No doubt: One of the most important skills for an investor to make better trading decisions is chart reading.
Candlestick charts are one of the most used types of charts, along with line charts, bar charts, and point and figures charts.
Candlestick analysis is all about continuation, indecision and reversal patterns – fine details, secrets gained and handed over from one trader generation to another. This technique brings another light to market psychology. Also, it can help you better track market movements.
So let’s get down to business:
This article will focus on the basics of Candlestick reading. You’ll understand how and why you should include them in your trading strategy to better enter and exit the markets. Also, it's great to measure volatility and understanding how to take advantage of it.
As you may know, the first thing to do when investing money on the markets is to choose a trading strategy. This strategy will be the cornerstone of your trading success. You will choose it depending on your risk-aversion, your trading capital, your availability, your time-horizon and above all your personality.
Trading with Candlesticks
Trading with Candlesticks started in Japan in the 18th century with the rice trader Munehisa Homma .
He said to have started to record rice price movements (OHLC – Open, High, Low, Close) and spot patterns and signals. This technique stayed in the Japanese trading rooms of important banks and financial institutions for several centuries. It continued until Steve Nixon popularized Candlestick techniques in the Western world.
What's exactly are Candlesticks?
Candlesticks can give you clues about when prices are about to reverse (also called reverse patterns) or when they are losing momentum. Also, if the existing trend is weakening (indecision patterns), as well as when prices will continue in their current direction (continuation patterns).
For this reason, it’s a great technique for “aggressive trading” – buying on a support level and selling on resistance levels. It's also a “classical approach” – buying after breaking through a resistance level and selling after breaking below a support level.
1st Lesson: How To Read Candlesticks
The 1st thing to know is to distinguish bullish candles from bearish ones, analyzing the color of the candle can help you do this.
Generally, if the color is green or white, it represents a bullish candle, meaning that the closing price is above the opening price (see the green hand on the chart). Conversely, if the closing price is below the opening price, the candle is red or black (see red hand on the chart).
2nd Lesson: How To Apprehend Volatility And The Intensity Of Market Movements With Candlesticks
The opening and closing prices define the body of the candle.
The wicks – also called shadows – display the highest and lowest levels reached within the timeframe used. The size of the candle, as well as the size of the shadow, reflects market psychology. A long candlestick or a short one does not convey the same message. The intensity of the movement is then described by the size of the body.
Now consider it this way:
A longer body suggests that buying/selling pressure is intense, as a long body means that the closing price is far from the opening price. If it’s a long green/white candlestick, then it shows a strong buying pressure. A long red/bearish candle often appears in times of high uncertainty where market participants panic. Or, when a large financial institution or fund is dumping a large amount of a given asset, pushing its prices down.
Always – remember to have in mind the big picture
You should also take into consideration the types of candles preceding the one you’re analyzing, as well as the trading volume. A market movement could bring prices close to a support/resistance level and instead of going through, prices might be about to reverse. A long candlestick could also be the sign that the previous trend is over and a new one is starting.
One example of a strong candle is the marubozu.
Marubozu is a long candle with almost no shadows (see red and green circles). A long green/white marubozu is a clear bullish signal, as the opening of the trading session is the lowest and ends at the highest level.
How it works:
A red/black marubozu indicates a strong bearish signal, especially if it appears on a resistance level. The lowest level/the highest level of this candle, as well as the mid-point. It's usually supported in a bullish market/resistance in a bearish market, as you can see on from the red circle.
It is therefore easy to spot important levels where prices could react. But, this is also a tool that can help you in your money management to place effective protective stop-losses.
Conversely, the more indecisive market participants are, the shorter the candlestick will be. This brings us to an important indecision pattern called the doji. It is a candlestick where opening and closing prices are the same (or very close) that it forms a simple horizontal line.
This is the most extreme form of indecision pattern in strong bullish or bearish markets. Doji happening in a rangy market won’t really have any specific signification.
You can find different forms of doji: standard doji, long legged doji, dragonfly doji, gravestone doji.
Other important indecision patterns are spinning tops. They are formed with long upper and lower shadows and small bodies, and harami. It's is formed with 2 candles – a long one followed by a smaller one that should fit inside the previous one.
3rd Lesson: The Importance Of Gaps In Japanese Candlestick Analysis
As a lot of Candlestick patterns are formed with gaps, it’s important to understand what a gap is and how you can use them in your trading.
Gaps – also called windows–represent a zone without any trading transactions, usually between at least 2 consecutive trading sessions, and can be subdivided into four categories: common gaps, breakaway gaps, runaway gaps, and exhaustion gaps.
Here’s how it goes:
They are often highly significant support/resistance zones, which prices test several times. The reason to use Candlesticks while analyzing gaps is that they allow you to better understand the function of the gaps. Also, they supply more qualitative information about the underlying price movement and what to expect next.
As an example, a bullish gap happening after a long congestion zone with a bullish marubozu candle will be a stronger bullish sign than a gap that appears with a red/black candle or a doji.
Candlestick analysis is a popular and effective way to analyze charts, for novices as well as experienced traders. If you can spot indecision, reversal, or confirmation patterns and know if a trend is over or just slowing down. Then – you will make better trading decisions with a more precise entry/exit strategy.
Remember that with the Dow Theory, a trend has changed when a pattern of peaks and troughs have reversed. A bullish trend is formed by higher highs and higher lows, while a bearish one is formed by lower highs and lower lows.
It’s easier than you think.
You can see how Candlestick analysis should be combined with Technical Analysis and Chartism. The latter will be used to determine relevant areas where price movements can happen.
Candlesticks will be used to better understand market psychology when prices are close to those areas (resistance or support levels). Also, they popular where market participants are fighting to take over (buyers vs sellers).
We’ve talked about some basic candlestick patterns such as doji, spinning top, harami, and marubozu.
Now let’s see some of the most common single, dual and triple candlestick patterns in this Candlestick cheat sheet:
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