More than 300 years ago a Japanese rice trader Munehisa Homma introduced a new visual display of the price action that considered the data on open, high, low, and close price within a particular period of time. It is exactly when the candlestick concept was born. An approach swiftly gained popularity and became a base for a wide range of strategies. For example, Steve Nison revolutionized the world of technical analysis with his book called Japanese Candlestick Charting Techniques (1991). Since then, a wide range of traders, regardless of trading styles and markets they operate on, use candlestick charts and patterns that enable them to get more detailed information on price action and interaction between buyers and sellers in the market. Thus, understanding candlesticks is a must for any trader. And this article is a starting point to candlestick analysis.
First of all, let’s get a general understanding of what a single candlestick says. To start with, a candlestick gives a brief report on price dynamics during a particular period of time. Each candlestick indicates 4 data points of the price:
Candlestick body indicates the open-to-close range:
- Open — The opening price of the time period
- Close — The closing price of the time period
Candlestick shadow (wick) represents the highest and lowest price levels:
3. High — The highest price over the time period
4. Low — The lowest price over the time period
Colour of a candlestick displays the price momentum within a fixed period of time.
- Greed (bullish) candlestick means that the opening price was lower than the closing price. It is a sign of buyers’ pressure (there were more buyers than sellers in the market during this period of time), therefore, the price is growing.
- Red (bearish) candlestick tells that the opening price was higher than the closing price (indicated the pressure of sellers).
You can use candlesticks across various time frames. It can be short (from 1 to 45 minutes), middle (from 1 hour to 12 hours) and long term (from 1 day to a year). For example, if you use a weekly chart, a candle indicates Monday’s open, Friday’s close and the highest and the lowest prices of the week. Note please, that Monday-Friday time frame is used only on traditional financial markets, while cryptocurrency exchanges are open 24/7, and the market never stops. It means that each week a new candle will appear on the chart.
Thus, even a single candle provides a trader with valuable information on price dynamics. At the same time, combinations of candlesticks (also called candlestick patterns) are a more powerful tool of technical analysis that can reveal the possible market movements, for example, reversal and continuation. We’ll consider the most widely-used of them, but before, it’s important to study when candlestick patterns are likely to provide accurate signals. So, the three major rules for effective candlestick analysis are the following:
- Previous trend. Obviously, a signal of reversal and continuation should be applied within the trending market. Generally, candlestick patterns don’t anticipate significant changes in a flat market.
- Volume. With the price reversal or strong trend continuation, a volume tends to increase (volume indicated an interest in a particular asset). Therefore, it’s worth taking volume into account while analyzing candlestick patterns.
- Confirmation. To make sure the pattern works, we also recommend you to wait for the pattern confirmation, for example, the next candle that confirms the market direction
Furthermore, please note that candlestick patterns are likely to provide you an “edge” in trading only if you use them within a complex trading system. In other words, candlestick patterns rather serve as additional signals to supplement and confirm your trading setup.
So, keeping these rules in mind, let’s observe some of the patterns, starting from the signals of reversal.
Reversal candlestick patterns
Reversal candlestick patterns signify that the market is likely to change the direction. Hence, a reversal pattern in a bullish market means that sellers are becoming dominant. Therefore, the supply may exceed the demand and cause a downward trend. In a bearish market, a reversal pattern means that the demand exceeds supply and the price is likely to increase.
As for the patterns themselves, they look alike for both bullish and bearish markets, but represent a mirror image of each other. Let’s start with hammer and shooting star:
Hammer and Shooting Star
Hammer: rejection of lower prices
Hammer is a reversal pattern that signals a probable price uptrend after a bearish market. It consists of one candle with a long bottom shadow (generally, about 3 times longer than the body) and without an upper wick (or extremely short).
Great, but what’s behind? Simply, the upcoming pressure of buyers. Before the market closes, sellers are taking control and pushing the price lower (shadow). However, the strong buying pressure is stepping in and pushing the price higher, making the closing price higher than the opening price. Thus, the lower prices are rejected and the market is likely to trend up.
Shooting Star: rejection of higher prices
On the flip side, if you see a Shooting Star (mirror image of a hammer) in the bullish market, you may expect the price to decline. The same way, after the price increase, the sellers take control of the market (overwhelm buyers’ pressure) and result in the closing price lower than the opening price.
Bullish and Bearish Engulfing Patterns
Bullish Engulfing Pattern
Bullish Engulfing Pattern consists of 2 candles that may be a signal of the upcoming upwards trend. The first bearish candle of the pattern is “covered” by the body of the second one.
Now let’s break down what happens behind the scenes. During the first candle formation, the sellers are still controlling the market. Thus, the closing price is lower than the opening one. But on the second candle, a strong buying pressure comes into the market and closes the period above the high of the previous candle, starting a probable bull rally.
Bearish Engulfing Pattern
Bearish Engulfing Pattern, on the other hand, consists of the bullish candle “covered” by the longer body of the bearish candle. In this case, the sellers steal the show and close the market below the high of the previous candle. Demand overwhelms supply, making the price decline.
Morning Star and Evening Star
Morning Star: bull rally sign
Morning Star is a reversal pattern that indicates a potential bull rally after a downwards trend. The pattern consists of 3 candles. The first one (bearish) is followed by a small candle with a short body and shadows (it can be either bullish, or bearish). The third candle is bullish and closes at least halfway up the first candle.
So, in this case, the first candle says that sellers control the market, however, the second candle indicates that the buyers are already strong enough and push the market upwards. In this war buyers finally win, forming the third long bullish candle that is possibly a start of the bull rally.
Evening Star: bear rally sign
In the case of the Evening Star pattern, the market dynamics is the opposite. After a bullish trend, the buyers’ power is weakening. Thus, the pressure of bulls and bears stays in equilibrium for some time (the second candle), however, finally, sellers win the battle (at the third long bearish candle) and push the price upwards.
Thus, the candlestick patterns may show you what is hidden behind the price, revealing the interaction between buyers and sellers. We considered the major reversal patterns that signify the possible change of the market direction. However, candlestick patterns can also confirm the current trend, acting as a signal for its further development. These patterns are called continuation patterns. Let’s review some of them:
Continuation candlesticks patterns
Rising Three Method and Falling Three Method
Rising Three Method
Rising Three Method is a bullish trend continuation pattern that signals that the market is likely to continue trending higher. Generally, it consists of 5 candles (the number may vary). The first large bullish candle is followed by 3 short bearish candles with a small range. These candlesticks usually do not exceed the high or the low of the first candlestick. The fourth candle is green and usually is closed at least at the same level as the first candle of the pattern (or above).
Let’s translate the candles’ language into the actions of market participants. The first candle means the buyers’ power and overall bullish sentiment in the market. The next three candles indicate that the sellers are trying to seize power, pushing the market down bit by bit. However, the buyers are still strong and successfully resist the pressure. This way, the sellers fail to break the resistance (the high of the first bullish candle) and the market moves upwards again.
Falling Three Method
Falling Three Method is the opposite of the Rising Three Method. The first bearish candlestick (a continuation of downwards trend) signifies the current sellers’ pressure. It is followed by a group of small body candlesticks, slowly ascending within the price range of the first candle (buyers are trying to take the market over). Finally, the last candlestick of the pattern closes below the closing price of the first day, meaning that the sellers still dominate the market (so, you may expect a bearish trend).
Thus, being one of the oldest types of charts, candlestick charts can help you understand the actions of market players and navigate the waters of trading with more precise price action analysis.
However, please remember that to make candlestick patterns indeed a powerful tool, it’s recommended to use them in a well-rounded strategy along with other technical analysis patterns, indicators, and trading setups. This way, candlestick analysis might become a trading treasure that helps make meaningful decisions.
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