Out of all the charting tools used in trading, the candlestick chart is probably the most popular and the most important to know for day traders. You can use candlesticks when trading forex, looking for investment patterns on the stock market, buying cryptocurrencies, or when trading on any other market. Candlestick charts are versatile tools that you should try to master, and the following guide provides a comprehensive introduction.
Here’s What You Need to Know
- Candlestick patterns have been used to predict market trends for hundreds of years. The chart was first invented in Japan but is now widely used all over the world for every available market.
- There are multiple patterns that one needs to learn in order to fully take advantage of candlestick charts. On this page, we will walk you through several of them.
- Like any investment strategy, one should not only rely on candlestick patterns to plan their investments but instead always combine them with other analytical strategies, both fundamental and technical.
The History of Candlesticks
Candlesticks were invented close to 400 years ago in Japan by a man named Homma. This man had dedicated his life to rice production and trading, and in his career he made a revolutionary discovery.
Before Homma’s discovery, it was well known that the price of rice was controlled by supply and demand, just like any product in our society. However, Homma started to notice that investors’ psychology also affected the price and that you could predict how the price would develop by studying how much or how little people were trading.
What Homma had discovered was that investors’ emotions influence market prices in the short term and he managed to create a brand new chart that demonstrated investor trends.
About 100 years after Homma’s discovery a charting tool called bar charts was invented in the West, and it has many similarities to candlestick charts.
How Do Candlestick Charts Work?
Unlike regular charts that only show one price for each asset, a candlestick shows the opening price, the closing price, as well as the highest and lowest price. The candlestick chart is made up of several vertical bars with a line sticking out at the top and bottom of each bar.
The wide part of each bar is called the body or the “real body,” and it represents the asset’s price development. If the bar is black, red, or filled with another darker color it means the asset is bearish and that the closing price was lower than the opening price. If the body is not filled (white) or green, it means the asset is bullish and that the closing price was higher than the opening price.
There is also a line sticking out of the body on each side called a “wick” or a “shadow.” The top wick represents the highest price while the bottom wick represents the lowest price.
In addition, there is a candle called a “doji” which happens when the opening and closing price is virtually the same. A doji results in the candle looking like a cross with the real body being a horizontal line.
For the sake of being as clear as possible, we will use black and white for the bodies in our examples for this article.
Candlestick Patterns and How To Use Them
Generally speaking, a candlestick chart shows a month or more where every candle represents one trading day. In fact, a candle per day is the absolute most common setup, but there are a few exceptions where the candles can represent one hour or even a full week.
At first glance, a candlestick chart can seem rather chaotic, and the candles might look completely random, but that’s not necessarily true. Not every single candle in a candlestick chart provides useful information, but sometimes you can find patterns in the charts that show what’s about to happen.
Your goal is to learn what these patterns look like and then use them to predict the market and hopefully make profitable trades. Below we’ve provided examples of some of the most basic patterns that you can get started on.
Hanging Man and Hammers
These two patterns are some of the easiest to learn since they only include one candlestick. They are characterized by having small real bodies with tiny to no top wick and a bottom wick that is at least twice the length of the real body.
A hanging man is a bearish candle pattern that forms at the end of an upward trend indicating that the price is about to decrease. On the other hand, a hammer is a bullish candle pattern in a downward trend indicating that the price is about to increase.
Note that a hanging man and a hammer look identical with the exception of the color of the body.
An evening star is a bearish pattern that indicates that buyers have stopped investing and that increased selling could happen, thus a decrease in price. This pattern is characterized by a large black or white body opening below a very small previous real body.
Bullish and Bearish Engulfing Patterns
An engulfing pattern can be either bullish or bearish showing that sellers or buyers have taken control and that the price is about to increase or decrease.
A bullish engulfing pattern is created in a downward trend where a long white candle is much bigger (engulfing) than the previous small body, meaning the price is likely to increase.
A bearish engulfing pattern is characterized by a long black candle engulfing the previous small white real body.
Harami patterns are not really used to take decisions but are patterns that you should keep an eye on since they can indicate the start of a pattern. You can decide how to act depending on how the market develops after the pattern. Moreover, a harami pattern can either be bullish or bearish and graphically it looks like the complete opposite of an engulfing pattern (see above).
- A bullish harami pattern develops when a small white real body is completely inside the previous day’s black real body, i.e. the previous day’s bearish body is much bigger than the current bullish body. If the following day is bullish, it indicates that more growth is to be expected.
- A bearish harami pattern occurs when a small black body is completely covered by the last day’s large bullish body. If the next day is bearish, the market is set to decrease further.
- A harami pattern can also be characterized by either a downward or upward trend being followed by a doji completely inside the last day’s body which indicates that the market is turning. This is referred to as a Harami Cross Pattern.
Rising Tree and Falling Trees
This is one pattern spread out over five days where the bullish version is called a rising tree and the bearish pattern is called a falling tree and it works the following way.
On day one you have a large bullish candle and on day two, three, and four, you have smaller bearish bodies that all fit within the first day’s body without reaching a new low, followed by a large bullish candle on day five. Even though the three middle days are a downward trend, the two large bullish candles indicate that there is traction on the market and that the price will continue to increase.
A falling tree is the complete opposite of a rising tree. On day one you have a large bearish candle followed by three small bullish bodies within the first day’s body, followed by another large bearish candle. Naturally, this pattern shows that the market is losing traction and that the price is about to decrease.
Trading Strategies Using Candlesticks
As always, a technical analysis should consist of several indicators and only relying on one candlestick pattern is not enough to accurately predict the market. That being said, if you can learn how to find candlestick patterns on the market and then cross-check that data with another tool, you will be on your way to making more successful trades. In fact, knowing and understanding how candlesticks work is essential for any day trader’s strategy, and it’s something you need to master.
We suggest you start by immersing yourself in the above-mentioned patterns before you continue to develop your analytical skills further.
A Summary of Candlestick Charts and Patterns
For the past 400 years, traders have used candlestick charts on the world’s markets to look for trend patterns to base their investments on. Compared to other charts, the candlestick chart is one of the most detailed in terms of the information it provides the investor with. Due to the amount of information in each chart, one can study many different patterns and take advantage of several price developments. The more patterns you as an investor know, the better your chances of predicting the market will be.