No matter what market you’re navigating, trading is a complex activity that implies all sorts of processes, factors, and tools and requires specific knowledge and skills. The only way to thrive in this competitive industry is by continuously learning and being aware of the many variables that can influence trading outcomes. One such aspect that can make the difference between successful trades and failed attempts or missed chances is understanding candlestick patterns.
Candlesticks are widely used tools in the trading space that can tell you a lot about what’s going on in a financial market in terms of price action and trends. Therefore, knowing how to identify and interpret them can be a real game-changer for your trading strategy. If you’re looking to get into trading and you’re not yet familiar with the concept, here you can find out everything you need to know about candlestick patterns – what they are, why they matter, and how you can leverage them to boost your trading performance.
Candlestick patterns explained
Far from being a new notion, candlesticks have been employed for centuries, and have come to play a key role in modern trading. They represent graphical displays of an asset’s price evolution over a certain period of time and are used to interpret market sentiment and price trends.
The earliest instances of trading analysis employing candlesticks can be traced back to 18th century Japan, and have been used as a technical analysis tool ever since. Historical records tell of a merchant named Munehisa Homma who traded rice in Osaka during the Tokugawa Shogunate and developed an early version of this technique as a way to monitor price action in the rice market.
The idea behind candlesticks charting is that price movements in a market are determined by a combination of psychological factors and bearish and bullish signals. The system developed by Homma implied extracting patterns from historical data in order to anticipate potential changes.
While this method quickly became popular among Japanese traders, the Western world adopted it much later, towards the end of the 20th century. Recognizing the benefits of using candlestick charting to forecast price fluctuations, traders started integrating the strategy into their technical analysis to gain insights into financial markets and optimize trades and investments.
The structure of candlestick formations
Candlesticks are shaped by the opening, high, low, and closing prices of a financial asset. As such, there are three main components that make up the structure of a candlestick, as follows:
- The (real) body – This is the portion between the opening and the closing price of an asset. The opening price is the price at which the asset starts trading in a day, while the closing price is the final value at which the asset eds the trade day. Longer bodies typically denote stronger buying/selling pressure while shorter bodies suggest indecision.
- The shadows (wicks) – These parts of the candlestick that sit above and below the body represent the highest and the lowest values reached within the analyzed period and can help assess risks by measuring market volatility. If there is no shadow, these extremes will be indicated by the upper or lower sections of the real body.
- The color – Candlesticks are assigned colors depending on the price direction they depict. A bearish candlestick where the closing price is lower than the opening price points towards a downward trend and will be either black or red. A bullish candlestick where the closing price is higher than the opening price hints at a potential price rise, and are colored white or red.
Interpreting candlesticks
When analyzing candlestick charts, traders look at the four data points in each formation, namely the opening price, closing price, highest price, and lowest price for the given period. Each of these elements can provide clues into the buying and selling dynamics for an asset, showing positive or negative movements, and the extent of these trends.
Colored candlesticks offer an easy way to assess current momentum, as they clearly expose bearish and bullish sentiments. However, there are other aspects that can reveal further information about the state of the market. For example, identifying common patterns, which we’re going to address shortly, evaluating shadows and considering trading volumes are a great way to conduct a more nuanced analysis.
Common candlestick patterns
There are many types of candlestick patterns, each of which conveys different narratives. Here are some of the most common patterns to look out for.
Bullish candlestick patterns
- Hammer – Small body, long lower wick; appears after a downtrend, signals reversal.
- Bullish Engulfing – Large green candle fully engulfs the previous small red candle.
- Morning Star candlestick – Three candles: red, small-bodied (star), and large green; reversal signal.
- Piercing Line – Green candle opens below and closes above the midpoint of the prior red candle.
- Inverted Hammer – Small body, long upper wick; after a downtrend, suggests possible reversal.
Bearish candlestick patterns
- Shooting Star candlestick – Small body, long upper wick; appears after an uptrend, and signals reversal.
- Bearish Engulfing – Large red candle fully engulfs the prior small green candle.
- Evening Star candlestick – Three candles: green, small-bodied (star), and large red; bearish reversal.
- Dark Cloud Cover – Red candle opens above and closes below the midpoint of the prior green candle.
- Hanging Man – Small body, long lower wick; appears after an uptrend, and signals weakness.
Benefits and limitations
Learning about candlesticks and being able to recognize different patterns can make it easier to spot trends and come up with accurate predictions that can guide your trades in the right direction. This facilitates decision-making and helps traders reduce risks and manage funds more efficiently by maintaining a more objective approach. Used in conjunction with other technical indicators, candlestick patterns can confirm or contest existing trends and provide a more comprehensive view of market conditions.
However, candlestick charting has its limitation and is by no means a foolproof method for forecasting market movements. They are best used for short-term predictions and one shouldn’t rely on them blindly as they can produce false signals, leading to misinterpretations and costly mistakes.
While candlesticks can be extremely helpful for technical analysis purposes, one should always take the insights they deliver with a grain of salt and resort to complementary metrics to ensure better trading decisions.
