A candlestick chart is a type of financial chart that can be quite fun to learn. Because it introduces a visual and colorful aspect to trading. And in contrast to many other types of trading tools they are quite simple.
In this post I will focus on simple ways in which we can use candlesticks. For example their basic shapes, patterns and construction. I am researching them both to refresh my own knowledge, and to compile research for others. Therefore, if you have any ideas of your own, regarding candlestick setups, feel free to describe them below this article.
To the left is a typical green candlestick. The green color shows that it closed above its open. And the filled thick body, in the middle, is called the ”real body”. The beginning of the real body, shows the open, and the top of the real body shows the close.
The long thin lines above and below the ”body” are called shadows, or wicks. The shadows display the high and low of the candle.
A candlestick chart is a type of trading chart, with shapes that looks like Japanese candles, which is why they are called “candlesticks”. There are several varieties of Candlestick charts. The most common style is the green and red one, which I will stick to in the first half of this article. But other styles of candlesticks exists as well. Especially black and white candlesticks are more common in older books and charts. And they are displayed further below in this article.
Tug of war
The rise and fall of green and red candlesticks is like a tug of war between buyers and sellers. If the close is near the high it means buyers are in control. Because sellers were not able to sell down the price even the slightest. Conversely, when there are lots of big red candles after each other, that close near their lows, then sellers are in control.
An example of this never ending battle is seen below in a chart of the Dow Jones. The large red candle at the top is an “engulfing candle”, since it engulfs the prior green candle. Engulfing candles are one of the strongest indicators of a coming reversal and trend change.
Length of body
In general a long body means that intense buying, or intense selling, was present. And it often indicates further movement in that same direction. A short candle, on the other hand, means that price is not moving with as much momentum, that it is consolidating or range trading. And this could mean that a turning point is in the cards, or the beginning of a long stretch of sideways trading.
A long green candle represents momentum. Although this all depends on the prior price action. For example, if that candle appears at the end of a long trend it might even signal euphoria and therefore an imminent reversal. Because the momentum might then consist of unprofessional traders that are going into a euphoric stage. And in that case they might push the price up, in one last spurt, before the eventual crash.
Above are two examples of “engulfing candles”. It is a very reliable reversal pattern. The high probability comes from the fact that buyers, or sellers, had a strong presence where they appeared. And this shows up in the form of a big engulfing candle. As a result prices are likely to keep on going in the same direction of the engulfing candle. In the case of a green engulfing candle, as in the example above to the left, it means that a lot of buyers were present.
The same can be said of the bearish engulfing candle to the right, and in the chart below, where sellers took control. In a verified engulfing pattern the second candle should always completely engulf the prior candle, although the shadows might not always be engulfed , as can be seen in the example below.
Long and short shadows
If the close is very high on a green candle with a small, to none existent shadow, buyers are in control. And more upside is expected when this happens. But if the shadow extends a long way above the real body most of the trading took place above the close. Indicating that sellers pushed the prices down and are now a force to be reckoned with. And the opposite is true on the downside.– Chart from TradingView
A single shadow on a single candle usually indicates a reversal. But multiple shadows after each other can mean a weakening of support. And that means that the support line is now beginning to weaken and potentially break. To the right is an example of how this can look. Multiple shadows showing vaining support. This means that sellers are trying to push prices down and buyers are gradually losing control of price. This eventually leads to a breakdown of support.– Chart from TradingView
Below is a Doji candle. It is an iconic indecision candle that has no well defined real body, and it often appears as a reversal candle, at the end of a trend.
The open and close, of a Doji, should ideally be at the same level. Because the Doji is then considered to be more reliable. A Doji shows a tug of war between buyers and sellers where both sides are insecure. And this eventually results in a standoff, which gives rise to the charcteristic cross shape above. Trading a Doji requires that you keep track of the prior trend. Because they are not as reliable when they appear in the middle of a trend, as they are when they appear at the end of a trend. The difficult part is to know the difference. Therefore, other indicators should be used alongside candlesticks as well, to study the overall trend.
A Doji sometimes appears in the middle of a strong trending market, as in the picture to the left. And in that case they don’t have to mean anything at all. Therefore the context, in which they appear, is always an important factor to keep track of.– Chart from TradingView
Black and white candlesticks
The black and white style is more common in older books and among older traders. They work the same way as green and red candles do. White candles symbolizes a buying candle similar to a green candle, and a black candle is conversely dominated by sellers. In the rest of this article I will display candlesticks in black and white.
Earlier in this article I talked about candles that close on their highs as signaling momentum. The correct term, of these candles, are the “Marubozu Brothers”. These candles close on their highs, which is a sign of continued movement in that same direction. In the picture below they are in the black and white style. A white marubozu candle means that buyers are in control from start to finish. While a black candle has the opposite meaning.
Above are two examples of “spinning tops”. They are quite similar to Dojis. Spinning tops have long upper, and lower shadows, but small real bodies. They show that both bulls and bears were active during the battle. But that it eventually ended up in a draw. These candles indicates weakness after a long advance. And strength when they appear after a long decline. They are indecision candles similar to Dojis.
Long candle next to a Doji
If a Doji appears after a long black, or white, candle it means indecision is present in the market. And the strength of that prior candle might be diminishing. But this has to be studied within its context. Because the uptrend could also continue. For example if a long white candlestick comes after the doji it probably confirms the direction of the trend. Conversely the same thing is true for a downtrend. Therefore the context is very important and it is smart to wait for confirmation.
The Gravestone doji is a reversal pattern when it appears at the end of a trend. It looks like a gravestone. And it indicates a reversal if it happens at the end of a trend. The open, close and low are equally big. The high creates a long upper shadow, which makes the candle look like an upside down turned T.
Gravestones indicates imminent doom if they appear at the end of an uptrend. Because in that situation buyers were present, but sellers resurfaced and drove down the price again with force. Indicating further downside.
Hammer, Hanging man and Shooting star
The hammer is a bullish reversal candle and it looks a bit like an inverted Gravestone doji. But with a slightly bigger body. They should ideally form at the end of a downtrend to be a good trade setup. And they often arise at support levels when price trades within a range. The long wick at the bottom shows that sellers are still present. Therefore, it should be used with caution. And to act upon the hammer, volume should be watched closely along with other indicators.
The hanging man looks like the hammer but forms at the end of uptrends. And as the name implies it looks like a hanging man that tries to hold on to a cliff. Now, if this happens on low volume and after a steep uptrend it can be a reliable trading opportunity.
The inverted hammer and the Shooting star are the opposites of the hammer and hanging man. The shooting star forms at the end of an uptrend. And it is a bearish sign that can mark a reversal. The upper shadow should preferably be quite long to verify a reversal. Ideally over two times the length of the real body.
The inverted hammer looks like the shooting star. In addition, it looks like a hanging man but forms at the end of a downtrend. A bullish sign could be if a gap upwards comes after this candle on heavy volume. But trading reversals based on this candle should be done with caution. And preferably a prior uptrend should be in place with signs of weakening. Further, candlesticks don’t tell you what happened inside a specific candle. They just tell us what they look like when they are finished.
The Dragonfly doji is similar to the hammer candle, when it comes at the end of a downtrend. The open, close and high are equal and the low is a long shadow. Which results in a shape that looks like a T. It lacks an upper shadow. This candle indicates that sellers dominated the trading at first. But that buyers took control, at the bottom, and then drove price back up again.
How it should be interpreted depends on the previous price action. Sellers are still present, which is shown by the long shadow at the bottom. If it comes at the end of a long downtrend it means that a potential reversal is coming.
Long legged doji
A long legged Doji has a long upper and lower shadow. And this candle shows indecision and stress. Because prices traded well below, but also well above, that session’s open and close, while the open and close were very close to each other. Therefore, after a volatile session, the candle finally closed virtually unchanged. Showing indecision and insecurity.
The star position
A candlestick that gaps up and away from a previous candlestick is said to be in ”star position”. Because it gaps away from a large candle and has a small real body. They appear isolated from the previous price action. Dojis, shooting stars, hammers and spinning tops can all appear as stars. Because they all have small real bodies and signal indecision.
When a star appears after an uptrend it signals a coming reversal or a slowdown of the trend. If they happen at resistance and gaps up they could mean more upside. But it all depends on the prior price action.
The Harami is a candle that forms within the body of a previous candelstick. In Japan Harami means “pregnant”. The second candle should be smaller than the first candle. Although the shadow of the second candle is not always contained within the first candle’s body. Dojis and spinning tops can appear in this position because of their smallness. It is generally considered to be a reversal pattern.
Several candles can be combined into one candlestick, by using the open of one candlestick, and combining that candle with the close of another candle. For example, to create a hammer, from a bullish engulfing pattern as below.
Another combination is to create a Shooting star from a bearish engulfing pattern, as above to the right. And several candlesticks can be combined into one long bullish candle as below.
Above are “three white soldiers” that are combined into one large candle. This pattern appears when three small candles appear after each other and close on their highs. The three white soldiers convey bullish information. And they can be combined into one large bullish candle. This works if the closes are very near their highs, or lows. In that case they convey the same information as a long candle that close near its high or low.
As you can see Candlesticks can be a bit more fun and visually appealing than many other types of charts. And many traders think they are easier to interpret as well.
All technical analysis is based on the underlying assumption that trends exist. And candlesticks are no different. When many big green candles show up, after each other, it shows the strength of the underlying trend. Especially if the candles close near their highs. Moreover, if that happens on strong volume it is an even better indication that the trend is going to continue.
When I first started to use candlesticks I was overanalysing and overthinking them. Don’t do that if you can avoid it. Because candlesticks don’t tell you what happened inside an individual candle. A big green candle looks the same, regardless of the volatility inside of that candle. As a result they can give conflicting signals. Moreover the primary trend, patterns and other indicators are at least as important to watch. But it is good to be aware of how candlesticks work.
I think that many tools have a place in trading. For example charts, fundamental analysis and other indicators. But candlesticks are an important part of that greater puzzle. Because they offer useful information about charts and trends.