Candlestick Chart Definition:
Candlestick charts are a type of technical tool that combines data from different time periods into single bars on a price chart. They are more useful than simple bars or lines because they provide more information. Candlesticks form patterns that can help predict the direction of prices. These patterns are enhanced by using different colors for the candlesticks. This tool originated from Japanese rice traders in the 18th century.
Candlesticks are useful for traders who make decisions over longer periods, like a day or more. Each candlestick represents a day’s worth of information and shows whether buyers or sellers were in control. A green or white candle means buyers won, while a red or black candle means sellers dominated. The interesting part is what happens between the opening and closing prices, as it shows the battle between buyers and sellers. This is why candlesticks are popular for analyzing charts.
- A candlestick patterns are tools that have been used for a long time in trading to guess which way prices will go.
- In simple terms, there are many different candlestick patterns that have names describing what they look like. Most patterns have a matching pattern in the opposite direction. For example, an “abandoned baby top” has a corresponding pattern called an “abandoned baby bottom,” and “tweezer bottoms” have a matching pattern called “tweezer tops.”
- Traders use extra technical indicators along with candlestick patterns to improve their trading strategy, especially when deciding when to enter or exit trades.
- Candlesticks use information about how prices have been moving in the past and present, but they cannot predict what will happen in the future.
How to Read a Candlestick Chart Pattern:
A daily candlestick shows the opening, highest, lowest, and closing prices of a market. The main part of the candlestick is a rectangle called the body. If the price dropped, the body is colored dark (red or black), and if the price increased, it’s colored light (green or white). The lines above and below the body are called wicks or tails, representing the highest and lowest prices of the day. By looking at these parts, we can often spot changes in the market’s direction or important potential moves. However, it’s important to confirm these signals with the next day’s candle.
Difference Between Foreign Exchange (FX) Candles and Other Markets’ Candles:
Here is a brief explanation of the differences between foreign exchange (FX) candlesticks, stock/exchange-traded fund (ETF)/futures, and all other candlesticks before we get into some specific candlestick patterns. The daily close of one day typically marks the start of the following day because the foreign exchange market is operating around-the-clock. Less gaps can be seen in the price patterns on FX charts as a result. Only on weekends when the Friday close and Monday open are different may FX candles display a gap.
Price gaps are a key component of the signaling power of many candlestick patterns, and those gaps should always be taken note of. When it comes to FX candles, one must exercise some creativity to identify a potential candlestick indication that might not exactly fit the conventional candlestick pattern. For instance, the upper wick rather than the body of the bearish engulfing line perfectly engulfs the previous day’s body in the illustration below from an FX chart. You can recognize some patterns with a little ingenuity, even though they may not follow a strict mathematical formula.
Types of Candlestick Patterns:
The examples below contain a number of candlestick patterns that excel as indicators of price movement and probable reversals. Each one predicts greater or lower costs based on the surrounding price bars. They also have two time-sensitive aspects:
- Whether it is an intraday, daily, weekly, or monthly chart being examined, they can only operate inside its parameters.
- Three to five bars after the pattern is finished, their potency rapidly declines.
Doji and Spinning Top:
A candlestick configuration known as a doji occurs when the open and closure are identical or nearly identical. A spinning top is quite similar to a doji, but has a much smaller body and an almost comparable open and close.
Both patterns point to market hesitancy since buyers and sellers have successfully engaged in a battle to a standstill. However, these patterns are crucial because they serve as a warning that the uncertainty will eventually pass and a new price trend will emerge.
Here are some visual examples of doji and spinning tops:
Bullish/Bearish Engulfing Lines:
An enveloping line is a reliable sign of a shift in direction. An uptrend reversal pattern is a bearish engulfing line. The important thing is that the body of the second candle “engulfs” the body of the first in the opposite direction. This implies that, in the case of an uptrend, the purchasers made a brief attempt to move higher but ultimately ended the day much below the close of the previous candle. This indicates that the upward trend is stagnating and has started to turn downward. Also take note of the candles from the previous two days, which displayed a reversal pattern known as a double top, or tweezers top.
The opposite of a bearish engulfing line, which also develops after a downturn, is a bullish engulfing line. Another corollary formation that signals a downtrend may be ending and is about to reversal higher is a double bottom, also known as a double bottom.
A hammer signifies the end of a downward move (hammering out a bottom). Noting the lengthy lower tail, which suggests that sellers attempted to sell again at a lower price but were unsuccessful, the price recovered much or all of the day’s losses. The key reading is that this is the first instance of buyers showing up strongly during the current down move, which points to a shift in directional mood. The following day’s bullish candle confirms the pattern.
A hanging man pattern is a corollary to a bullish hammer formation and indicates a significant probable lower reversal. The candle’s backstory is that selling interest has returned to the market for the first time in several days, creating a long tail to the downside. The outcome of the buyers’ resistance is a little, dark body at the candle’s top. A dark candle on the next day indicates that a short signal has been received.
Abandoned Baby Top/Bottom:
A significant pattern that indicates a significant reversal in the earlier directional migration is known as an abandoned baby, also known as an island reversal. After an upward movement, an abandoned baby top forms, whereas an abandoned baby bottom occurs after a downward trend.
An island-like candle with a little body (spinning top or doji) is left alone at the top or bottom of the pattern due to a gap in the direction of the current trend. A gap lower (abandoned baby top) on the candle of the following day confirms the previous gap higher’s erasure and the emergence of selling interest as the key market factor. The following day, confirmation is accompanied with a long, black candle.
Take Special Note of Long Tails and Small Bodies:
Candlesticks with a small body, like a doji, show that buyers and sellers were unable to reach a consensus, leaving the close almost exactly at the open. (Such a candlestick might additionally have a very small body, resembling a spinning top.) Small bodies are a symbol of the market’s uncertainty on its current course.
Due to the possibility that the directional movement (up or down) may have peaked, it is suggested that such little bodies are frequently reversal signs. Because eventually one of the bulls or the bears will prevail, it is important to take careful note of significant indecision candles. Now is the moment to observe price movement while keeping your options open in case the market decides to make a move.
Long tails are another important candlestick indicator to look out for, especially when they’re coupled with small bodies. Long tails signify a failed attempt by buyers or sellers to move the price in their preferred direction, which causes the price to fall back to close to the open. The doji pattern below, which represents an attempt to rise higher and lower but failing to do so, is an example of just such a pattern. This follows a move higher, indicating that the following move will be downward.
Which candlestick pattern is most reliable?
Different traders favour various patterns and consider them to be the most trustworthy. Bullish/bearish engulfing lines, bullish/bearish long-legged doji, and bullish/bearish abandoned baby top and bottom are a few of the most well-known patterns. Numerous neutral potential reversal indications, such as doji and spinning tops, will manifest in the interim and should alert you to the impending direction of the trend.
Does candlestick pattern analysis really work?
Yes, candlestick analysis can be successful provided you adhere to the principles and wait for confirmation, which typically comes in the candle of the following day. Candlestick analysis is a popular tool used by traders all over the world, especially those based in Asia, to identify the general market trend rather than the direction in which prices will be in two to four hours. Daily candles operate better than temporary candlesticks because of this.
How do you read a candle pattern?
The best way to read a candle pattern is to determine if it is bullish, bearish, or neutral (undecided). The process of seeing a candlestick pattern emerge can be tedious and time-consuming. You have a basis for making a trade when you spot a trend and have confirmation of it. Avoid detecting patterns where none exist. You will ultimately receive a high-probability candlestick indication if you let the market run its course.
The Bottom Line:
Candlestick analysis has been used for decades and is effective because traders employ it, just as other types of technical analysis. Candlesticks are a stand-alone type of charting analysis, while they can be integrated with other technical analysis techniques like momentum indicators.
The best approach to observe a candlestick chart is using daily candlesticks because they show price movement and market data for the entire day. If you choose to employ shorter-term candles, keep in mind that their meaning only holds true for a small number of the time periods you select. For instance, a four-hour candle pattern is only reliable for a small number of four-hour time periods.
Individual candles, such as dojis, as well as multi-candle patterns, such as bullish/bearish engulfing lines, bullish/bearish abandoned infants, and bullish hammers/bearish hanging man patterns, can be used to identify candlestick signals. Although following candles are frequently required for confirmation in order to spot a specific pattern and place a trade based on it, candlesticks are excellent indicators that look ahead. Candlestick formations in particular commonly emit indications of hesitancy, warning traders of a probable change in direction.
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