What are Candlestick Charts and How to Use them for Trading

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Candlestick Charts

History of Candlestick Charts

The creation of candlestick charts is widely credited to an 18 th century Japanese rice trader Munehisa Homma. His prowess at gaming the rice trading markets was legendary. It is believed his candlestick methods were further modified and adjusted through the ages to become more applicable to current financial markets. Steven Nison introduced candlesticks to the Western world with his book “Japanese Candlestick Charting Techniques”. Candlesticks have become a staple of every trading platform and charting program for literally every financial trading vehicle. The depth of information and the simplicity of the components make candlestick charts a favorite among traders. The ability to chain together many candlesticks to reveal an underlying pattern makes it a compelling tool when interpreting price action history and forecasts.

How to Read Candlestick Charts

Basic Candle Formation

A candlestick is composed of three parts; the upper shadow, lower shadow and body. The body is colored green or red. Each candlestick represents a segmented period of time. The candlestick data summarizes the executed trades during that specific period of time. For example a 5-minute candle represents 5 minutes of trades data. There are four data points in every candlestick: the open, high, low and close. The open is the very first trade for the specific period and the close is the very last trade for the period. The open and close is considered the body of the candle. The high is the highest priced trade and low is the lowest price trade for that period.

How to Read a Candlestick

The high is represents by a vertical line extending from the top of the body to the highest price called a shadow, tail or wick. The low of the candle is the lower shadow or tail, represented by a vertical line extending down from the body. If the close is higher than the open, then the body is colored green representing a net price gain. If the open is higher than the close, then the body is colored red as it represents a net price decline.

Candlestick Chart Patterns

Every candlestick tells a story of the showdown between the bulls and the bears, buyers and sellers, supply and demand, fear and greed. It is important to keep in mind that most candle patterns need a confirmation based on the context of the preceding candles and proceeding candle. Many newbies make the common mistake of spotting a single candle formation without taking the context into consideration. For example, a hammer candle represents a near-term capitulation bottom if it forms after three preceding bearish candles, whereas hammer candle that forms on ‘flat’ sideways candles is basically useless. Therefore it pays to understand the ‘story’ that each candle represents in order to attain a firm grasp on the mechanics of candlestick chart patterns. These patterns tend to repeat themselves constantly, but the market will just as often try to fake out traders in the same vein when the context is overlooked. Candlestick charts tend to represent more emotion due to the coloring of the bodies. It’s prudent to make sure they are incorporated with other indicators to achieve best results. The following are some of common candlestick reversal patterns.

Hammer Candlestick

The hammer is a bullish reversal candlestick. It is one of the most (if not the most) widely followed candlestick pattern. It is used to determine capitulation bottoms followed by a price bounce that traders use to enter long positions.

A hammer candlestick forms at the end of a downtrend and indicates a near-term price bottom. The hammer candle has a lower shadow that makes a new low in the downtrend sequence and then closes back up near or above the open. The lower shadow (also called a tail) must be at least two or more times the size of the body. This represents the longs that finally threw in the towel and stopped out as shorts start covering their positions and bargain hunters come in off the fence. A volume increase also helps to solidify the hammer. To confirm the hammer candle, it is important for the next candle to close above the low of the hammer candle and preferably above the body. A typical buy signal would be an entry above the high of the candle after the hammer with a trail stop either beneath the body low or the low of the hammer candle. It is prudent to time the entry with a momentum indicator like a MACD, stochastic or RSI.

Shooting Star Candlestick

Shooting Star Candlestick

The shooting star is a bearish reversal candlestick indicating a peak or top. It is the exact inverse version of a hammer candle. The star should form after at least three or more subsequent green candles indicating a rising price and demand. Eventually, the buyers lose patience and chase the price to new highs (of the sequence) before realizing they overpaid.

The upper shadow (also known as a wick) should generally be twice as large as the body. This indicates the last of the frenzied buyers have entered the stock just as profit takers unload their positions followed by short-sellers pushing the price down to close the candle near or below the open. This in essence, traps the late buyers who chased the price too high. Fear is at the highest point here as the very next candle should close at or under the shooting star candle, which will set off a panic selling spree as late buyers panic to get out and curb losses. The typical short-sell signal forms when the low of the following candlestick price is broken with trail stops at the high of the body or tail of the shooting star candlestick.

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Doji Candlestick

The doji is a reversal pattern that can be either bullish or bearish depending on the context of the preceding candles. The candle has the same (or close to) open and closing price with long shadows. It looks like a cross, but it can also have a very tiny body. A doji is a sign of indecision but also a proverbial line in the sand. Since the doji is typically a reversal candle, the direction of the preceding candles can give an early indication of which way the reversal will go.

If the preceding candles are bullish before forming the doji, the next candle close under the body low triggers a sell/short-sell signal on the break of the doji candlestick lows with trail stops above the doji highs.

If the preceding candles are bearish then the doji candlestick will likely form a bullish reversal. Long triggers form above the body or candlestick high with a trail stop under the low of the doji.

Bullish Engulfing Candlestick

Bullish Engulfing Candlestick

A bullish engulfing candlestick is a large bodied green candle that completely engulfs the full range of the preceding red candle. The larger the body, the more extreme the reversal becomes. The body should completely engulf the preceding red candle body.

The most effective bullish engulfing candlesticks form at the tail end of a downtrend to trigger a sharp reversal bounce that overwhelms the short-sellers causing a panic short covering buying frenzy. This motivates bargain hunters to come off the fence further adding to the buying pressure. Bullish engulfing candles are potential reversal signals on downtrends and continuation signals on uptrends when they form after a shallow reversion pullback. The volume should spike to at least double the average when bullish engulfing candles form to be most effective. The buy trigger forms when the next candlestick exceeds the high of the bullish engulfing candlestick.

Bearish Engulfing Candlestick

Like a massive tidal wave that completely engulfs an island, the bearish engulfing candlestick completely swallows the range of the preceding green candlestick. This is a strong price reversal candlestick. The bearish engulfing candlestick body eclipses the body of the prior green candle. Even stronger bearish engulfing candlesticks will have bodies that consume the full preceding candlestick including the upper and lower shadows. These candlesticks can be signs of enormous selling activity on a panic reversal from bullish to bearish sentiment.

Bearish Engulfing Candlestick

The preceding green candle keeps unassuming buyers optimism, as it should be trading near the top of an up trend. The bearish engulfing candle will actually open up higher giving longs hope for another climb as it initially indicates more bullish sentiment. However, the sellers come in very strong and extreme fashion driving down the price through the opening level, which starts to stir some concerns with the longs. The selling intensifies as the price falls through the low of the prior close, which then starts to trigger some more panic selling as the majority of buyers from the prior day are now underwater on their shares. The selling intensifies into the candle close as almost every buyer from the prior close is now holding losses. The magnitude of the reversal is dramatic. The bearish engulfing candle is reversal candle when it forms on uptrends as it triggers more sellers the next day and so forth as the trend starts to reverse into a breakdown. The short-sell trigger forms when the next candlestick exceeds the low of the bullish engulfing candlestick. On existing downtrends, the bearish engulfing may form on a reversion bounce thereby resuming the downtrends at an accelerated pace due to the new buyers that got trapped on the bounce. As with all candlestick patterns, it is important to observe the volume especially on engulfing candles. The volume should be at least two or more times larger than the average daily trading volume to have the most impact. Algorithm programs are notorious for painting the tape at the end of the day with a mis-tick to close out with a fake engulfing candle to trap the bears.

Bullish Harami Candlestick

Bullish Harami Candlestick

A bullish harami candle is like a backwards version of the bearish engulfing candlestick pattern where the large body engulfing candle actually precedes the smaller harami candle. The preceding engulfing red candle should be a capitulation large body candlestick that makes the lowest low point of the sequence indicating a capitulation sell-off preceding the harami candle which should trading well within the range of the engulfing candle. The subtleness of the small body keeps the short-sellers in a complacent mode as they assume the stock will drop again, but instead it stabilizes before forming a reversal bounce that takes the short-seller by surprise as the stock reverses back up.

The harami is a subtle clue that often keeps sellers complacent until the trend slowly reverses. It is not as intimidating or dramatic as the bullish engulfing candle. The subtleness of the bullish harami candlestick is what makes it very dangerous for short-sellers as the reversal happens gradually and then accelerates quickly. A buy long trigger forms when the next candle rises through the high of the prior engulfing candle and stops can be placed under the lows of the harami candle.

Bearish Harami Candlestick

Bearish Harami Candlestick

The bearish harami is the inverted version of the bullish harami. The preceding engulfing candle should completely eclipse the range of the harami candle, like David versus Goliath. These form at the top of uptrends as the preceding green candle makes a new high with a large body, before the small harami candlestick forms as buying pressure gradually dissipates. Due to the gradual nature of the buying slow down, the longs assume the pullback is merely a pause before the up trend resumes.

As the bearish harami candlestick closes, the next candle closes lower which starts to concern the longs. When the low of the preceding engulfing candle broken, it triggers a panic sell-off as longs run for the exits to curtail further losses. The conventional short-sell triggers form when the low of the engulfing candle is breached and stops can be placed above the high of the harami candlestick.

Hanging Man Candlestick

Hanging Man Candlestick

A hanging man candlestick looks identical to a hammer candlestick but forms at the peak of an uptrend, rather than a bottom of a downtrend. The hanging man has a small body, lower shadow that is larger than the body (preferably twice the size or more) and a very small upper shadow. It is differs from a doji since it has a body that is formed at the top of the range. For some reason, the buyers thwarted a potential shooting star and lifted the candle to close at the upper range of the candle to maintain the bullish sentiment, often times artificially. However, the truth hits when the next candle closes under the hanging man as selling accelerates.

Hanging man candles are most effective at the peak of parabolic like price spikes composed of four or more consecutive green candles. Most bearish reversal candles will form on shooting stars and doji candlesticks. Hanging man candles are uncommon as they are a sign of a large buyer that gets trapped trying to support the momentum or an attempt the paint the tape to generate more liquidity to sell into.

A hanging man candlestick signals a potential peak of an uptrend as buyers who chased the price look down and wonder why they chased the price so high. It brings to mind the old road runner cartoons where Wile E. Coyote would be chasing the Road Runner and before he knew it, he realized he overstepped the cliff when he looks down, right before he plunges.

Short-sell triggers signal when the low of the hanging man candlestick is breached with trail stops placed above the high of the hanging man candle.

Dark Cloud Cover Candlestick

Dark Cloud Cover Candlestick

This is actually a three candlestick reversal formation where the dark cloud cover candle will actually make a new high of the uptrend sequence as it gaps above the prior candle close, but ends up closing red as sellers step in early. This indicates that longs were anxious to take proactive measure and sell their positions even as new highs were being made. Dark cloud cover candles should have bodies that close below the mid-point of the prior candlestick body. This is what distinguishes from a doji, shooting star or hanging man bearish reversal pattern. The prior candle, dark cloud candle and the following confirmation candle compose the three-candle pattern. The preceding candlesticks should be at least three consecutive green candles leading up the dark cloud cover candlestick.

The selling overwhelms and traps the new buyers. If the next candle fails to make a new high (above the dark cloud cover candlestick) then it sets up a short-sell trigger when the low of the third candlestick is breached. This opens up a trap door that indicates panic selling as longs evacuate the burning theater in a frenzied attempt to curtail losses. Short-sell signals trigger when the low of the third candle is breached, with trail stops set above the high of the dark cloud cover candle.

Understanding Basic Candlestick Charts

Candlestick charts originated in Japan over 100 years before the West developed the bar and point-and-figure charts. In the 1700s, a Japanese man named Homma discovered that, while there was a link between price and the supply and demand of rice, the markets were strongly influenced by the emotions of traders. 

Candlesticks show that emotion by visually representing the size of price moves with different colors. Traders use the candlesticks to make trading decisions based on regularly occurring patterns that help forecast the short-term direction of the price.

Key Takeaways

  • Candlestick charts are used by traders to determine possible price movement based on past patterns.
  • Candlesticks are useful when trading as they show four price points (open, close, high, and low) throughout the period of time the trader specifies.
  • Many algorithms are based on the same price information shown in candlestick charts.
  • Trading is often dictated by emotion, which can be read in candlestick charts.

Candlestick Components

Just like a bar chart, a daily candlestick shows the market’s open, high, low, and close price for the day. The candlestick has a wide part, which is called the “real body.”

This real body represents the price range between the open and close of that day’s trading. When the real body is filled in or black, it means the close was lower than the open. If the real body is empty, it means the close was higher than the open.

Traders can alter these colors in their trading platform. For example, a down candle is often shaded red instead of black, and up candles are often shaded green instead of white.

Candlestick vs. Bar Charts

Just above and below the real body are the “shadows” or “wicks.” The shadows show the high and low prices of that day’s trading. If the upper shadow on a down candle is short, it indicates that the open that day was near the high of the day.

A short upper shadow on an up day dictates that the close was near the high. The relationship between the days open, high, low, and close determines the look of the daily candlestick. Real bodies can be long or short and black or white. Shadows can be long or short.

Bar charts and candlestick charts show the same information, just in a different way. Candlestick charts are more visual, due to the color coding of the price bars and thicker real bodies, which are better at highlighting the difference between the open and the close.

The above chart shows the same exchange-traded fund (ETF) over the same time period. The lower chart uses colored bars, while the upper uses colored candlesticks. Some traders prefer to see the thickness of the real bodies, while others prefer the clean look of bar charts.

Basic Candlestick Patterns

Candlesticks are created by up and down movements in the price. While these price movements sometimes appear random, at other times they form patterns that traders use for analysis or trading purposes. There are many candlestick patterns. Here a sampling to get you started.

Patterns are separated into bullish and bearish. Bullish patterns indicate that the price is likely to rise, while bearish patterns indicate that the price is likely to fall. No pattern works all the time, as candlestick patterns represent tendencies in price movement, not guarantees.

Bearish Engulfing Pattern

A bearish engulfing pattern develops in an uptrend when sellers outnumber buyers. This action is reflected by a long red real body engulfing a small green real body. The pattern indicates that sellers are back in control and that the price could continue to decline.

Bullish Engulfing Pattern

An engulfing pattern on the bullish side of the market takes place when buyers outpace sellers. This is reflected in the chart by a long green real body engulfing a small red real body. With bulls having established some control, the price could head higher.

Bearish Evening Star

An evening star is a topping pattern. It is identified by the last candle in the pattern opening below the previous day’s small real body. The small real body can be either red or green. The last candle closes deep into the real body of the candle two days prior. The pattern shows a stalling of the buyers and then the sellers taking control. More selling could develop.

Bearish Harami

A bearish harami is a small real body (red) completely inside the previous day’s real body. This is not so much a pattern to act on, but it could be one to watch. The pattern shows indecision on the part of the buyers. If the price continues higher afterward, all may still be well with the uptrend, but a down candle following this pattern indicates a further slide.

Bullish Harami

The bullish harami is the opposite or the upside down bearish harami. A downtrend is in play, and a small real body (green) occurs inside the large real body (red) of the previous day. This tells the technician that the trend is pausing. If it is followed by another up day, more upside could be forthcoming.

Bearish Harami Cross

A bearish harami cross occurs in an uptrend, where an up candle is followed by a doji—the session where the candlestick has a virtually equal open and close. The doji is within the real body of the prior session. The implications are the same as the bearish harami.

Bullish Harami Cross

A bullish harami cross occurs in a downtrend, where a down candle is followed by a doji. The doji is within the real body of the prior session. The implications are the same as the bullish harami.

Let’s look at a few more patterns in black and white, which are also common colors for candlestick charts.

Bullish Rising Three

This pattern starts out with what is called a “long white day.” Then, on the second, third, and fourth trading sessions, small real bodies move the price lower, but they still stay within the price range of the long white day (day one in the pattern). The fifth and last day of the pattern is another long white day.

Even though the pattern shows us that the price is falling for three straight days, a new low is not seen, and the bull traders prepare for the next move up.

A slight variation of this pattern is when the second day gaps up slightly following the first long up day. Everything else about the pattern is the same; it just looks a little different. When that variation occurs, it’s called a “bullish mat hold.”

Bearish Falling Three

The pattern starts out with a strong down day. This is followed by three small real bodies that make upward progress but stay within the range of the first big down day. The pattern completes when the fifth day makes another large downward move. It shows that sellers are back in control and that the price could head lower.

The Bottom Line

As Japanese rice traders discovered centuries ago, investors’ emotions surrounding the trading of an asset have a major impact on that asset’s movement. Candlesticks help traders to gauge the emotions surrounding a stock, or other assets, helping them make better predictions about where that stock might be headed.

The 5 Most Powerful Candlestick Patterns

Candlestick charts are a technical tool that packs data for multiple time frames into single price bars. This makes them more useful than traditional open-high, low-close bars or simple lines that connect the dots of closing prices. Candlesticks build patterns that predict price direction once completed. Proper color coding adds depth to this colorful technical tool, which dates back to 18th-century Japanese rice traders.

Steve Nison brought candlestick patterns to the Western world in his popular 1991 book, “Japanese Candlestick Charting Techniques.”   Many traders can now identify dozens of these formations, which have colorful names like bearish dark cloud cover, evening star and three black crows. In addition, single bar patterns including the doji and hammer have been incorporated into dozens of long- and short-side trading strategies.

Key Takeaways

  • Candlestick patterns, which are technical trading tools, have been used for centuries to predict price direction.
  • There are various candlestick patterns used to determine price direction and momentum, including three line strike, two black gapping, three black crows, evening star, and abandoned baby.
  • However, it’s worth noting that many signals emitted by these candlestick patterns might not work reliably in the modern electronic environment.

Candlestick Pattern Reliability

Not all candlestick patterns work equally well. Their huge popularity has lowered reliability because they’ve been deconstructed by hedge funds and their algorithms. These well-funded players rely on lightning-speed execution to trade against retail investors and traditional fund managers who execute technical analysis strategies found in popular texts.

In other words, hedge fund managers use software to trap participants looking for high-odds bullish or bearish outcomes. However, reliable patterns continue to appear, allowing for short- and long-term profit opportunities.

Here are five candlestick patterns that perform exceptionally well as precursors of price direction and momentum. Each works within the context of surrounding price bars in predicting higher or lower prices. They are also time sensitive in two ways:

  1. they only work within the limitations of the chart being reviewed, whether intraday, daily, weekly or monthly.
  2. their potency decreases rapidly three to five bars after the pattern has completed.

Top 5 Candlestick Patterns

This analysis relies on the work of Thomas Bulkowski, who built performance rankings for candlestick patterns in his 2008 book, “Encyclopedia of Candlestick Charts.”   He offers statistics for two kinds of expected pattern outcomes:

  1. reversal – Candlestick reversal patterns predict a change in price direction
  2. continuation – while continuation patterns predict an extension in the current price direction.

In the following examples, the hollow white candlestick denotes a closing print higher than the opening print, while the black candlestick denotes a closing print lower than the opening print.

  • Three Line Strike

The bullish three line strike reversal pattern carves out three black candles within a downtrend.   Each bar posts a lower low and closes near the intrabar low. The fourth bar opens even lower but reverses in a wide-range outside bar that closes above the high of the first candle in the series. The opening print also marks the low of the fourth bar. According to Bulkowski, this reversal predicts higher prices with an 84% accuracy rate. 

  • Two Black Gapping

The bearish two black gapping continuation pattern appears after a notable top in an uptrend, with a gap down that yields two black bars posting lower lows.   This pattern predicts that the decline will continue to even lower lows, perhaps triggering a broader-scale downtrend. According to Bulkowski, this pattern predicts lower prices with a 68% accuracy rate. 

  • Three Black Crows

The bearish three black crows reversal pattern starts at or near the high of an uptrend, with three black bars posting lower lows that close near intrabar lows. This pattern predicts that the decline will continue to even lower lows, perhaps triggering a broader-scale downtrend. The most bearish version starts at a new high (point A on the chart) because it traps buyers entering momentum plays. According to Bulkowski, this pattern predicts lower prices with a 78% accuracy rate. 

  • Evening Star

The bearish evening star reversal pattern starts with a tall white bar that carries an uptrend to a new high.   The market gaps higher on the next bar, but fresh buyers fail to appear, yielding a narrow range candlestick. A gap down on the third bar completes the pattern, which predicts that the decline will continue to even lower lows, perhaps triggering a broader-scale downtrend. According to Bulkowski, this pattern predicts lower prices with a 72% accuracy rate. 

  • Abandoned Baby

The bullish abandoned baby reversal pattern appears at the low of a downtrend, after a series of black candles print lower lows.   The market gaps lower on the next bar, but fresh sellers fail to appear, yielding a narrow range doji candlestick with opening and closing prints at the same price. A bullish gap on the third bar completes the pattern, which predicts that the recovery will continue to even higher highs, perhaps triggering a broader-scale uptrend. According to Bulkowski, this pattern predicts higher prices with a 70% accuracy rate. 

The Bottom Line

Candlestick patterns capture the attention of market players, but many reversal and continuation signals emitted by these patterns don’t work reliably in the modern electronic environment. Fortunately, statistics by Thomas Bulkowski show unusual accuracy for a narrow selection of these patterns, offering traders actionable buy and sell signals.

Putting the insights gained from looking at candlestick patterns to use and investing in an asset based on them would require a brokerage account. To save some research time, Investopedia has put together a list of the best online brokers so you can find the right broker for your investment needs.

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