back. It is a sign of strength and usually occurs at the bottom of downwards trends.
The tweezer top is a bearish reversal pattern. Buyers tried to push the price up, but sellers pushed it back down. It is a sign of price rejection and usually occurs at the top of uptrends.
4 Common Chart Patterns
Now that you've gotten a glimpse of some common candlestick patterns, let's cover a few basic chart patterns.
1. Ascending Triangle
The ascending triangle is a bullish trading pattern. As the name indicates, it is characterized by a rising lower trendline and a flat upper trendline that forms the shape of a triangle. In this situation, the buyers aggressively push the price up, making the price reach higher lows. The pattern gets completed when the price breaks out of the triangle and reaches higher highs.
2. Descending Triangle
The descending triangle is a bearish trading pattern. It is categorized by a descending upper trendline and a flat lower trendline that forms the shape of a triangle. In this situation, the sellers aggressively suppress the price, forcing it to reach lower highs. The pattern gets completed when the price breaks out of the triangle and reaches lower lows.
3. Flags and Pennants
Flags and pennants chart patterns signal a continuation of a previous trend. They usually form right after there are bullish or bearish price movements followed by a consolidation period. The price tends to take a pause here and then continue in the original direction of the trend.
There are two main features of a flag pattern - the flag post and the flag. The flag post indicates strong price action while the flag indicates a consolidation period. Flag patterns usually happen after there is a big push up or down during the market open. A downward sloping flag represents a bullish flag whereas an upward sloping flag represents a bearish flag.
Pennant patterns are similar to flag patterns, but they form a triangular pattern instead of a flag. With pennant patterns, there is either a sharp move up or down and then consolidation in the shape of a pennant. A bearish pennant pattern will have converging trend lines that form an upward sloping pennant at the bottom end. A bullish pennant pattern looks similar to a bullish flag pattern, except the converging lines will form a symmetrical triangle pennant.
4. Head and Shoulders
A head and shoulders pattern has a neckline (or baseline) with three peaks, with the middle peak as the highest and the outside two relatively close in height. This pattern is a chart formation that indicates a bullish-to-bearish trend reversal.
The head and shoulders pattern forms when a security's price rises to a peak (left shoulder), falls and then rises higher (head), and then falls back to the previous peak (right shoulder) before falling back down to the baseline (neckline).
An inverse head and shoulders pattern, or head and shoulders bottom, is the opposite of a head and shoulders pattern and gets used to predict downtrend reversals.
Do Candlestick Patterns Work?
Candlestick patterns and charts are a great way to gauge how people feel towards different securities and where market prices are heading next. However, as we mentioned earlier, they do not tell the whole story! When using candlesticks, always combine them with other forms of analysis.
For stocks and cryptocurrencies, I use a combination of fundamental and technical analysis. I use fundamental analysis to understand what I am investing in and determine whether they have value and growth potential. After the securities get added to my watchlist, I then use candlestick patterns to find good entry points. Though I am mainly a buy-and-hold investor, I check my investments daily to see if there are opportunities to buy dips. While most investors recommend dollar-cost averaging into positions regularly, I also prefer leaving some dry powder on the side to pick up discounted assets.
The Bottom Line
Candlestick charting techniques are a popular and invaluable tool for investors and traders. If you are a beginner, we recommend setting aside some time to learn more about candlesticks and how you can incorporate them into your trading strategy.