On form of trading using technical analysis (the study of charts and chart patterns) involves the use of the Japanese candlestick charts. Japanese candlestick charting tries to predict the price movements of currencies, stocks, commodities and other financial market assets based in differing patterns from the charts. The candlestick chart shows the same information as a bar chart, but in a different way, allowing for interpretation and analysis.
Over 100 years before Western nations developed charting techniques, a Japanese rice trader developed candlestick charts. In the 1700s, a Japanese rice trader man named Munehisa Homma found that although the rice market was influenced by the laws of supply and demand, other factors were also important. One particular factor, according to Homma, is the emotions of traders and how emotions impacted on the price of rice. Homma went on to develop candlestick charting that was a graphical display of price and could reflect the emotions of traders and their impact on prices.
Today, Homma’s candlesticks are used by professional traders across currency, stock and commodities market to make informed trading decisions. Japanese candlestick charting looks to identify regularly occurring patterns. These patterns can then help in making prediction as to where prices are going to go. Most brokers have candlestick charts as an option on their trading platforms.
Your daily candlestick chart looks similar to a bar graph or Open High Low Close (OHLC) chart. The daily candlestick chart shows the market’s close price, low price, open and high price for the day.
The candlestick chart differs to a bar chart in that it has wide parts referred to as the “real body”. This part shows you the range of open and close prices for the day, the wide section is the difference between the open and close for the time period. When the real body is filled with a solid colour (often red) or is black, it means that the closing price is lower than the open price. If it is not filled or is empty (or sometimes green), the open price is lower than the close price. Colours can change depending on the platform. On many platforms, the black candle or the down candle is often red, while the up candles are usually not filled or white but often green.
You will also see lines above and below the real body of the candle. These are referred to as shadows, with the shadow above the “real body” called the “wicks” and those below the “real body” the “tails”. These shadows represent the lows and highs prices for the time period, so in the case of a daily candlestick, for the day.
The relationship of the highs and lows and the opening and closing prices for the period being looked at determines what the chart looks like. So, we could see some short real bodies and some long in either black or white (or red or green.) The shadows (wicks and tails) can also be long or short. The different combinations of these form the shapes of the candlesticks and the differing shapes and combinations of shapes across a number of candlesticks reflects both the shifting of demand and supply and also the emotions and behaviours of the traders.
So, the candlesticks form different price patterns which can be either bullish or bearish. Bearish patterns indicate a price fall, while bullish ones indicate a rise. Although this sounds rather simple, these patterns do not guarantee success, they only show tendencies.
Here we are now going to look at some common and useful candlestick patterns that can help to give you an edge in your trading.
Bearish engulfing pattern – This pattern happens during an uptrend. It’s represented by a long black real body (negative) is engulfing a smaller real body from the previous candlestick. This indicates that sellers of a particular asset are taking control and usually translates to lower prices.
Bullish engulfing pattern – The pattern will show a long white (positive) body engulfing a small body from the previous candlestick. This pattern appears when buyers start taking control of the market and means that prices are more likely to then go higher.
Hammer – A prior down trend is required. The Hammer candle has a small real body, small upper shadow and long lower shadow. This highlights a market that has dipped lower and then rebounded. It can signal a bullish reversal.
Inverted Hammer – As with the Hammer, a down trend is vital, but in this case the candlestick again has a small real body, but with a long upper shadow and small lower shadow. The market has rallied and failed back lower. A bullish reversal is only signalled when the price subsequently moves above the high of the Inverted Hammer.
Shooting Star – This candlestick has a small real body, with a long upper shadow and small lower shadow, but requires an underlying uptrend. It signals a likely shift to lower prices.
Hanging Man – Like the Hammer, the Hanging Man candle has a small real body, small upper shadow and long lower shadow. But in this case it occurs in an uptrend and the signal for a shift to more negative (bearish) is only when the market subsequently breaks below the low of the Hanging Man candlestick.
Three black crows – Three large black (bearish) bars going lower consecutively indicate a broader, intact downtrend.
Three white soldiers crows – Three large white (bullish) bars going higher consecutively indicate a broader uptrend set to continue.
Candlesticks charts and patterns are a great addition to any technical analysis that a trader may do. They can be used alongside regular chart patterns and trend following tolls to help build a strong and sustainable trading strategy. These are a handful of the most significant candlestick patterns, so if the charting student and beginner trader finds success with this type of analysis, there are more to discover.