How To Read Candlestick Charts

Guide to Candlestick Charts

When starting out trading crypto, the interface can appear daunting. There are all the changing numbers, contrasting red and green colors, and of course, the chart. Many inspiring traders will look at the screen and ask the same question: how do you read candlestick charts?

Charts are used to convey information in a visual manner and can be extremely useful aids when analyzing data. Because of their ability to display information, charts and graphs have become instrumental when examining markets, and cryptocurrencies are no exception. However, there are dozens and dozens of different types of graphs and charts, each with their own strengths and weaknesses: in order to properly organize data sets into an easy to understand format, we must determine which chart suits our specific needs. Here we will look at one of the more specialized, but very handy methods called Candlestick charts.

History Of Candlestick Charts

While some opinions vary, this interesting method to represent data is thought to have been developed in 18th century Japan by a man known as Munehisa Homma (also known as Sokyu Homma). During this time a futures market around rice was established using coupons for delivery upon a later date. This secondary market, trading rice futures, is where Homma thrived and was able to develop this tool. Homma is also credited with writing the first book on market psychology and incorporated this understanding of how traders’ attitudes and emotional states could affect the market price.

Whether Homma himself used Candlestick charts, or they were developed later on as a byproduct of some of his work is unclear. What is certain, however, is the utility and effectiveness these charts have when analyzing market patterns, especially in terms of day trading. Let’s take a look at the structure of these charts and how they display data.

Parts of a Candle

In order to effectively read Candlestick charts, it is best to understand the different pieces of data that make up the “Candle”. These charts are made up of units, or candles, each representing a specified unit of time—hours, days, weeks, etc. However, for our purposes, we will be using days. Each candle displays four pieces of price information: the market open, the market close, the market high and the market low.

Parts of candlestick

The main rectangle is called the “real body” and represents the price difference between market open and market close. The real body of a candle will be differentiated by color to indicate Bullish (closing price higher than open) or Bearish (closing price lower than open) market movement, usually white or green and black or red, respectively. When the closing price is higher than the opening price (Bullish) the real candle will be green and vice versa.

The next key feature of the candle is called the “wick” or “shadow”. These are lines that extend up and down from the real body. The upper wick shows the highest point that market price reached during the specified time period, while the lower wick shows the lowest point the price dipped to.

By using this information-dense charting tool traders are able to glean the day’s market action at a glance: high and lows for asset price as well as open and close prices. Through examining a collection of these candles over an extended period of time a picture of market action is visible, which can help traders to discern and analyze broader patterns in the market.

Candlestick Basics

Later, we will examine the 15 different Candlestick patterns, but first, let’s get a basic understanding.

Through analyzing the patterns formed by these candles traders are able to make predictions on market movement by understanding the psychology behind the movements. In order to further understand the psychology that can be understood from candlestick patterns, let’s look at how markets function.

An easy way to understand market fluctuation is to look at it as a fight between the buyers and the sellers. Buyers expect prices to rise and push the price up with their buying interest. Alternatively, sellers expect prices to fall and push prices down with selling interest.

When there are more buyers than sellers, there are not enough people to buy from, and the price goes up. Eventually, the price will rise to the point that more sellers get involved to profit on this price increase. The price will rise too high over time and the buyers will stop buying. Vice versa: if there are more sellers than buyers eventually the price will drop enough for buyer interest to return and equilibrium is reached.

Candle Body Length

These trends can be exemplified in the shape and color of candlestick charts. Long, rising candle bodies can indicate strong buying interest and a positive price move. If candle bodies get longer over time it can represent an accelerating trend and a continued rise in prices. Alternatively, if candle bodies gradually grow shorter it can indicate a slowing of trends and a return to balance, which is represented by bodies that remain constant. When long positive (Bullish) bodies are suddenly replaced with long negative (Bearish) bodies it can indicate a reversal of trends and market volatility.

Candle Wick Length

The wick length of each candle can also indicate different market trends. Wicks represent the range in price and thus can be used to evaluate the volatility of an asset. Long wicks usually indicate volatility and uncertainty: it means strong competition between buyers and sellers with neither side controlling the market. Alternatively, short wicks indicate stability in the market.

Body to Wick Ratio

In order to gain a more comprehensive understanding of how candlesticks can represent trends, these first two aspects must be looked at in relation to each other. When trends are strong they will usually have long candle bodies, with short or nonexistent wicks: a strong Bullish candle will often appear as a long body with little to no wick. This is because as the price rises along with the trend it is closing near the top of the range with little volatility to be represented by the wick.

As the trend loses momentum the patterns change and the wick grows in relation to the candle body. At points of trend reversal candle bodies are often short with long wicks in either direction, both up and down. This represents the relative balance achieved and the uncertainty of the future direction of the market. It is at this point where trends often shift and the process begins again.

Position of Real Body

One more feature of a Candlestick is the position of the body. The position of the candle body can be understood through the two most common configurations. The first is commonly referred to as a hammer, pinbar, or rejection (more on this later). This refers to a candle with a dominant wick present on only one side with a candle body on the opposite end. It is worth noting that these terms refer to the specific shape, whether in a Bullish or Bearish direction. This shape indicates that while there was a strong push in one direction (the direction of the wick), market forces pushed the price in the opposite direction; hence the term “rejection”.

The other prominent shape worth mentioning is a relatively small body with wicks on both sides. This shape is sometimes referred to as an indecision, as it can represent uncertainty in the market. While this shape can signify uncertainty, it can also mean that the market is in a state of equilibrium, with the forces of buyers and sellers in relative balance.

Common Candlestick Patterns

There are 15 common patterns that are often encountered when examining Candlestick charts. It is a good idea for any trader to become familiar with the specific visual representations and market significance of these regularly occurring shapes.

Long Periods

These patterns show a substantial difference between opening and closing prices, usually with little to no wicks on either end, signaling a major imbalance in market forces. These patterns are most often found during times of high volatility and represent either strong buying pressure in cases of Bullish movement or strong selling pressure in Bearish movements.

Short Periods

In opposition to Long Periods, short periods are visualized by a small body and short wicks on either end. These represent little movement of the price during the trading period and indicate lower volatility.

Marubozu

Marubozu candles have long bodies with no wicks on either end. These represent strong pressure in one direction, either buying (Bullish) or selling (Bearish).

In Bullish Marubozu the opening price is equal to the low price and the close price is equal to the high price. These Bullish shapes often indicate the start of a Bullish reversal pattern or the continuation of a Bullish trend.

In contrast, a Bearish Marubozu’s open price is equal to the highest price and the closing price is equal to the low point for the trading period, which indicates that sellers are in control of the market. This pattern indicates a continuation of a Bearish trend or can signify a Bearish reversal.

Spinning Tops

These shapes have long wicks for both high and low prices, with relatively small candle bodies. This represents a small change in real price for the trading period, with much more uncertainty than other patterns. When examining these candle patterns it is important to know that whether Bullish or Bearish, the most important information they convey is market indecision.

Doji

These patterns have extremely short bodies, indicating the open and close prices were almost exactly the same. There are four different Doji that are differentiated based on the location of the body relative to the wick. Doji represent even stronger market indecision than spinning tops. They are usually found at the end of a trend or in times when there is little buying or selling power. They are like a stalemate between buying and selling force.

Long-legged Doji have long upper and lower wicks with a tiny body representing price fluctuation during the trading period with the eventual closing price landing back at the opening price. These show indecision and relatively equal force for buyers and sellers.

Dragonfly Doji (Bullish) have a very small body at the top of a long wick. This means that the open, high and closing prices were almost all identical. This means that all market price activity was below the open price and can often indicate a reversal towards a more Bearish situation.

Gravestone Doji (Bearish) are the opposite of Dragonfly Doji: they have a very small body at the bottom of a long wick. In this scenario, the open, close and low prices are all practically equal. Unlike Dragonfly Doji, here all market movement was above the opening price which can often signify a Bullish trend reversal.

Hammer

Hammer candles have a wick that is two or three times the length of the body and usually have little or no top wick. These almost exclusively take place during a downtrend in the market. These represent a Bullish trend reversal whether the Hammer is green or red. During a downward trend, a Hammer signifies more buyers are participating and may shift the balance towards a Bullish trend.

Inverted Hammer

Inverted Hammers as you could guess are the opposite of Hammer candles. These patterns can indicate trend reversals depending on the candle next to it. Inverted Hammer candles must be Bullish following a Bearish shape. The long wick indicates that buyers tried for higher bids, but the selling pressure eventually pushed the price back down towards the opening price.

Hanging Man

Hanging Man candles and Hammer shapes are visually similar but have opposing meanings dependent on the market conditions preceding it. Like a Hammer, the Hanging Man has a lower wick two to three times the length of the body with very little upper wick, if any at all. It can indicate a Bullish reversal if the conditions around it are correct. If the Hanging Man occurred at a resistance level, sellers were trying to push prices down but buyers were able to drive the price back up.  

Shooting Star

Shooting Star patterns look exactly the same as the Inverted Hammer, with an upper wick two to three times larger than the small candle body, but must occur during an uptrend, and they often signify a Bearish reversal. As with the Hanging Man, the preceding and proceeding patterns inform the Shooting Star’s meaning. In the case of a Shooting Star following an uptrend means that while buyers pushed the price up for the previous trading period, sellers were able to pull prices back down and the trading period ended with a closing price lower than the opening price.

Engulfing Candles

Engulfing Candles occur when the real body of one candle fully engulfs the body of the preceding candle. A Bullish Engulfing Pattern is a Bullish reversal indicator and takes place when a Bearish candle is followed by a larger, Bullish candle whose real body completely engulfs the preceding candle’s body. It is usually the case that the larger the real body of the Bullish candle the larger the price reversal.

A Bearish Engulfing Pattern is generally a reversal signal for a Bearish trend. It occurs as the mirror image to a Bullish Engulfing Pattern and consists of a Bullish candle followed by a larger Bearish candle whose body fully engulfs the previous candle’s body.

Harami/Inside Bar

The Harami/Inside Bar is the opposite of an Engulfing candle and has the opposite significance. A Harami pattern occurs when a candle (either Bullish or Bearish) is followed by a candle whose real body is smaller than the preceding candle body. Their significance corresponds accordingly: a Bullish Harami occurs during a downtrend and indicates a reversal to a more Bullish market; a Bearish Harami occurs during an uptrend and signifies a Bearish trend reversal.

Piercing Candle

Piercing Candle patterns often signal reversals towards a Bullish trend. This pattern is made up of two candles where the preceding candle is Bearish and is followed by a Bullish shape. The Bullish candle’s opening price is equal to or below the previous, Bearish, candle’s closing price. The closing price of the Bullish candle must intersect the midpoint of the preceding candle without rising above its opening price. In this way, the Bullish candle body “pierces” the Bearish body.

Dark Cloud Cover

The Dark Cloud Cover is another pattern consisting of two candles and can be seen as the opposite of the Piercing Candle. A Bullish candle is followed by a Bearish candle and often indicates a reversal to a Bearish trend. In this scenario, the opening price of the Bearish body is equal to or above the closing price of the preceding Bullish candle body, with the closing price of the Bearish candle at or below the midpoint of the preceding candle, but not below its opening price. In this configuration, the Bearish candle “pierces” the midpoint of the Bullish candle body.

Morning Star

The Morning Star pattern contains three candles and often signifies the closing of a trend or at least a Bullish reversal. In order for a true Morning Star to occur several conditions must be met.

A)     The first candle in the pattern must be Bearish in the midst of a recognized downtrend.

B)     The following candle can be Bearish or Bullish, but it must be either a Short Period candle or a Doji. This signifies indecision in the market.  

C)     The final candle in the pattern must be a Bullish shape with its closing price at or above the midpoint of the first candle’s real body. This indicates a trend reversal will take place.

Evening Star

The Evening Star pattern is the opposing figure to the Morning Star and occurs at the end of a trend or when a Bearish reversal is likely. Again, this three candle configuration must meet certain conditions to be considered an Evening Star.

A)     The first candle must be Bullish and take place during an ongoing uptrend.

B)     The second may be Bullish or Bearish, but must have a short body or be a Doji.

C)     The third candle is a Bearish shape and must close at or below the midpoint of the first candle which confirms the reversal will occur.

Reading Candlestick Charts

This charting method may seem a bit complex, but given a bit of time and studying the information the different patterns hold make them a worthwhile analytical tool. Once familiar with the different patterns and shapes, Candlestick charts allow traders to glean large amounts of data from a quick glance. The amount of data contained within one candle for one time period set them apart from other graphing methods, and when viewed in the context of a longer time frame the understanding of market forces contained in these charts is surprising. Any person with an interest in examining trading markets would do well to become comfortable with this method.

 


 

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References

Carter, E. (2015, July 11). Marubozu Candlestick Pattern. Retrieved from:  https://hitandruncandlesticks.com/marubozu-candlestick-pattern/

Chen, J. (2019, June 25). Doji Definition. Retrieved from: https://www.investopedia.com/terms/d/doji.asp

Chen, J. (2019, June 25). Real Body. Retrieved from: https://www.investopedia.com/terms/s/shadow.asp

Chen, J. (2019, August 12). Shadow. Retrieved from: https://www.investopedia.com/terms/r/realbody.asp

Kristopher, G. (2018, December 12). Analyzing Morning Star And Evening Star Candlestick Pattern. Retrieved from: https://marketrealist.com/2014/12/analyzing-morning-star-evening-star-candlestick-pattern/

Mitchell, C. (2019, August 9). The Engulfing Candle Day-Trading Strategy. Retrieved from:  https://www.thebalance.com/engulfing-candle-day-trading-strategy-1030873

Sikder, T. (2019, May 2). Market Psychology Through Candlesticks. Retrieved from: https://www.dittotrade.academy/education/intermediate/technical-analysis/candlestick-patterns-technical-analysis/understanding-market-psychology-through-candlesticks/

Trade the News. (2018, July 22). The Most Successful Price Action Trader In History: Munehisa Homma. Retrieved from: https://medium.com/@fncnewz/the-most-successful-price-action-trader-in-history-munehisa-homma-84410008fa0e

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