Candlestick charts are a style of technical analysis in which data from multiple periods is condensed into a single price bar. This distinguishes them from conventional open-high, low-close bars or from just joining closing price dots. When completed, candlesticks form patterns that signal the price's direction. Appropriate color-coding adds dimension to this bright technical tool, which dates back to 18th-century Japanese rice merchants.
In his acclaimed book published in 1991, "Japanese Candlestick Charting Techniques," Steve Nison introduced candlestick patterns to the Western market. Numerous traders are already familiar with dozens of these patterns dubbed bearish dark cloud cover, evening star, and three black crows. Many long- and short-side trading methods utilize single bar patterns such as the Doji and hammer.
What Is a Candlestick?
A candlestick pattern is a visual representation of an asset's price movement. Candlestick patterns are popular technical analysis components because they enable traders to evaluate price information using only a few price bars quickly.
This post will examine a daily chart where each candlestick represents a single trading day. It possesses three fundamental characteristics:
The body which denotes the range of open-to-close
The wick, or shadow that serves as an indicator of the intraday high and low
The body color denotes the direction of market movement — a green (or white) body indicates a price increase, whereas a red (or black) body indicates a price decline.
Individual candlesticks develop patterns that traders can use to identify significant support and resistance levels over time. Numerous candlestick patterns signal an opportunity in a market - some reveal the balance of buying and selling pressures, while others reveal continuation patterns or market indecision.
Before you begin trading, it is critical to becoming familiar with the fundamentals of candlestick patterns and how they can help you make judgments.
Why Should We Use Candlesticks?
Candlesticks are an intuitive way to visualize price action. You can use candlesticks to determine when to buy and when to sell. No analysis is 100 percent accurate all of the time. However, many dealers are adamant about their use.
How to Read Candlestick Patterns?
Japan invented candlestick patterns over a century before the Western world produced bar charts and point-and-figure charts. A Japanese man named Homma observed that because there was a correlation between rice prices and supply and demand in the early 1700s, the markets were also heavily impacted by traders' emotions.
Daily candlestick charts display the security's open, high, low, and closing prices for the day. The comprehensive or rectangle portion of the candlestick is referred to as the "true body," and it illustrates the relationship between the opening and closing prices.
This natural body depicts the price range between the day's open and close.
When the candle's real body is filled, black, or red, it indicates that the close is lower than the open and is referred to as a bearish candle. It demonstrates that prices opened higher, were pushed lower by bears, and closed lower than the opening price.
If the candle's body is empty, white, or green, the close was more significant than the open, referred to as a bullish candle. It indicates that prices opened, bulls pushed prices higher, and the closing price is always higher than the opening price.
The thin vertical lines up and down the actual body are referred to as wicks or shadows, and they represent the trading session's high and low prices.
History of Candlestick Charts
The invention of candlestick charts is commonly assigned to a Japanese rice trader named Munehisa Homma in the 18th century. He was notorious for his ability to game the rice trade markets. It is claimed that his candlestick tactics have been refined and tweaked throughout time to make them more appropriate to modern financial markets. In his book "Japanese Candlestick Charting Techniques," Steven Nison introduced candlesticks to the Western market. Candlesticks have become an integral part of virtually every trading platform and charting program used in financial trading. Candlestick charts are popular among traders because of the amount of information and the simplicity of the components. Tying multiple candlesticks together to uncover an underlying pattern makes it an enticing tool for understanding price action history and forecasts.
Hammer Candlestick
The hammer candlestick represents a bullish reversal, and it is one of the most extensively observed candlestick patterns (if not the most widely followed). It is used to identify bottoms of capitulation followed by a price bounce, which traders exploit to enter long positions.
A hammer candlestick forms at the end of a downtrend and indicates a near-term price bottom. The hammer candle's bottom shadow forms a new low during the downtrend sequence and closes near or above the open. The lower shadow (alternatively referred to as a tail) must be at least twice the size of the body. This indicates the longs who have finally given up and stopped as shorts cover their positions, and bargain hunters enter from the sidelines. Additionally, increasing the volume of the hammer helps to harden it. The next candle must shut above the hammer candle's low, preferably over the body, to confirm the hammer candle. A critical buy signal would be an entry above the high of the next candle with a trailing stop below the body low or the hammer candle's low. Timing the entrance with a momentum indicator such as the MACD, stochastic, or RSI is prudent.
Bullish Engulfing Candlestick
A bullish engulfing candlestick is a big green candle that engulfs the previous red candle's range—the greater the size of the body, the more extreme the reversal. The body of the next red candle should completely swallow the body of the preceding red candle.
The most effective bullish engulfing candlesticks emerge near the conclusion of a downtrend to initiate a strong reversal bounce that overwhelms short-sellers, resulting in a panic purchasing frenzy for short covering. This encourages bargain hunters to into the fray, further increasing the buying pressure. When bullish engulfing candles develop following a shallow reversion downturn, they can act as reversal signs on downtrends and continuation signals on uptrends. To be most effective, the volume should increase to at least double the average when bullish engulfing candles appear. When the subsequent candlestick exceeds the high of the bullish engulfing candlestick, a buy trigger is formed.
Bullish Harami Candlestick
A bullish harami candle is similar to a reversed version of the bearish engulfing candlestick pattern, except that the large body engulfing candle comes before the smaller harami candle. The previous engulfing red candle should be a large body candlestick that forms the sequence's lowest low point, signaling a capitulation sell-off preceding the harami candle, which should trade well within the engulfing candle's range. The tiny body's subtlety keeps short-sellers complacent, as they expect the stock will continue to decline. However, it stabilizes before forming a reversal bounce that surprises the short-seller when the stock reverses back up.
The harami is a subtle indicator that frequently keeps sellers satisfied until the trend reverses gradually. It lacks the intimidation and drama associated with the bullish engulfing candle. The delicacy of the bullish harami candlestick makes it extremely dangerous for short-sellers, as the reversal occurs gradually and then accelerates rapidly. When the subsequent candle climbs above the high of the preceding engulfing candle, a long buy trigger is formed, and stops can be placed below the harami candle's lows.
Piercing Line Pattern
A piercing pattern is a multi-candlestick chart pattern that develops following a downtrend and signals a bullish reversal.
It is produced by two candles, the first of which is a bearish candle indicating that the downturn will continue.
The second candle is a bullish candle that opens the gap down. However, it closes more than 50% of the preceding candle's natural body, indicating that the bulls have returned to the market and a bullish reversal is about to occur.
Morning Star
Morning Star is a multi-candlestick chart pattern that forms following a downturn and indicates a bullish reversal. It is composed of three candlesticks, the first of which is a bearish candle, the second is a Doji, and the third is a bullish candle.
The first candle denotes the continuation of the downtrend, the second candle is a Doji, indicating market indecision, and the third bullish candle suggests that the bulls have returned to the market and a reversal is imminent.
Inverted Hammer
The hammerhead is at the bottom of the inverted hammer motif depicted above. The opening and closing prices are within a few cents of one another.
Hammer handles should be at least twice as long as the hammerhead. While the price did not close at the range's top, it did close higher than it opened.
Three White Soldiers
A three-day sequence of three white troops occurs. Long green candles with short wicks that open and close higher and higher each day make up the structure.
An extremely bullish indicator emerges following a decline and indicates a continuous increase in buying pressure.
Abandoned Baby
The bullish abandoned baby reversal pattern forms at the downtrend's low, following a string of black candles printing lower lows. The market gaps downward on the next bar, but no new sellers materialize, resulting in a narrow range of Doji candlesticks with identical opening and closing prices. The pattern is ended at a bullish gap on the third bar, indicating that the recovery will continue to higher highs, possibly initiating a broader-scale upswing. According to Bulkowski, this pattern accurately forecasts increased prices by 49.73 percent.
Bearish Engulfing Candlestick
As with a large tidal wave enveloping an island, the bearish engulfing candlestick eats the range of the preceding green candlestick completely. This is a strong candlestick indicating a price reversal. The bearish engulfing candlestick body eclipsed the previous green candle's body. Even more powerful bearish engulfing candlesticks will have bodies that entirely absorb the preceding candlestick, including the upper and lower shadows. These candlesticks may indicate massive selling activity due to a panicked switch from bullish to bearish emotions.
The accompanying green candle maintains the confidence of unassuming purchasers, as it should be trading at the top of an uptrend. The bearish engulfing candle will initially open higher, promising the further climb for longs, as it initially implies greater bullish sentiment. However, the sellers arrive forcefully and aggressively, sending the price below the opening level, causing some fear among the longs. The selling becomes more intense as the price falls through the preceding day's low, which triggers additional panic selling as the bulk of the previous day's buyers are now underwater on their shares. The selling continues into the candle close, as nearly every purchase from the previous close now holds losses. The scale of the reversal is quite significant. When a bearish engulfing candle appears on an upswing, it is a reversal candle because it spurs further selling the following day until the trend begins to reverse into a breakdown. When the subsequent candlestick exceeds the low of the bullish engulfing candlestick, a short-sell trigger is formed. On established downtrends, the bearish engulfing pattern may occur during a reversal bounce, resuming the downtrends faster due to the new purchasers stuck on the bounce. As is the case with all candlestick patterns, it is critical to monitor volume, particularly on engulfing candles. The volume should be at least twice or higher than the average daily trading volume to have the most significant impact. Algorithm programs are known for painting the tape with a mix-tick at the end of the day to close with a bogus engulfing candle to trap the bears.
Bearish Harami Candlestick
Bearish harami is the inverse of bullish harami. As with David facing Goliath, the preceding enveloping candle should eclipse the range of the harami candle. These occur at the tops of uptrends when the preceding green candlestick sets a new high with a large body, followed by the formation of the little harami candlestick as purchasing pressure progressively diminishes. Because the buying slows gradually, the longs believe the retreat is simply a breather before the uptrend continues.
As the bearish harami candlestick ends, the subsequent candlestick falls lower, alarming the longs. When the low point of the preceding engulfing candle is breached, a panic sell-off ensues as longs flee to avoid further losses. When the bottom of the engulfing candle is breached, a typical short-sell trigger occurs, and stops can be placed above the harami candlestick's high.
Hanging Man Candlestick
A hanging man candlestick is similar to a hammer candlestick. Except it forms at the top of an upswing rather than the bottom of a decline. The hanging guy has a small body, a massive lower shadow (at least twice the size of the body), and a minimal top shadow. It is distinguished from a doji by the presence of a body developed at the summit of the range. The purchasers blocked a possible shooting star and lifted the candle to close at the candle's upper range, frequently artificially, to sustain the bullish feeling. However, the truth becomes apparent as selling speeds and the next candle closes beneath the hanging man.
Hanging man candles perform best at the apex of parabolic price rises comprised of four or more consecutive green candles. On shooting stars and Doji candlesticks, most bearish reversal candles will form. Hanging man candles are uncommon because they indicate a huge buyer who becomes stranded in an attempt to maintain momentum or paint the tape to generate additional liquidity to sell.
A hanging man candlestick indicates a possible uptrend top, as purchasers who followed the price look down and wondered why they chased it so high. It mentions the old Road Runner cartoons, where Wile E. Coyote was chasing the Road Runner and realized he had overstepped the cliff just before he plunged.
Shooting Star
The shooting star is a famous bearish reversal candlestick that signals the end of a trend, and it is the polar opposite of a hammer candle. The star should form after at least three or more additional green candles signaling rising price and demand. Buyers eventually lose patience and attempt to drive the price to new all-time highs (of the sequence) before discovering they overpaid.
Generally, the upper shadow (also known as a wick) should be twice the size of the body. This implies that the final wave of frantic buyers has entered the stock just as profit-takers offload their positions. It was followed by short-sellers pushing the price down to close the candle near or below the open. This effectively captures late buyers who chased an unrealistically high price. Fear is at an all-time high, as the next candle should close at or below the shooting star candle, triggering a panic selling binge as late purchasers scramble to exit and limit losses. The traditional short-sell signal occurs when the next candlestick's low is broken, with trailing stops at the shooting star candlestick's body or tail high.
Dark Cloud Cover Candlestick
This is a three-candlestick reversal pattern in which the black cloud cover candle gaps above the last candle's closure but ends up closing red as sellers enter early. This suggests that longs were eager to act pro-actively and liquidate their positions even as fresh highs were set. Dark cloud cover candles should have bodies close below the previous candlestick's body's midpoint. This differentiates it from a bearish reversal pattern such as a Doji, shooting star, or hanging man. The three-candle pattern is formed by the preceding candle, the dark cloud candle, and the subsequent confirmation candle. Before the black cloud covers the candlestick, the candlesticks should be at least three consecutive green candles.
The selling, on the other hand, overwhelms and traps new buyers. If the next candle fails to create a new high (above the dark cloud cover candlestick), a short-sell trigger is established when the third candlestick's low is breached. This creates a trap door, indicating panic selling as patrons flee the burning theater in a hasty attempt to minimize losses. When the low point of the third candle is breached, short-sell signals are generated, with trailing stops put above the high of the dark cloud cover candle.
Evening Star
There is a long white bar that accelerates an uptrend to a new high at the start of the bearish evening star pattern. No fresh buyers appeared despite the market gaps higher on the next bar, leaving us with a candlestick with a narrow trading range. This candlestick pattern is completed by a gap down on the third bar, indicating that the slide will continue to even lower lows, possibly sparking a broader-scale slump. Bulkowski asserts that this pattern accurately forecasts decreased prices by 72%.
Three Black Crows
The bearish three-black crows' pattern begins at or near the uptrend's high, with three black bars posting lower lows that close near intrabar lows. This pattern implies that the drop will continue to lower lows, possibly initiating a larger-scale slump. The most bearish variant begins with a fresh high (point A on the chart), trapping purchasers in momentum bets. Bulkowski asserts that this pattern accurately forecasts decreased prices with a 78 percent accuracy rate.
4 Candlestick Patterns of Continuation
If a candlestick pattern does not signal a shift in the market's direction, it is referred to as a continuation pattern. These can assist traders in identifying a time of market rest when there is market hesitation or neutral price movement.
Doji Pattern
The Doji pattern is a reversal pattern that can be bullish or bearish based on the preceding candles' background. The candle has the same (or nearly the same) open and closing prices with extended shadows. It resembles a cross; however, it can also have a petite body. A Doji is a symbol of indecision and a metaphorical line in the sand. Due to the fact that the Doji candle is often a reversal candle, the direction of the preceding candles might provide an early indicator of the direction of the reversal.
Suppose the preceding candles are bullish before the Doji formation. In that case, the next candle closes below the body low, triggering a sell/short-sell signal on the break of the Doji candlestick lows with trailing stops above the Doji highs.
If the preceding candles have been bearish, the Doji candlestick will almost certainly form a bullish reversal. Long triggers are formed above the body or candlestick high and have a trailing stop below the Doji's low.
Spinning Top Candlestick
In the spinning top candlestick pattern, the wicks are equal in length, and the body is located in the middle of them. There was no meaningful movement in the price, as bulls drove the price up and bear drove it down. Consolidation or rest periods following a large rally or drop are sometimes seen in spinning tops.
However, even though the spinning top is a very innocuous indicator in and of itself, it can be seen as a sign that the current market pressure is losing its grip.
Falling Three Methods
Whether it is bullish or bearish, the continuation of a current trend can be predicted using three unique pattern-creation processes.
Falling three techniques' refers to bearish patterns. Long red bodies make up the rest of it, three little green bodies and another red body — the green candles are all contained inside the bearish bodies' range. It demonstrates to traders that the bulls lack the necessary strength to reverse the trend.
Rising Three Methods
The bullish pattern, dubbed the 'rising three methods' candlestick pattern, is the inverse. Three short reds are placed between two long greens. The pattern demonstrates to traders that, despite some selling pressure, purchasers continue to maintain market control.
Summarization
Many of the reversal and continuation signals supplied by candlestick patterns fail to work reliably in today's computerized trading environment. Fortunately, Thomas Bulkowski's data show remarkable accuracy for a subset of these patterns, allowing traders to get essential buy and sell signals.
A brokerage account is required to put the insights obtained from studying candlestick patterns to use and invest in an asset based on them. To save time on research, Top1 Markets may be able to assist you in locating a beneficial investment.
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