Candlestick Charts

Introduction

It’s interesting noting the various intricacies associated with the stock market. Whether it be those numerous indicators capable of deciphering the several unique circumstances that assets may go through or those charts that seek to give a more thorough understanding of price movements, you can be sure to find something worthwhile that can cater to any trading need you may have. 

But rather than indicators, the things that we’ll be looking at today are candlestick charts and their various roles within stock trading.

What Are Candlestick Charts?

Candlesticks are basically a kind of price chart, usually part of technical analysis. They show the low, high, open, and closing prices for securities within specific periods. 

Interestingly enough, this chart has its origins in Japan, where traders and rice merchants used it for hundreds of years prior to its popularization within the United States. Back then, it was used to monitor daily momentum and market prices.

Candlestick Components

There are a couple of primary components within candlestick charts that traders should know about, which we’ll be looking at extensively within this section. 

So, to start, you have the “real body,” which is basically the rectangular candlestick, or wide part, that displays the close and open prices of the equities and shares. 

The wick, otherwise known as the “shadow,” runs from top to bottom of that real body and shows the two extreme price points for the day.

Types of Candlesticks

Next, we’ll look at the types of candlesticks, or rather, the colors, and what they could mean. So, the color of the candlestick is important. Why? It’s because it identifies whether prices have increased or decreased overall. 

Conventionally, the color green is used for specifying price increases, where the closing price is above the opening price. But some platforms like to use blue instead. 

Likewise, red candlesticks are used to indicate falling prices, where the opening price is above the closing price. In other words, the blue or green candlesticks represent bullish sentiments, with red candlesticks representing bearish.

Key Components

Earlier, we went over closing, opening, high, and low prices, but what do those actually mean? Firstly, you have the high price, which is represented by the topmost wick of the candlestick, and this indicates the highest point that the price hit over a certain trading session. 

Then there’s the low price, which the bottom wick indicates, and this naturally represents the lowest point an asset’s price hit over a specific trading session.

As for the opening and closing prices, well, the latter would be the price from a business day’s last or final transaction, whereas the former would be the first.

Common Candlestick Patterns

It’s intriguing that there can be a lot of unique patterns that may be discerned from the various movements that the candlestick chart undertakes, whether it be a reversal or a continuation, or something entirely else.

Reversal Candlestick Patterns

The first set of patterns that we’ll be looking at today are those indicating a reversal in trends, which signifies a substantial shift in the market.

Bullish Reversal Patterns

Starting with the bullish reversal patterns, we’ll look at the hammer, morning star, and bullish engulfing patterns. The hammer is a one-candle pattern with a long lower wick or shadow, and this has to be twice the size of that “real body.” 

Because of this, hammers are fairly easy to recognize and imply that while the bears pulled prices to new lows, they failed to hold them there. Then there’s the morning star, which is a 3-candle pattern. 

Following a lengthy bearish candle, you have this bearish gap down. Here, the bears appear to be in control; however, they fail to achieve anything substantial. 

The second candle is therefore quite small, with its color not mattering that much, though it would be better if it were bullish. Finally, the third candle opens with an upward gap and completely fills the last bearish gap. This candle is typically longer in comparison to the first one. 

Then you have the bullish engulfing pattern, which appears after a downtrend’s end and involves the first candlestick’s body being entirely engulfed by the following candlestick’s.

Bearish Reversal Patterns

On to the bearish reversals. Starting with the shooting star, it’s a one-candle pattern where the candlestick’s body is small but its upper shadow is very long, exceeding the body by twice at least. 

Then, there’s the evening star, a three-candle pattern, where the first candle is bullish and a bit long, with the second being small and a bullish gap up, and the third being a bearish candle with a downward gap that fills the preceding bullish gap and it’s longer than that first bullish candle.

Finally, the bearish engulfing is like the bullish engulfing, only it appears after an uptrend instead of a downtrend.

Continuation Candlestick Patterns

Besides reversals, you have certain candlestick patterns that signify a continuation of trends, and these can either be bullish or bearish.

Bullish Continuation Patterns

Starting off with the rising three methods, you have a long bullish candle, followed by this series of smaller bearish candles. The preferred number for these pullback candles would be three. 

Then you have the bullish flag continuation pattern that forms when stocks are in an upward trend and experience some brief consolidation before eventually continuing their upward trajectory.

Bearish Continuation Patterns

Now with the bearish continuations, you first have the falling three methods, which involve a long bearish candle with a series of small bullish candles, with the optimal number being 2-5 candlesticks. 

Finally, there’s the bear flags, which are basically the opposite of the bull flags we went over earlier.

How to Use Candlesticks in Trading

By now, you must have a fair idea of what candlestick charts are, so let’s see how you may use them in trading.

Trend Following with Candlesticks

First, use any of the continuation patterns we discussed or others to identify a trend, and then, after confirming it, act accordingly by opening all sorts of positions.

Spotting Reversals

Previously, we went over various reversal patterns, so just use those or others we didn’t mention to spot reversals, bullish or bearish, to then open the relevant positions.

Using Candlesticks with Other Indicators

Sometimes, it’s better to include some additional confirmation, and every manner of trade these days does it, so you might want to incorporate indicators like the RSI or various moving averages to confirm those chart readings.

Candlestick Strategies for Different Trading Styles

Let’s see how candlestick charts relate to some of the more popular trading styles out there, namely day, swing, and long-term trading.

Day Trading with Candlesticks

For day trading, traders can incorporate shorter time frames and scalping reversals, which will likely benefit their short-term profitability requirements.

Swing Trading with Candlesticks

Since swing trading is more concentrated on medium-to-long-term gains, traders may incorporate time frames accordingly and may benefit more from reversals and trend continuations with the extra time that they give themselves to work with.

Long-Term Investing with Candlesticks

Long-term traders may give themselves even longer time frames to confirm entries and exits while relying heavily on trend continuation patterns.

Advantages and Limitations of Candlestick Charts

Like with anything these days, there are limitations and there are benefits, so let’s dive into both below.

Benefits of Using Candlestick Charts

Candlestick charts can be a good visual representation of market sentiments, making them effective for reversal identification and working across various time frames.

Limitations of Candlestick Charts

Unfortunately, these charts aren’t always reliable in isolation, as there’s always the potential for false signals. Not only that, but they can be subject to interpretation too.

Conclusion

Candlestick charts have been a vital tool in discerning various market sentiments, but as with any trading tool, you’ll need to possess a strong grasp on how it works and its limitations before you invest any funds based on implications and interpretations.