How to interpret the Candlestick Charts

Interpreting the Candlestick Charts

Candlestick charts were developed by early Japanese Rice Future Traders in the 17^th century. The Japanese traders considered the behavior of price more important than the cause of the price movement. They also believed that the price movement was mainly due to the buyers and sellers trading activity based on speculations, fear, greed and other factors. Therefore the underlying value may not reflect the actual price of a stock. These are the factors that led to the Candlestick charting development. Today it has evolved itself to become a reliable tool for assessing any given market. It has the ability to foresee the market with greater accuracy. Today it is widely used for market analysis and a prediction tool. Candlestick charts when used with other trend indicators, gives a trader the much required confidence. The knowledge of Candlestick Charting is very essential for a trader.

This article attempts to focus on some of the most important Candlestick chart patterns, which has very commonly occurrence 

The above diagram is a description of a basic Candle. It consists of an Upper shadow, a Lower shadow, Opening Price, Highest Price, Lowest Price, and Closing Price. The positive candle is indicated in green body color. The negative candle is indicated in red body color. This may also be represented by other colors like white and blue. The candle can have long or short bodies. Long bodies indicate the intensity of the trading activity by the buyers and sellers. Short bodies on the other hand, tell us the level of participation and indicate price consolidation. Each candlestick pattern varies considerably and given appropriate names identifying them. Most of these names are Japanese as this system was developed in Japan. 

Long Shadows

Long shadows are a common occurrence in the candlesticks charts. Hence understanding this pattern becomes necessary. A longer upper shadow tells us that the buyers were in control, until the sellers pushed the price downwards. A longer lower shadow indicates the dominance of the sellers in the trading session and the buyers stepping in to push the prices upwards. Whenever we observe a longer shadow, we should remember this in order to avoid unnecessary panic.

Engulfing patterns

Bullish Engulfing Pattern

 This is an important pattern which should be always looked for in a chart. In this pattern we see a green candle forming after the red candle. The green candle is larger than the red candle. It covers completely cover the red candle. This pattern indicates that the bulls are getting ready to step in a big way. In other words there is buying activity which surpasses that of selling pressure. This pattern can normally form in a downtrend or even in a sideways moving market. By looking for a confirmation signal, we can interpret this pattern as a reversal in the making.

Bearish Engulfing Pattern

The Bearish Engulfing Pattern exactly the opposite of Bullish Engulfing. The second red body completely covers the previous day’s green candle.  This type of pattern can be found in an uptrend market. This means the bears have controlled the days and they are winning. Like the Bullish engulfing this pattern too very important as it signals that the market is neared its top and a reversal in trend is signaled. 

Hammer

The general rule for this pattern is the lower shadow will be twice that of the body. The Hammer can be found at the bottom of a down trend. However this can occur even in the middle of the downtrend. This along with other confirming indicators will identify a termination of a downtrend and a possible reversal. Another important point to note here is Hammer is an indication of support levels being formed. 

Inverted Hammer

The Inverted Hammer and Shooting Star will be almost same except for the body color. Depending on the place it appears in a chart they carry different meaning. The green body inverted hammers appearing in a downtrend signals a trend reversal. The red body shooting star appearing on an uptrend chart, cautions a trend reversal. These candlestick patterns require a confirmation candle formation. 

Hanging Man

The Hanging man pattern also carries the same rule as a Hammer. This will be white candle forming at the top of an uptrend. This signals the stock price more room left to move upwards. The next candle will decide the course of action.

Shooting star

This pattern also appears in an uptrend market. A candle appears with a long upper shadow this pattern indicates the bears are trying to pull the price down and manage to succeed. When this pattern forms usually the next candle gives out the definite signals – probably a trend reversal.

 

Bullish Harami

This pattern can be identified as white (green) candle forming at the end of the down trend. While the previous candles may reflect the general trend the last candle will be white. Its upper shadow and the lower shadow will be within the previous candle. This is trend reversal signal that means the Bears are giving up.

Bearish Harami

This is exactly opposite of Bullish Harami. This can be seen in an uptrend market. The body of the previous candle will be green and the last candle will be red. This signals the Bears are ready to step in and a possible trend reversal.

Both Bullish Harami and Bearish Harami are very important signals as they can indicate a trend reversal in advance

Doji

The Doji is a pattern that signals a reversal in the trend. This can also indicate disturbance in the ongoing trend. It is identified when the opening price and the closing price are almost the same. The length of the upper shadow or the lower shadow may be any length. The most important thing is opening price should be more or less equal to closing price. This can be safely interpreted as the buyers are not willing to enter market. The sellers are trying to hold on to the price and not willing to give up.

The Gravestone Doji

 This type of Doji can be identified with longer upper shadow and no lower shadow. It will still have the same open and close price. This is not a commonly occurring signal. The Grave stone Doji can be found when market is bottoming out. 

Dragonfly Doji

Dragon fly Doji can be identified from its long lower shadow.  The candle resembles the letter “T". The candle bears no upper shadow. Dragon fly Doji is an indication of sellers domination in the trading session and buyers determination of holding on to the price and taking the price back to the opening levels 

The interpretation of this candle could be said as a reversal after a long downtrend. If this pattern appears in an uptrend market this indicates a resistance forming. A confirmation candle forming after this pattern plays important role in deciding the future trend of the market. 

Long-legged Doji

The Long-legged Doji can be seen very often in a candlestick chart. It can be easily identified. It will consist of a longer upper shadow and lower shadow. This type of Doji also signals a reversal pattern. We often observe the ongoing trend being reversed after the formation of long legged Doji.

Morning Star

This formation is normally observed in a downtrend. This pattern can be seen very frequently. This consists of three candles- one green and two red. The second green candle signals a reversal formation happening. This confirms the end of the downtrend.  In other words the bulls are about to step in. this pattern is considered a very important especially in a long downtrend to identify a reversal.

Evening Star

Like the morning star this pattern too consists of three candles. This formation can happen in an uptrend. The first and the second candle indicate the uptrend is on. The third candle which is almost covering the first candle signals that the Bulls are giving way to bears. This pattern can happen in the middle of an uptrend or at the top of the uptrend.

Marubozu

Marubozu in Japanese language means a clear cut or shaven. The candle that goes to make up the Marubozu signal does not carry any shadows (both upper and lower). Only the body is displayed. We have to understand this pattern well because this is a strong pattern. In a bullish Marubozu, the stock opens at a price and goes on to climb high and close well above. This indicates the Bulls are in control of the market. On the contrary the Bearish Marubozu, there will not be any highs or lows. The opening price will decline to close at a price. This indicates the Bears are in control of the market. In both pattern the length of the candle body will be long.

Close Marubozu - Close Marubozu will have no upper shadow. This is a strong signal indicating the continuation of the trend.

Open Marubozu - The Open Marubozu is the reversal of the close Marubozu. This too when found in the charts we observe a continuation of the trend.

Dark Cloud Cover

 The Dark Cloud Cover consists of two candles. The second red candle will indicate a higher opening than the previous candle. This pattern normally indicates a reversal. But a confirmation will be needed to take a call. Or confirming other indicators must be looked into.

Spinning Top

Spinning tops could be identified by its long lower or upper shadow and a small red or green body. Essentially spinning tops indicates the continuation of the market trend. When it appears in an uptrend it confirms the continuation of the upper trend. In a downtrend it will reaffirm the downtrend. In a sideways market also it should be regarded as a continuation of sideways trend. 

Three Black Crows

This is a pattern which forms in the up trending market. It comprises of three almost identical red candles trending down wards. This gives the appearance of three birds sitting on a tree branch which is pointing downwards. This pattern points out that the price of the stock is looking downwards and even lower price could be expected.

Three white soldiers 

This is an inverted pattern of three black crows. This is a reversal pattern normally forms in the downtrend. However the proceeding candles should be taken into consideration before arriving at any trading decision. 

Bullish Abandoned Baby

This pattern is rarely seen in a chart. But if noticed this could be a very reliable pattern. This pattern consists of a Doji in between bullish and bearish candles. The Doji is placed in a gap down like pattern. The Doji indicates the uncertainty in the market. The following green candle indicates the reversal trend in the making. Naturally, this pattern can be seen in the end of a downtrend.

Bearish Abandoned Baby

The Bearish Abandoned Baby is exactly opposed to the Bullish Abandoned baby this can form in an uptrend market. A Doji appearing in a gap up like pattern, after which a red candle forms well below the first candle. This indicates a downtrend. The reliability of these candle stick patterns are quite high. Any student of candlestick charting should not ignore this pattern.

Candlesticks offer us a safe way of studying the markets. All the data are well presented for easier understanding of the trading session. However candlesticks cannot indicate the trading session in a sequence. The highs and lows could have formed anytime during the session. It may be middle of the session or towards the end of the session. Also the order of highs and lows can also change. This means the high may have come first and the low followed. This order can be reversed too, which means the low may have come first and high following it. Apart from this candlestick charting method is a reliable system for any trader.

In the above write-up I have focused mainly on very commonly seen chart patterns, which can be of great value to a student of candlestick charting. I wish every reader of this article good luck and happy trading!