Candlestick patterns are visual representations in the chart form that play a key role in trading strategies. These patterns are easy to read as their formation is simple. For creating a trading strategy with candlestick patterns, you need to know the concepts such as what the candlestick patterns are, how they are formed, their types, their working etc.
You can learn all about the abovementioned concepts with this blog that covers the candlestick patterns in detail.
This blog covers:
- What are candlesticks?
- Anatomy of candlesticks
- History of candlesticks
- Candlestick charts vs line charts
- What are candlestick patterns?
- Categories of candlestick patterns
- Types of candlestick patterns
- How to read different candlestick patterns?
- Benefits of reading candlestick patterns for trading
- Drawbacks of reading candlestick patterns for trading
- How to overcome the drawbacks related to candlestick patterns trading?
- Frequently Asked Questions about Candlestick patterns
What are candlesticks?
Candlesticks are used in trading to represent the Open, High, Low, and Close (OHLC) price movements of the tradable instrument (security, derivative, currency etc.). Candlesticks resemble the shape of a real-life candlestick and hence, the name.
You can see the OHLC prices in the image below with the help of candlestick formation. These prices indicate three situations in the market or of a financial instrument.
There are two types of candlesticks indicating the trend of the market or an instrument. These two types are:
- White Candlesticks or Green Candlesticks: Indicate an uptrend
- Black Candlesticks or Red Candlesticks: Indicate a downtrend
Candlesticks have various sizes, shapes and even colours to portray different prices. Since the prices keep varying, the size and shape of the candlesticks also vary.
These various shapes and sizes can be highly effective in helping you predict the future market direction since they can point towards the formation of a trend or anticipation of a trend reversal.
Here is a short video below to help you learn all about candlesticks.
Let us learn more about candlesticks by seeing the anatomy of the same which will help you with the information regarding what each part of the candlestick represents.
Anatomy of candlesticks
The anatomy of the Candlesticks has stayed almost similar throughout the ages to give us the current shape and meaning. It consists of 4 distinct values namely:
- The opening price,
- Closing price,
- The highest price for a given interval, and
- The lowest price for a given interval.
It is like a combination of a line chart and a bar chart, where each bar represents all four important pieces of information for an interval.
In the image above, the thin vertical lines above and below the body are called the wicks or shadows which represent the high and low prices of the trading session.
Ahead in the blog, let us find out about how candlesticks came about and more about their interesting history.
History of candlesticks
Candlesticks were developed in the 17th century in Japan. This is the reason why they are also known as Japanese candlesticks.
After they were developed, locals in Japan began using candlesticks while trading rice. This idea was gradually adopted by various people and across countries and kept evolving for the better. The evolution of the same led to what the candlesticks are at present.
Japanese Candlesticks are thought to have been introduced to the West in the book, ‘Japanese Candlestick Charting Techniques by Steve Nison. The West developed the bar point and figure analysis almost 100 years later.
In ancient Japan, the principles were applicable to Rice and today they are applicable to stocks.
Munehisa Homma, a renowned rice merchant from the Japanese town of Sakata, traded in the Dojima market in the 1700s. Further study of candlesticks mentions ‘Sakata’s Methods’ or ‘Sakata’s Rules’, which are based on the name of this particular market.
Homma is said to have developed candlestick charts during his lifetime by studying years of historical data and comparing them with weather conditions. This study also helped him understand the role of emotions in the value and pricing behind the trade of rice.
Let us take a look at the difference between candlestick charts and line charts in the next section.
Candlestick charts vs line charts
Below you can see the tabular representation of the difference between candlestick charts and line charts.
|
Feature |
Candlestick Charts |
Line Chart |
|
Representation |
Depicts four key price points: Open, High, Low, and Close. |
Typically represents only the closing prices over time. |
|
Visual Detail |
Provides detailed information with OHLC price movements indicating market sentiment (bullish candlestick pattern or bearish candlestick pattern). |
Offers a simple view of closing price creating a line chart over a period of time. |
|
Pattern Recognition |
Allows identification of specific candlestick patterns (e.g., Doji, Hammer, Engulfing) that can signal potential reversals or continuations of trend. |
Recognises broader trends with the help of price lines over a period of time. |
|
Time Frame |
Each candlestick represents a specific period (e.g., 1 minute, 1 day), showing the price movement within that period. |
Usually represents the line for closing price at regular intervals (e.g., daily, weekly). |
|
Market Sentiment |
Can indicate market sentiment through the body and shadows of the candlesticks. |
Can provide a rough indication. If it is a minute time horizon, then a fall can indicate fear in the market and vice versa. |
|
Complexity |
Needs knowledge of candlesticks in order to be able to read and interpret. |
Simpler to read, and suitable for quickly understanding the overall trend. |
|
Usage |
Popular among technical analysts and traders who focus on short-term trading strategies owing to the detailings of OHLC available for shorter time periods. |
Often used for long-term trend analysis, providing a clearer view of the overall market direction. |
|
Price movement range |
Shows the highest and lowest prices within the time frame through the wicks or shadows. |
Displays only one type of price line at a time. |
Let us see the practical example of both candlestick chart and line chart with AAPL Inc.
Candlestick chart
Below is the candlestick chart representing candlesticks (bullish or bearish).
Here are the observations for the chart:
- Each candlestick is formed based on the OHLC of the particular trading day.
- The interval is one trading day for a year.
- The stock used is Apple Inc.
Line chart
The line chart below shows the close price of Apple Inc. for a year.
Recommended read:
How to use Pivot Point in conjunction with candlestick charts
As we know about candlesticks in detail now, we will discuss the meaning and use of candlestick patterns next.
What are candlestick patterns?
Candlesticks are the graphical representations of price movements which are commonly formed by the open, high, low, and close prices of a financial instrument. These candlesticks are used to identify the trading patterns which help the technical analysts take the trading positions.
Also, sometimes you will find similar-looking candlesticks or a group of the same appearing frequently which can give you a particular pattern for that very time period.
This video below covers information regarding candlestick patterns and their advantages in brief.
Going forward, we will look at the categories in which candlestick patterns are divided for predicting price movements.
Categories of candlestick patterns
Trade analysts use candlestick patterns to recognise market turning points and they are utilised to reduce one’s exposure to market risks. Also, candlestick patterns can be based on two candlesticks and at times even a series of multiple candlesticks can be used.
- Candlestick patterns are divided into the number of Candlesticks: One, Two, Three and more.
- Candlestick patterns are categorised into two broad categories, namely Bullish and Bearish.
Bearish candle
When the body is filled, with black or red colour, it means that the close is lower than the open and is known as the bearish candle.
It implies that the bearish price movements led to the prices going down and hence, the closing price turned out to be lower than the opening price.
Bullish candle
If the body is empty, is white or green, then it means that the close was higher than the open making it a bullish candle.
It implies that the bullish price movements led to the prices going up and hence, the closing price turned out to be higher than the opening price.
We will now discuss the types of candlestick patterns.
Types of candlestick patterns
With the variety of candlesticks that are prevalent in the market, it is only with practice that you may gain complete knowledge of each of them.
We have compiled all the types of candlestick patterns in one infographic. This infographic will be very useful for those who are using candlestick techniques to monitor market movement and also for those who are learning about them.
These are the candlestick patterns represented below:
How to read different candlestick patterns?
You may have come across a lot of candlestick patterns, but do you know the interpretation of some commonly observed patterns helps?
Below are some candlesticks and their interpretation that will be helpful for making the trading decisions. The candlestick patterns can be read as three main categories that is as follows:
- Single-Candlestick Patterns
- Multi-Candlestick Patterns
- Price Action Patterns (Over Multiple Candles)
Single-Candlestick Patterns
- White Candlestick and Black Candlestick - White candlestick represents a bullish candle where the closing price is higher than the opening price.
The black candlestick represents a bearish candle where the closing price is lower than the opening price.
- Hammer and Inverted Hammer - Hammer is a bullish reversal pattern with a small body and a long lower shadow, indicating that buyers pushed the price up after sellers initially drove it down. Inverted Hammer is a bullish reversal pattern with a small body and a long upper shadow, indicating potential reversal after a downtrend.
- Spinning Tops - Candlesticks with small bodies and long upper and lower shadows, indicating indecision and potential for a reversal or continuation.
- Doji - A candlestick where the open and close prices are nearly equal, indicating indecision in the market.
- Marubozu - A candlestick with no shadows, indicating strong momentum in the direction of the candle (bullish if it's a white Marubozu, bearish if it's a black Marubozu).
Recommended read:
Candlestick Trading: A Momentum Strategy with Example
- Bullish Pin Bar and Bearish Pin Bar - Pin bars are quite frequent and are the most powerful patterns. It is commonly known that a pin bar has a very long shadow and a small body.
Hence, a bullish pin bar must have a lower low as compared to the previous candle.
A “small” body can be defined as a body whose width is less than the candle range divided by 3.
A bullish pin bar will then have the body located in the upper half of the candle.
The bearish pin bar is similar to the bullish pin bar, but the body is now located in the lower half of the candle and it has a higher high than the previous candle.
Multi-Candlestick Patterns
- Inside Bar - It is a pattern that is made of two candles. The second entire candle is included in the range of the first candle.
The inside bar pattern shows a contraction in volatility that may be a prelude to a strong directional explosion.
- Outside Bar - It is the opposite of the inside bar. The candle range includes the entire previous candle.
Price Action Patterns (Over Multiple Candles)
- Bullish Swing - This is a simple one which is a 3-candle pattern. The second candle has the lowest low among the three. It signals a possible bullish movement in the prices.
- Bearish Swing - It is the opposite of a bullish swing. It is also a 3-candle pattern and the second candle here has the highest high.
The patterns above fit into different types of technical analysis, with single-candlestick patterns providing immediate signals, multi-candlestick patterns offering more context, and price action patterns reflecting broader market trends.
Going ahead, let us also see which benefits come with reading candlestick patterns for trading.
Benefits of reading candlestick patterns for trading
Here are some benefits of candlestick patterns while trading.
|
Benefit |
Description |
|
Visual Representation of Price Action |
Provides a clear, visual interpretation of price movements, showing open, close, high, and low prices. |
|
Identification of Market Sentiment |
Helps gauge overall market sentiment, identifying whether buyers or sellers are in control. |
|
Recognition of Reversal and Continuation Signals |
Detects potential trend reversals (e.g., Doji, Hammer) or continuations (e.g., Marubozu). |
|
Timing of Trades |
Assists in fine-tuning trade entry and exit points based on specific patterns. |
|
Versatility Across Markets and Time Frames |
Can be applied to various markets (stocks, forex, etc.) and time frames (minutes to weeks). |
|
Enhancement of Trading Strategies |
Works well with other technical indicators (e.g., RSI, MACD) to strengthen trading strategies. |
|
Early Warning Signals |
Provides early indications of potential market movements, allowing for quick reactions. |
|
Risk Management |
Aids in setting stop losses and taking profits by identifying potential reversal points. |
|
Psychological Insights |
Offers insight into market psychology, understanding the actions of buyers and sellers. |
|
Simplification of Complex Market Data |
Condenses complex market data into an easy-to-read visual format. |
Along with the advantages, there are some drawbacks as well that you should be aware of.
Drawbacks of reading candlestick patterns for trading
Below you can see some drawbacks.
|
Drawback |
Description |
|
Subjectivity in Interpretation |
Candlestick patterns can be interpreted differently by different traders, leading to inconsistent decisions. |
|
No Guarantee of Success |
Patterns do not always predict future price movements accurately, and relying solely on them can lead to losses. |
|
Limited in Ranging Markets |
Candlestick patterns are less effective in ranging or sideways markets where trends are unclear. |
|
Requires Experience |
Properly reading and interpreting patterns requires experience and knowledge, which can be a barrier for beginners. |
|
Lack of Context |
Candlestick patterns alone may not provide enough context; they often need to be used with other indicators. |
|
Over-Reliance on Historical Data |
Patterns are based on past price movements and may not account for unexpected market events or news. |
|
Short-Term Focus |
Candlestick patterns are often more useful for short-term trading, which may not suit all trading strategies. |
|
False Signals |
Patterns can produce false signals, leading to premature trades or incorrect decisions. |
|
Complexity in Combination |
Combining multiple patterns and indicators can become complex and confusing, leading to analysis paralysis. |
|
Market Noise |
In volatile markets, candlestick patterns can be distorted by market noise, reducing their reliability. |
But, is it possible to overcome the drawbacks? Definitely Yes!
Let us discuss the ways to overcome the drawbacks related to candlestick patterns trading.
How to overcome the drawbacks related to candlestick patterns trading?
|
Drawback |
Overcoming Strategy |
|
Subjectivity in Interpretation |
Use clear rules and guidelines for pattern recognition, and combine with other technical indicators to confirm signals. |
|
Limited in Ranging Markets |
Apply oscillators (e.g., RSI, MACD) to identify overbought/oversold conditions in ranging markets. |
|
Requires Experience |
Practice with demo accounts and study historical patterns to build experience before trading live. |
|
Lack of Context |
Integrate candlestick patterns with trend analysis, volume, and other indicators to gain full market context. |
|
Over-Reliance on Historical Data |
Stay informed about current market events and use stop losses to manage risk during unpredictable situations. |
|
Short-Term Focus |
Combine candlestick patterns with longer-term analysis (e.g., moving averages) to align with broader trends. |
|
False Signals |
Wait for pattern confirmation through additional indicators or price action before entering trades. |
|
Complexity in Combination |
Simplify analysis by focusing on a few key patterns and indicators that have proven reliable over time. |
|
Market Noise |
Use higher time frames to filter out market noise and focus on significant price movements. |
Let us move to some frequently asked questions related to candlestick patterns trading.
Frequently Asked Questions about Candlestick patterns
Q: How do candlestick patterns work?
A: Candlestick patterns work by visually representing price action (open, high, low, close) within a specific time frame. Traders analyse these patterns to interpret market sentiment and potential reversals or continuations in trends.
Q: What are the most common candlestick patterns?
A: Some of the most common candlestick patterns include:
- Doji: Indicates market indecision.
- Hammer: Suggests a potential bullish reversal.
- Inverted Hammer: Indicates a potential bullish reversal in a downtrend.
- Engulfing Pattern: Signals a possible reversal in the market.
- Marubozu: Shows strong momentum in the direction of the candle.
- Shooting Star: Suggests a potential bearish reversal.
Q: How reliable are candlestick patterns in predicting market movements?
A: While candlestick patterns can be reliable indicators, they are not foolproof. Their reliability increases when combined with other technical indicators and market analysis. False signals can occur, especially in volatile or ranging markets.
Q: Can candlestick patterns be used for all financial markets?
A: Yes, candlestick patterns can be used across various financial markets, including stocks, forex, commodities, and cryptocurrencies. They are versatile and can be applied to different asset classes and time frames.
Q: How can I confirm a candlestick pattern?
A: Confirmation can be achieved by using additional technical indicators, such as moving averages, RSI, or MACD, or by observing subsequent price action. Waiting for a follow-up candle or a break of key support/resistance levels can also confirm the pattern.
Q: What is the difference between bullish and bearish candlestick patterns?
- Bullish Candlestick Patterns: Indicate that the price is likely to rise (e.g., Bullish Engulfing, Hammer).
- Bearish Candlestick Patterns: Suggest that the price is likely to fall (e.g., Bearish Engulfing, Shooting Star).
Q: Can candlestick patterns be used for long-term trading?
A: Candlestick patterns are often more effective for short to medium-term trading due to their focus on recent price action. However, they can be used in long-term trading when combined with broader trend analysis and other indicators.
Q: Do candlestick patterns work in all time frames?
A: Yes, candlestick patterns work across all time frames, from minutes to weeks or months. However, the significance of the patterns may vary; patterns in higher time frames generally carry more weight than those in lower time frames.
Q: What are the limitations of candlestick patterns?
The limitations include potential subjectivity in interpretation, the possibility of false signals, and reduced effectiveness in ranging or choppy markets. They also require context and are often more reliable when used with other technical analysis tools.
Q: How can I improve my accuracy with candlestick patterns?
To improve accuracy, combine candlestick patterns with other technical indicators, stay updated on market news, use patterns in conjunction with support and resistance levels, and practice pattern recognition in different market conditions.
Conclusion
Each pattern tells a story, reflecting the emotions of market participants and providing a glimpse into potential future price movements. As you embark on your journey to decipher these patterns, consider the benefits and drawbacks, acknowledge their reliability over different timeframes, and recognise the nuanced language they speak.
Candlestick patterns are the most interesting and simple way of predicting the prices for creating your unique trading strategies. Although there are a lot of candlestick patterns that you can look at, a subtle practice of reading and interpreting candlestick patterns can help you predict and design strategies more effectively.
Candlestick patterns are one of the predictive techniques used by traders all over the world. The candlestick charts are used in stock markets and forex markets among others.
Knowledge of Candlesticks proves to be invaluable. One can learn about Candlesticks and with some effort, one can memorise Candlestick Patterns quickly and apply this knowledge in a short time.
Explore our course on Candlestick Patterns based Automated Trading. This course is designed to introduce the learners to patterns formed using candlesticks. The course gives insights on single and multiple candlestick patterns, how to combine them in your trading strategy, and the advantages and disadvantages of trading these candlestick patterns.
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Author: Chainika Thakar and Viraj Bhagat
Note: The original post has been revamped on 9th September 2024 for recentness, and accuracy.
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