How to Read Candlestick Charts
Candlestick charts are among the most popular of charting styles followed by traders today.
However, they have a distinguished history that dates back to the early part of the 18th century.
Candlestick notation was developed by Japanese rice merchants who were keen to be able to track and record price movements in a most important commodity. Ultimately these merchants would use their accumulated knowledge to make predictions about what should happen to rice prices in future. The style of notation that we would recognise today came into existence in the later part of the 19th century. But it would be another 100 years before candlestick analysis would cross the Pacific ocean, to reach the west and its financial markets.
The first major western work on the subject was published by Steve Nison in 1991 and again in 2001. Nison is a highly respected technical analyst, and he is considered by many, to be the father of this style of analysis outside of Asia.
Candlestick vs. other chart types
Of course, candle charts are not the only type of chart available to traders. They are just one of many graphical representations of price action, which have developed alongside the markets.
The simplest form of a chart that traders routinely plot is a line chart. This is exactly what it sounds like, a series of discrete price points or prints, which are recorded and joined together via a line that connects all of the points, in a period of observation.
In the chart above, we can discern a general trend within the price action over the lifetime of the chart, the high and low over the time frame and the change in the underlying over this period. But we can’t extract any more intelligence or information than that.
To do this we need to be able to visualise how price has changed and behaved between the periods of observation or individual plots, so that when combined, they form the line chart. To provide this level of additional insight traders developed the bar chart.
The big leap forward that we see with this kind of chart, is that it records the range that a price trades over, during the periods under observation. The bars achieve this by displaying the high, low, open and closing price for each period observed (as we have annotated below). Because of this, we can now start to see the behaviour of price action during individual periods within our observations and over the lifecycle of the chart as a whole.
What candles tell us that other charts don’t and why they are better?
While it's true that Candlestick and Bar charts are derived from the same basic information, i.e., Open High Low Close or OHLC. It's the way that this information is displayed that differentiates the two styles. Thanks to the way they are configured, Candle charts impart more visual information, compared to Bar charts. The basic building block of the Candlestick chart are the candles themselves, see the illustration below.
I think you can quickly see where the name comes from. Indeed the extensions from the Candles, which signify the high and low price points, are known as wicks.
The use of open and filled candles (or colour coding) to signal bullish or bearish price action is a major plus point for candlesticks over bar charts, and it makes them far easier to use and interpret, for many traders. The shapes of the individual candles, which are rarely as symmetrical as the examples above, can also impart a great deal of meaningful data to traders.
Strange names, full of information
As we noted earlier Candlestick charts hail from Japan and much of their historical nomenclature followed the charts across the Pacific ocean. To our ears, some of these names and phrases sound antiquated and unrelated to modern trading. For example "gravestone doji" or "three black crows". But this distinctive terminology makes the phrases and the patterns they represent very memorable. Japanese as a language is of course written in a Kanji script and is, therefore, a very image oriented medium. A culture that recognises words through symbolism was always likely to throw out some flowery descriptions for chart patterns. What's more, the candles and the patterns they form can inform us about the psychology of the market, that is the balance between supply and demand or greed and fear if you prefer.
Let’s look at some examples to illustrate what we mean here.
The Shooting Star is characterised by its long wick (tail) or upper shadow as it's formally known. Which is combined with a small real body, that is the rectangular portion of the candle to form the distinctive shooting star shape.The candle pattern typically appears in an uptrend and can signal a potential end to, or reversal in that trend. That's because the price has rejected a move higher and then moves back towards the opening price, before closing at or close to the period low. That tells us that buyers, who initially bid up the price to the period high, then ran into sellers at that point. Sellers whose supply outweighed the limited demand at the high price. That selling pressure continued, and therefore the price retreated. Moreover, the sellers remained active until the close of the period under observation.
The Hammer can be considered to be the opposite candle to the Shooting Star. In that, it usually appears in the midst of downtrend and can signal an end to, or reversal in that trend.
In this case, price is likely to have been moving lower within a downtrend and continues to do so in the next period. However, buyers quickly appear and out muscle the sellers. The price then begins to rise, and we may even make a new high on the day, shown in this example by the small upper shadow. We then see a close, near the high and well away from the low, posted earlier in the period.
It's important to note that both the Hammer and Shooting Star will often require confirmation, either from an indicator or a subsequent candle. For example, after the posting of a Shooting Star, if the price subsequently gaps lower at the open or posts lower lows, then that can confirm the trend reversal. Equally, divergence within the MACD and or Stochastic indicators, or indeed a pullback from overbought readings in these, or in RSI 14, could well confirm, such a reversal signal.
What to look for
Candlestick charts are all about pattern recognition and interpretation, and as such it takes a while to master their use. In the examples above, we looked at two common reversal patterns signified by a single candle. However, many candlestick patterns consist of more than one candle, or are defined by the interaction between multiple candles. One such pattern is the Outside Day or Bullish / Bearish Engulfing pattern. Engulfing patterns occur when a short, often indecisive candle is engulfed by a subsequent larger and more demonstrative candle, which can be either bullish or bearish. This candle is overwhelming the prior candle and asserting a new trend or direction in the underlying instrument. In the image below, we can see an example of a Bearish Engulfing pattern.
The bearish engulfing pattern typically appears in an existing uptrend that is running out of steam or looking for fresh impetus. This explains the appearance of the indecisive white candle, which itself is known as a spinning top. The bearish engulfing candle posts both a new high and low. And crucially a close, below both, the close and the low that was seen in the prior candle. The concept of sellers or bears controlling the price into the close is a key part of the formation. In demonstrating this, the candle tells us that supply is asserting itself over demand. So sellers replace buyers as the dominant force. The Bulls have used up their ammunition and are no longer in control of the price. To be absolutely certain, we would still look for confirmation of this signal, from within the price action. But it's not uncommon to see the price gap lower at the open of the subsequent candle when a “textbook“ bearish engulfing pattern is posted.
The Bullish Engulfing pattern typically occurs in a downtrend. Once again, the trend is likely to be losing momentum and searching for fresh impetus. Reversal patterns highlight potential inflection points between supply and demand; ie buyers and sellers.
In the Bullish Engulfing pattern we see an indecisive candle, in this case, the short filled candle on the left, surrounded by the larger demonstrative candle on the right. The bullish reversal candle posts a lower open, a lower low and a higher high than seen in the previous candle.
Crucially the closing price is towards the high of day and is higher than the prior period high.
Once again we would look for confirmation of the signal from subsequent price action. But the Bullish Engulfing pattern is warning us of a change in the power balance between buyers and sellers. In this case, the sellers or bears are spent, and the buyers or bulls have signalled their clear intention to take control of the price.
Trading is often about doing some groundwork, or in this case, homework.
That means getting to know and recognise common candlestick patterns and the market psychology behind them. To do this, you will need to do some study by comparing cheat sheet candle patterns with those on your trading platform. Arm yourself with a good book on the subject that you can return to time and time again as a reference and refresher.
You don't have to master all Candle patterns at once of course. In fact, I would suggest you get familiar with three or four simple patterns and once you are confident with those, you can move on to something more complex. This really is a case of practice makes perfect. Having become adept at recognising and interpreting candle patterns, the next step would be to trade them.
You can do this on a demo account, to begin with, or if trading live then with small trade sizes and sensible stop losses. As your confidence and ability grow, you could scale up to your regular trade size. Good luck, I think you will find it's worth making the effort to understand Candle Charts which should, after all, help to make you a better trader.