The origins of candlestick charting can be traced to the rice futures markets of 18th-century Japan. A merchant and trader named Honma Munehisa from the town of Sakata is widely credited as the father of this unique charting method. Steve Nison learned about candlesticks from a Japanese broker and popularised candlestick charting in the West in the 1990s. Since then, Japanese candlesticks have grown to be one of the most popular charting forms among traders worldwide.
What are Candlestick Patterns?
Japanese candlesticks charts show the open, close, high, and low price points for a given time period. They are easy for traders to read because a different colour is used to depict whether the price rose or fell during the set period. Candlesticks are formed on a chart as follows:
- Candlesticks where the price closed higher than the open are colored green (or white) in the area between the open and close.
- Candlesticks where the price closed lower than the open are colored red (or black) in the area between the open and close.
- This area between the open and close is called the ‘real body.’
- The marks above and below the real body are called ‘shadows’ or ‘wicks.’ These show the high and low prices of the given time period.
Candlesticks patterns are used by traders to gauge the psychology of the market and as potential indicators of whether price will rise, fall or move sideways.
- Some patterns are referred to as bearish in that they suggest that price may fall.
- Others are viewed as bullish and an indication that price may rise.
- Some candles simply reflect indecision among market participants.
- Patterns may be identified by a single candlestick or in some cases a series of specific candlesticks.
Candlestick charting can be used on all time frames, whether you are using a 1-minute chart or a monthly chart to do your analysis. Candlestick patterns for day trading are the same as those used for swing trading and long-term investing. Likewise, stock candlestick patterns are the same as those used for analysing futures, forex, or cryptocurrencies. The principles of candlestick charting apply across different time frames and markets. Some traders base their entire strategy on trading candlestick patterns and avoid complex technical indicators.
How to Read Candlestick Patterns
Understanding candlestick patterns can help you get a sense of whether the bulls or the bears are dominant in the market at a given time. Candlestick charts give traders an easy-to-read snapshot of the psychological stance of market participants.
This idea of reading market psychology from Japanese candlestick patterns may seem far-fetched, but there is really no mumbo jumbo going on. Candlesticks simply show what price did in a set period. Looking at the relationship between the open, close, high, and low clearly indicates something about the relative confidence of buyers and sellers and the psychological undercurrent of the market. Having an understanding of this, while other traders do not, arguably gives you an edge.
Here are some of the things that candlesticks can tell you about the market at a glance:
- Long-bodied green candles tell you that there was a significant bullish move and strong buying pressure.
- Long-bodied red candles show that there was a significant bearish move and strong selling pressure.
- A long-bodied candle without a wick is called a Marubozu pattern. A green (or white) Marubozu forms when the opening price is the low of the period, and the closing price is the high of the period. This pattern suggests that the buyers (bulls) are firmly in charge. The opposite, when the opening price is the high of the period and the closing price is the low, indicates that sellers (bears) have the upper hand.
- Short-bodied candlesticks show a lack of bullish or bearish price movement and reflect a period of consolidation, where neither buyers nor sellers dominate.
- Candlesticks with a long upper shadow (wick) indicate that the buyers dominated for part of the period, but were later overcome by sellers.
- Candlesticks with a long lower shadow (wick) reflect that the sellers were in control but were overwhelmed by buyers before the end of the period.
- Candlesticks with a long upper and lower shadow (wick) show that both buyers and sellers made advances, but neither could end the period with a firm advantage.
What is a Reversal Candlestick Pattern?
Reversal candlestick patterns indicate that a change in the prevailing price trend may be imminent. A reversal pattern in an uptrend suggests that prices could turn lower. Conversely, a reversal pattern in a downtrend indicates that prices may start trading higher.
What is a Continuation Candlestick Pattern?
Continuation patterns are the opposite of reversal patterns. They suggest that price will continue moving in the same direction. A continuation pattern in a downtrend suggests that price will fall further. A continuation pattern in an uptrend indicates that price will continue to rally higher. Marubozus are an example of a continuation pattern.
Bullish Candlestick Patterns
Bullish candlestick patterns suggest that the buyers (bulls) are in charge and that price will move higher.
Here are some of the most popular bullish candlestick patterns:
The Hammer Pattern is a single candlestick bullish reversal pattern that forms in a downtrend and has a short body with a long lower shadow (wick). The shadow should be at least twice the height of the body. The long lower shadow shows that after sellers took price to a new low level, they were forced to retreat as buyers came in and drove prices right back up to close near the open.
The Bullish Engulfing Pattern is a two-candlestick reversal pattern that takes place in a downtrend. The first candle is small-bodied and bearish (red/black). The second candle is bullish (green/white) with a real body that is large enough to contain (engulf) the real body of the first one.
The Morning Star Pattern is a three-candlestick bullish reversal pattern. It begins with a long-bodied bearish (red/black) candlestick. This is followed by a short-bodied candle that gapped lower on the open. The pattern is completed by a long-bodied bullish (green/white) candlestick that gapped higher on the open.
Bearish Candlestick Patterns
Bearish candlestick patterns indicate that the sellers (bears) are in control and that price may move lower.
The following are some of the most popular bearish candlestick patterns:
The Shooting Star Pattern is a single candlestick bearish reversal pattern that forms in an uptrend and has a short body with a long upper shadow (wick). The shadow should be at least twice the height of the body. The long upper shadow shows that after buyers took prices to a new high, they were forced to retreat as sellers came in and drove prices right back down to close near the open. The Shooting Star is the opposite of the Hammer and is often viewed as one of the best candlestick patterns.
The Bearish Engulfing Pattern is a two-candlestick reversal pattern that takes place in an uptrend. The first candle is small-bodied and bullish (green/white). The second candle is bearish (red/black) with a real body that is large enough to contain (engulf) the real body of the first one. Bearish Engulfing is the opposite of Bullish Engulfing.
The Dark Cloud Cover Pattern is a bearish two-candle reversal pattern. The first candlestick is long-bodied and bullish (green/white) and takes place during an uptrend. The next candlestick opens at a new high but closes below the midpoint of the body of the first candlestick in the pattern. The fact that sellers are able to drive price to close below the middle of the first candle represents a psychological victory for the bears. Dark Cloud Cover is the opposite of the Piercing Line pattern.
Some patterns simply reflect indecision in the market. The Doji candlestick pattern is a single candlestick pattern that forms when the opening price and the closing price are equal. This suggests that neither bulls nor bears could dominate during that period. Dojis on their own are viewed as neutral patterns. They also form a part of some multiple-candlestick patterns, such as the Tri-Star pattern, for example.