Candlestick charts were developed in Japan during the 18th or 19th century. Introduced to the West by Steve Nison, candlestick charts can be used by investors and financial institutions for all time frames and markets. Day traders and long-term investors use them for the stock, forex, futures or commodity markets, and candlestick charts “can be a powerful trading tool for option trading,” Nison says.
This charting technique is complex, yet common. Investors and financial professionals should learn how to read candlestick charts to help gain insights into market trends.
Why use candlestick charts?
The basis for candlestick chart analysis is to measure market emotions surrounding a stock, according to Investopedia. By merging Western and Eastern analysis, candlestick charts provide timing and trading benefits unavailable to traditional Western charting techniques.
“While a line chart gives you only one data point (normally the close price) for a stock at any point in time, candlesticks actually give you five: open, close, low, high and direction of movement,” says TheStreet contributor Jonas Elmerraji. “That’s a significant advantage when your trading decisions are based entirely on price action.”
Like bar charts, candlestick charts show the trend of the moves. “But, unlike bar charts, candlestick charts also show the force underpinning the move,” Nison says. Candlestick charts offer a market perspective that other charting methods cannot provide.
Basic components of a candlestick chart
Each candlestick or candle represents a session — typically one day. The following diagram helps visualize the themes and data required to read candlestick charts.
- Upper or lower shadow: Displayed when a high or low price swing falls outside of the opening or closing price.
- Real body: The range between the opening and closing trades.
- Color: Body is white (or unfilled or green) if price closed higher (increasing or bullish). Body is black (or filled or red) if price closed lower (decreasing or bearish).
- High: Highest price for the day (or period of time charted).
- Open: Opening price.
- Close: Closing price.
- Low: Lowest price for the day (or period of time charted).
Candlestick chart patterns
There are dozens of identified candlestick chart patterns, ranging from simple one-candle patterns to more complex multiple-candle formations. Investors can apply some of these patterns to trading to help determine market trends and emotions.
Doji: A doji pattern forms when opening and closing prices are nearly the same, eliminating the appearance of a real body. It can indicate that the market’s trend is losing momentum.
Dragonfly Doji: This doji pattern forms when equal opening and closing prices occur at the high of the day. It typically indicates indecision and a market trend nearing a major turning point.
Gravestone Doji: This doji pattern forms when equal opening and closing prices occur at the low of the day. Like the dragonfly doji, it typically indicates a market trend nearing a major turning point.
Long-Legged Doji: This doji pattern forms when opening and closing prices are equal, despite a lot of price movement throughout the trading period. It indicates indecision and can be significant during a strong uptrend or downtrend, where the long-legged doji suggests a shift in the direction of the market trend.
Big Black Candle: Defined by an unusually long black body with a wide range between the high and low closing prices. It is a bearish pattern.
Big White Candle: Defined by an unusually long white body with a wide range between the high and low closing prices. It is a bullish pattern.
Marubozu: A marubozu is a candlestick with no shadows, which means that pricing stayed between the opening and closing prices. A marubozu is a continuation pattern; a white marubozu is bearish and a black marubozu is bullish.
Abandoned Baby: The abandoned baby candlestick pattern is a reversal pattern that can be bullish or bearish. It consists of three candles. In the bullish abandoned baby pattern, the first candle is a long bearish candle, the second candle is a small bearish candle or doji and the third candle is a long bullish candle. This pattern (bullish version) predicts higher prices with a 70 percent accuracy rate, according to Thomas Bulkowski in Encyclopedia of Candlestick Charts.
Three Black Crows: The bearish three black crows pattern is a reversal pattern that starts at or near the high of an uptrend. The pattern is defined by three consecutive black long-bodied candles that close lower than the previous day (or period), and each session’s open occurs within the body of the previous candle. This pattern predicts lower prices with a 78 percent accuracy rate.
Evening Star: The bearish evening star pattern is a reversal pattern that starts within an uptrend. The pattern starts with a large white candlestick and is followed by a small-bodied white or black candle that closes above the first white candle. The final candle is a large black candle that opens below the middle candle and closes near the center of the first candle’s body. This pattern predicts lower prices with a 72 percent accuracy rate.
Three Line Strike: The three line strike pattern is a reversal pattern that occurs within a downtrend and predicts a bearish recovery. It starts with three black candles that each post a lower low. The fourth candle opens even lower but reverses, creating a white bar that closes above the high of the first candle in the series. This pattern predicts higher prices with an 84 percent accuracy rate.
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This post originally appeared Grace College Online.