History
Candlestick charts can be traced back to technical analysis used by the Japanese who began using chart patterns to trade rice in the 16 hundreds. Candlestick charting began to appear sometime in the late 1800’s in a form that is somewhat similar to what is currently used today. Much of the credit for candlestick development and charting goes to a legendary rice trader named Homma from the town of Sakata.
Definition
A Candlestick bar is derived from price points that contain an open, high, low and close value for the period needed to display. The body of the candlestick is the hollow or filled portion, which is the middle of the candle. The thin lines above and below the body are the shadows, wicks or tails. The high price for a given period is marked at the top of the shadow (wick) and the low is at the bottom of the shadow (tail).
When a financial asset like a stock or commodity closes higher than the opening price, the body of the candle is drawn as either hollow (or green). The top of the body is the closing price and the bottom of the body represents the opening price. If the inverse is true, where the closing price is lower than the opening price, the body of the candle is filled (or red). In this situation, the top of the body is the opening price and the bottom of the candle is the closing price.
Compared to traditional bar charts, many traders consider candlestick charts more visually appealing and easier to analyze. Each candlestick provides a clear picture of price action. When looking at a chart, a trader can compare the relationship between the open and close as well as the high and low. The relationship between the open and close is considered very important information and this forms the essence of candlesticks. Hollow (or green) candlesticks, where the close is greater than the open, indicate buying pressure. Filled candlesticks (red), where the close is less than the open, indicate selling pressure.
The shape and size of the Candlestick (or the open, high, low and close), gives insight into the intensity of the price action over a given period. The longer the body of the Candlestick, the more intense the buying or selling pressure during the course of the period of trading. Conversely, short candlesticks indicate low volume, little price movement and consolidation.
Long hollow (green) candlesticks represent strong buying pressure. The longer the hollow (green) candlestick is, the greater the distance between the opening price and the closing price. This indicates that prices increased from open to close and buyers were aggressive in purchasing the financial asset. While long hollow (green) candlesticks are generally bullish, much depends on their position relative to other candlesticks and the broader technical picture. After robust declines, long hollow (green) candlesticks can indicate turning point for the market or support levels. If buying gets too aggressive after a long advance, it can lead to excessive bullishness and overbought conditions.
Long red candlesticks indicate strong selling pressure. The longer the red candlestick the greater the distance between the opening prices and the closing price. This indicates that sellers were aggressive in selling or short a financial asset. While long red candlesticks are generally bearish, much depends on their position relative to other candlesticks and the broader technical picture. After robust increases, long red candlesticks can indicate turning point for the market or resistance levels. If sellers get too aggressive after a long decline, it can lead to excessive bearishness and oversold conditions.
Although individual candlesticks can give a trader an idea of the current day’s price action, it is the combination of candlesticks that create a robust technical picture.
Candle Stick Variations:
The price action with a given period creates numerous variations of price bars, which in turn form specific types of Candle Sticks. Hollow bodies are generally bullish for price action while long red shaded bodies are bearish for price action. A shadow, which is the wick or the tail of the Candle Stick, reflects different information.
The upper and lower shadows on candlesticks can provide pertinent trading information about the price action. Upper shadows represent the session high and lower shadows the session low. Candlesticks with short shadows indicate that most of the trading action is confined near the open and close. Candlestick with long shadows show that traded extended well past the open and close. When price action is either rejected from the high and lows with large shadows, a trader understands that the opening and closing prices are the areas of current supply and demand for that particular financial instrument.
Candlesticks with a long upper shadow and short lower shadow indicate that buyers dominated during the session, and pushed prices higher as demand was great then supply. However, sellers later forced prices down from their highs, as supply became great then demand, and the weak close created a long upper shadow. Conversely, candlesticks with long lower shadows and short upper shadows indicate that sellers dominated during the session as supply was initially great then demand, and drove prices lower. However, buyers later resurfaced to bid prices higher by the end of the session and the strong close created a long lower shadow.
Candlesticks with a long upper shadow, long lower shadow and small body are known as spinning tops. This type of price action displays consolidation since both the upside and the downside have been rejected. One long shadow represents a reversal of sorts; spinning tops represent indecision. The small real body shows little movement from open to close, and the shadows indicate that both bulls and bears were active during the session. Price action was active during the trading session, but neither longs nor shorts where able to gain an advantage. A long advance or long white candlestick, a spinning top indicates weakness among the bulls and a potential change or interruption in trend. After a long decline or long black candlestick, a spinning top indicates weakness among the bears and a potential change or interruption in trend.
In the world of Candle Stick charting, an open and close that equal one another is called a “Doji”. When and open and closing price are almost the same (virtually equal), they will also be referred to as a Doji. The length of the upper and lower shadows can vary and the resulting candlestick looks like a cross, inverted cross or plus sign. Alone, doji are neutral patterns. Any bullish or bearish bias is based on preceding price action and future confirmation. The word “Doji” refers to both the singular and plural form.
Long-legged Doji have long upper and lower shadows that are almost equal in length. These Doji reflect a great amount of indecision in the market. Long-legged Doji indicate that prices traded well above and below the session’s opening level, but closed virtually even with the open. The longs had control of the market for a while, but higher prices were rejected. Additionally, shorts had control of the trading session for a while, but lower prices were also rejected. Supply and demand for this particular financial asset are equal, thereby forming a Doji pattern.
The relevance of a Doji depends on the preceding trend or preceding candlesticks. After an advance, or long white candlestick, a Doji signals that the buying pressure is starting to weaken. After a decline, or long red candlestick, a Doji signals that selling pressure is starting to diminish. Doji indicate that the forces of supply and demand are becoming more evenly matched and a change in trend may be near. Even after the Doji forms, further downside is required for bearish confirmation. This may come as a gap down, long red candlestick, or decline below the long white candlestick’s open. The reverse is also true. Even though the bears are starting to lose control of the decline, further strength is required to confirm any reversal. Bullish confirmation could come from a gap up, long white candlestick or advance above the long black candlestick’s open.
Dragon fly Doji form when the open, high and close are equal and the low creates a long lower shadow. The resulting candlestick looks like a “T” with a long lower shadow and no upper shadow. Dragonfly Doji indicate that sellers dominated trading and drove prices lower during the session. By the end of the session, buyers resurfaced and pushed prices back to the opening level and the session high. This is a sign of a reversal, but will also need confirmation.
The robust nature of Candle Stick charting focuses on the ability of a trader or investor to analyze combinations of Candle Stick pattern. Patterns show up as reversals or continuations, and can assist a trader immeasurably in defining the current trading environment.
The Hammer pattern and the Hanging Man pattern are two examples of bullish and reversal patterns. These patters look similar, but have different implications based on the preceding price action. Each pattern has small bodies (hollow or red), long lower shadows (tails) and short or non-existent upper shadows (wicks).
The Hammer is a bullish reversal pattern that forms after a decline in prices. A Hammer pattern can be used to initiate a new position, but can also be used as a risk management tool, and help a trader exit an existing position. After a decline in prices, a hammer will signal a bullish revival. The low of the long lower shadow implies that sellers drove prices lower during the session. However, the strong finish indicates that buyers regained momentum at the end of the session and finished on a strong note. While this may seem enough to act on, hammers require further bullish confirmation. The low of the hammer shows that plenty of sellers remain. Further buying pressure, and preferably on expanding volume, is needed before acting. Such confirmation could come from a gap up or long white candlestick. Hammers are similar to selling climaxes, and heavy volume can serve to reinforce the validity of the reversal.
The Hanging Man is a bearish reversal pattern that can also mark a top or resistance level. A Hanging Man forms after an increase in prices. A Hanging Man signals that selling pressure is starting to increase. The low of the long lower shadow confirms that sellers pushed prices lower during the session. Even though the bulls regained their footing and drove prices higher by the finish, the appearance of selling pressure raises the yellow flag. As with the Hammer, a Hanging Man requires bearish confirmation before action. Such confirmation can come as a gap down or long black candlestick on heavy volume.
Within the world of Candlestick charting there are numerous patterns that create bullish and bearish signals. Some of these patterns signify a reversal, while others constitute a break out or the continuation of a trend. Below are a few patterns that can easily be recognized.
An Engulfing Pattern is a reversal pattern that can be bearish or bullish, depending upon whether it appears at the end of an uptrend (bearish engulfing pattern) or a downtrend (bullish engulfing pattern). A small body, followed by a day whose body is completely engulfed by the previous day’s body, characterizes the first day. In a bullish engulfing pattern, the prior day is usually down, and the engulfing day is usually hollow signifying a positive close. For a bearish pattern, the opposite occurs. The prior day is
A Piercing Line is a bullish two-day reversal pattern. The first day, in a downtrend, is a long red day, where the close is lower than the open. The next day opens at a new low, and then closes above the midpoint of the body of the first day.
A Harami is a two-day pattern that has a small body day completely contained within the range of the previous body, and is the opposite color.
Morning Doji Star is a three-day bullish reversal pattern that is very similar to the Morning Star. The first day is in a downtrend with a long black body. The next day opens lower with a Doji that has a small trading range. The last day closes above the midpoint of the first day.
An Abandoned Baby is a rare reversal pattern characterized by a gap followed by a Doji, which is then followed by another gap in the opposite direction. The shadows on the Doji must completely gap below or above the shadows of the first and third day.
Patterns can form with one or more candlesticks; most require bullish confirmation. The actual reversal indicates that buyers overcame prior selling pressure, but it remains unclear whether new buyers will bid prices higher. Without confirmation, these patterns would be considered neutral and merely indicate a potential support level at best. Bullish confirmation means further upside follows through and can come as a gap up, long white candlestick or high volume advance. Because candlestick patterns are short-term and usually effective for only 1 or 2 weeks, bullish confirmation should come within 1 to 3 days after the pattern.