Candlestick is a pattern originated in Japan and is used by Japanese from a very long time. West started using this pattern a few decades ago only. The term, candlestick, actually refers to two different, but related subjects. First, & possibly the more popular, is the method of displaying stock & futures data for chart analysis.
Secondly, is the art of identifying certain combinations of candlesticks in defining the proven combinations. Fortunately, both techniques can be used independently or in combination.
Charting market data in candlestick form uses the same data available for standard bar charts; open,high, low & close prices. While using the exact same data, candlestick charts offer a much more visually appealing chart.
You can see how the name “candlesticks” came about. They look somewhat like a candle with a wick. The rectangle represents the difference between the close & open price for the day, & is called the body. Notice that the body can be either black or white.
A white body means that the closer price was greater than the open price. The black body means that the close price was lower than the open price. The small lines above & below the body are referred to as wicks or hairs or shadows.
The different shapes for candlesticks have different meanings. The Japanese have defined different primary candlesticks, based upon the relationship of open, high, low & closes prices.
Different body/shadow combinations have different meanings. Days in which the difference in open & close prices is great are Long Days. Likeways, days in which the difference between the open & close price is small. Are called Short Days.
Spinning Tops are days in which the candlesticks have small bodies with upper & lower shadows that are of greater length than that of the body. The body colour is relatively unimportant in spinning top candlesticks. These candlesticks are considered as days of indecision.
When the open price & the close price are equal, they are called Doli lines. Doji candlesticks can have shadows of varying length. When referring to Doji candlesticks, there is some consideration as to whether the open & close price must be exactly equal. This is a time when the prices must be almost equal, especially when dealing with large price movements.
The Long-legged Doji has long upper & lower shadows & reflects considerable indecision on the part of market participants. The Gravestone Doji has only a long upper shadow & no lower shadow. The longer the upper shadow, the more bearish the interpretation.
The Dragonfly Doji is the opposite of the Gravestone Doji, the lower shadow is long & there is no upper shadow. It is usually considered quite bullish.
Candle Pattern Analysis
A Japanese candle pattern is a psychological depiction of traders’ mentality at the time. It vividly shows the actions of the traders as time unfolds in the market.
A Japanese candle pattern can consist of a single candlestick line or be a combination of multiple lines, normally never more than five. While most candle patterns are used to determine reversal points in the market, there are few that are used to determine trend continuation. They are referred to as reversal & continuation patterns. Whenever a reversal pattern has bullish implications, an inversely related pattern has bearish meaning.
Similarly, whenever a continuation pattern has bullish implications, an opposite pattern gives bearish meaning. When there is a pair of patterns that work both in bearish & bullish situations, they usually have the same name.
A reversal candle pattern is a combination of Japanese candlesticks that normally indicate a reversal of the trend. One serious consideration that must be used to help identify patterns as being either bullish or bearish is the trend of the market preceding the pattern.
You can not have a bullish reversal pattern in an uptrend. You can have a series of candlestick that resemble the bullish pattern, but if a trend is up, it is not a bullish Japanese candlestick pattern. Likewise, you can not have a bearish reversal candle pattern in a downtrend.
Dark Cloud Cover
This is a two day reversal pattern that only has bearish implications. This is also one of the times when the pattern’s counterpart exists but has a different name. The first day of this pattern is a long white candlestick. This reflects the current trend of the market & helps confirm the uptrend to traders.
The next day opens above the high price of the previous day, again adding to the bullishness. However, trading for the rest of the day is lower with a close price at least below the midpoint of the body of the first day.
This is a significant blow to the bullish mentality & will force many to exit the market. Since the close price is below the open price on the second day, the body is black. This is the dark cloud referred to in the name.
Trading Strategies for Beginners
The opposite of the Dark Cloud Cover, the Piercing Line, has bullish implications. The scenario is quite similar, but opposite. A downtrend is in place, the first candlestick is the long black day which solidifies traders’ confidence in the downtrend. The next day, prices open at a new low & trade higher all day & close above the midpoint of the first candlestick’s body. This offers a significant change to the downtrend mentality and many will reverse or exit their position.
Evening Star & Morning Star
The Evening Star & its cousin, the Morning Star, are two powerful reversal candle patterns. These are both three day patterns that work exceptionally well. The evening star is a bearish reversal candle pattern, as its name suggests.
The first day of this pattern is a long white candlestick which fully enforces the current uptrend. In the open of the second day, prices gap up above the body of the first day. Trading on the second day is somewhat restricted & the close price is near the open price while remaining above the body of the first day. The body for the second day is small. This type of day following a long day is called a Star pattern.
A star is a small body that gaps away from a long body day. The third & last day of this pattern opens with a gap below the body of the star & closes lower with the close price below the midpoint of the first day.
Each trading day, a decision needs to be made, whether it is to exit the trade, enter a trade, or remain in the trade. A candle pattern that helps identify the fact that the current trend is going to continue is more valuable than may first appear. It helps answer the question as to whether or not you should remain in a trade.
Rising & Falling Three Methods
The Rising three methods continuation candle pattern is the bullish counterpart to this duo and will be the subject of the scenario building. A bullish continuation pattern can only occur in an uptrend & a bearish continuation pattern can only occur in a downtrend. This restated the required relationship to the trend that is so necessary in candle pattern analysis.
The first day of the Rising Three Methods pattern is a long white day which fully supports the uptrending market. However over the course of the next three trading periods, small body days occur which, as a group, trend downward.
They all remain within the range of the first day’s long white body & at least two of these three small bodied days have black bodies. This period of time when the market appears to have gone nowhere is considered by the Japanese as a “period of rest.”
On the fifth day of this pattern, another long white day occurs which closes at a new high. Prices have finally broken out of the short trending range and the uptrend will continue.
Japanese candlestick charting & candle pattern analysis are essential tools for making market timing decisions. One should use Japanese candle patterns in the same manner as any other technical tool or technique; that is, to study the psychology of market participants. Once you become used to seeing your price charts using candlesticks, you may not want to use bar charts again.
Japanese candle patterns, used in conjunction with other technical indicators in the filtering concept, will almost always offer a trading signal prior to using other price based indicators.