In addition to standard price graphs, e.g. line graphs or bar graphs, most traders use a more advanced and informative graph called the candlestick graph.
The name candlestick comes from each bar, which resembles a candle and is therefore called a candle.
A regular line graph only shows the closing price while a candlestick graph shows an opening price, the lowest price, the highest price and a closing price for the selected period.
So, what are Candlesticks?
A candlestick chart / diagram is a digram that shows the development in a price over a selected time period. It is simply a price graph but instead of lines it contains candles / bars. Each bar represents a selected time period and each bar has a body and any tails on the top and bottom.
The black vertical lines that form above and below the body are called tails. The red and green boxes are called body. The body can be red or green or it can just be a line.
- Green body = the price has risen
- Red body = the price has gone down
- Only one line = the price is unchanged.
How to trade using candlesticks
There are a number of ways to use candlesticks to create an edge in the market. You can use the bars to identify support and resistance, but you can also find formations in the bars which in turn give buy or sell signals.
1. Support and resistance using the bars
Many people look at the bars and identify support and resistance.
You can, for example, see if several tails go to approximately the same price level several times and then turn back again and close a bit away from that level.
Then you can see that there may be support at just that level.
There are buyers or sellers who cut to as soon as the price reaches there.
You can also use the highest or lowest of the previous bar as support or resistance. The trade in the previous bar showed that it turned at these levels and it can therefore do about the same during the next bar.
If a long tail is formed on the underside, it shows that there are probably buyers lying and lurking in the lower part of the tail.
2. Formations in the bars
The most common is to look for formations in the bars.
The design of the bars gossips about the trade and gives buy or sell signals via their appearance. You can use single bars as a buy and sell signal, but you can also combine 2-3 bars to create a formation.
You can find formations that give a signal that the trend is reversing (cover formations) and you can find formations that show that the trend is likely to continue (continuation formations).
When you look at individual bars, you usually look for weakness or strength in the bars.
Long tails on the underside often indicate strength while long tails on the upper side indicate weakness.
Advantages of Candlesticks in trading
Since their introduction more than three decades ago, candlesticks have become one of the most common and popular chart types on the market.
Candlesticks simply have many benefits, and here are some of them:
1. Easy to read the market
Candlesticks are easy to interpret, and even an amateur can feel at home quickly and follow the movements of the market.
The colorful boxes make the candlesticks easy to read and easy to decipher, which means that you immediately get an overview of market movements.
The fact that you do not have to waste time and capacity to interpret what the market has done gives you more time and energy to do what counts, namely to analyze the market.
2. Candlesticks form patterns
As many of you probably already know, candlesticks can form a plethora of different candlestick patterns and candlestick formations, all of which are interpreted differently.
Just to name a few, hammer, shooting star, hanging man, marubozu, candlestick doji, and spinning top are some popular candlesticks.
When several candlesticks are put together, they form recognizable patterns, such as harami, hiccup, evening star, abandoned baby and tweezers.
All these patterns tell different stories about how the market has moved, and how supply and demand have shaped the price graph.
How to use candlesticks without memorizing them
In this guide I will cover a lot of different candlesticks and candlestick formations. What we already want to point out, however, is that it is not necessary to memorize all the patterns separately.
The important thing is to understand how the candlesticks reflect market behaviors, and what these behaviors mean.
Here are some tips to help you read candlesticks without memorizing them.
1. Candlens Closing Price
A closer look at where in relation to the range that the candlestick closed, can help you understand what forces are currently controlling in a candlestick chart.
If the closing price is close to the highest quotation, it is a sign of a strong positive force.
Likewise, a closure near the lowest quotation is an indication that it is the sellers who are in control at the moment. To take an example, the closing price of a bullish engulfing, which is a positive signal, is close to the highs.
This shows that it is the buyers who have control.
If, on the other hand, you look at a bearish engulfing or dark cloud cover, the closing price of, for example, the share is close to the lowest listing, which indicates that it is the sellers who are in control at the moment.
Here is an example:
Gaps are important to keep track of, because what happens while the market is closed can provide us with strong clues as to which direction the market will move in the future.
A gap is simply when the market opens higher or lower than the closed one, which creates a gap in the price range. In addition to noting in which direction the gap occurs, you should also note whether the gap fills or not.
An open gap that is not filled signals that the market is not strong enough to fill the gap.
And of course, such an insight can help you in your market analysis.
How the candlesticks fit into the general market structure
Price movements often create different structures, or imminent patterns in the market.
Some patterns that many traders look at are the head-shoulder formation, double bottom and double top formations, triangles and wedges.
And depending on where a candlestick pattern arises in relation to these structures, it may be more or less relevant.
To take an example, a positive wrap formation on the right shoulder in a main-shoulder formation is not very relevant.
However, perhaps a negative cover formation would be something to keep your eyes open for!
To be completely honest, my experience is that graph patterns such as the head-shoulder formation do not work very well!
Be careful when incorporating things into your trading! The absolute best way to avoid using things that do not work is backtesting!
How time resolution affects candlesticks in a chart
As with any other type of signal, the reliability of a candlestick is very much affected by the time resolution you use.
A cover formation formed in the 1-minute chart is by no means as reliable as one in the daily chart.
In other words, higher time resolutions have higher reliability, and there are several reasons for this:
1. Higher time resolutions cover more transactions
Each candlestick represents all transactions in the market that took place during a certain period of time.
In other words, many more transactions take place in candlesticks that represent a longer period of time, which gives greater weight to what they show.
For example, 5 minutes may not be long enough to absorb a single order from an institutional player.
Over the course of a day, however, it is much more likely that even a large player will have time to make a lot of transactions, which increases the weight behind the signal given.
2. Higher time resolutions have less noise
What appears to be a large price movement in small bars may not even be enough to be noticed in the higher time resolutions.
A trend in the five-minute resolution could, for example, be a single candlestick in the 4-hour resolution.
Usually the shorter the intervals you use, the more noise there is!
3. Higher time resolutions show the trend much more clearly.
A higher time resolution has enough weight in itself to be able to chart a trend in the market, which may not be the case with lower time resolutions.
Summary / Brief History
There are countless forms of candlesticks and candlesticks formations with names like Hammer, Evening Star etc.
Some candlesticks have Japanese names, such as Harami candlesticks. This is because candlesticks were originally a Japanese invention that was already used a couple of hundred years ago to predict price movements in rice.
Since then, Steve Nison in particular has introduced the concept of use in modern technical analysis of the securities market in the book “Japanese Candlesticks Charting Techniques”.