Ask any professional stock or cryptocurrency day trader about the most powerful weapon in their arsenal, and their answer will usually be short: candlesticks.
Candlestick charting is one of the most common methods of plotting and analyzing price patterns. They were invented by a Japanese rice merchant named Monehisa Homma in the 1700s, 100 years before the West developed the bar and point-and-figure charts. Homma discovered that the price of rice, while dictated by supply and demand, was also heavily influenced by the emotions of traders. Homma’s graph was then refined over the centuries, most notably by Charles Dow, one of the founding fathers of the field of technical analysis.
Candlestick charts, so-named because of their appearance, are used by traders and investors to help make trading decisions based on historic market data, which may offer some lessons from the past, such as important price resistance and support levels to be aware of, and the possible impact they may have.
The candlesticks visually represent the traders’ emotions with different colors depending on the size of the price movement. If you are a novice trader, one of the most important things you’ll need to learn is how to correctly read and analyze candlestick charts. They can seem daunting at first but this guide will provide all the basics on what each element in the chart means and how to read them in order to use historical price data to your advantage.
When trading, it’s essential to understand that trading is all about the time frame you’re using. For day trading, it is usually best to use a time frame of 1 hour and under, to give you a better chance of identifying and quickly responding to patterns created by Japanese candlesticks.
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How Do Candlestick Charts Work?
The following data sets or price points are required to create each candlestick:
Open - the first recorded trading price of a particular asset within a specified timeframe.
High - the highest recorded trading price of the asset within the timeframe.
Low - the lowest recorded trading price of the asset within the timeframe.
Close - the last recorded trading price of the asset within the timeframe.
Together, these data sets are often referred to as the OHLC values. The relationship between them determines the appearance of the candlestick.
The distance between the open and close price points is called the body, while the distance between the body and the high and low points is called the wick or shadow. The range is calculated by subtracting the highest price point from the lowest.
Candlestick charts give an advantage over bar charts as they are more visual. Additionally, bar charts make it difficult to visualize which direction the price moved, which candlestick charts help with.
How to Read Candlestick Charts?
The benefit of candlestick charts is that they can be read at a glance because they provide a simple representation of price history. Each candlestick on the graph represents the same timeframe, which could include any length of time, from seconds to decades.
Generally, the longer the body of the candlestick, the more intense the battle between the bulls and bears was during that time frame, and if the wick is short, it means the high or low price was close to the closing price during the measured time frame. If the body of the candlestick is green, it means that the asset closed higher than it opened and vice versa if it’s red. However, some charting tools will use black and white instead of red and green, with hollow candlesticks representing up movements and solid representing down.
Different Types of Candlestick Charts
Candlestick charts can be divided into single, double, and triple candlestick patterns, with each pattern representing different market trends.
Single Candlestick Patterns
This pattern forms the basis of the other two. Understanding single patterns can help you pick up market trends from double and triple patterns. There are eight basic single candlestick patterns:
- Doji - “Doji” means “the same as” in Japanese and is formed when the opening and closing price within a certain time frame is the same or almost identical. The body of the candle will be compressed and the tail will be very prominent.
- Gravestone - Resembles a gravestone and represents bearish conditions, there will be a long wick above the body.
- Inverted gravestone/dragonfly - Represented by a tail below the body and indicates that the bullish power is diminishing.
- The hammer/hanging man - There is a very long wick below the body with a very slight upper wick. The hammer indicates the end of a bullish or bearish force. The hammer representing a bullish force is called a “hanging man”.
- Inverted hammer/Shooting star - This represents a reversing trend and is visualized by a long upper wick and smaller body. When indicating a change to a bearish market, it’s called a “shooting star”, while the opposite is called an “inverted hammer”.
- Spinning top - This pattern forms when the market has experienced very little movement. It’s represented by a short body with wicks on either side that are almost identical in length.
- Standard line - this pattern has candles with long bodies and very short tails at either end. This pattern doesn’t give important market cues but instead indicates that whatever direction the market is headed - bullish or bearish - it has sustaining power.
- Marubozu pattern - This pattern is represented by a body with no tails. It indicates the advancement of a bullish or bearish atmosphere.
Double Candlestick Patterns
These candlestick patterns are read in pairs. The most common double candlestick patterns are:
- Bearish/bullish engulfing - engulfing patterns that indicate a reversal in market conditions and illustrate that one trend is being overpowered by the other in the opposite direction. Two neighboring candles display this trend, indicating whether bullish or bearish movements are dominating - a bullish engulfing pattern will have a bearish candle followed by a bullish candle with a bigger body.
- Tweezers - this pattern also represents a reversal in market conditions. Both candles will have the same body and wick length but tweezers can be at the top (wicks are underneath) or bottom (wicks are at the top) with tweezers at the bottom signaling a change from bullish to bearish, and vice versa.
Triple Candlestick Patterns
As the name suggests, three candles make up these patterns. The two most important triple candlestick patterns, which both represent a trend reversal, are the:
- Morning/evening star - the evening star pattern starts with a bullish candle, followed by a small bullish/bearish star and then a longer bearish candle that is longer than the first bullish one of the set.
- Three soldiers - this pattern is a staircase with three steps. For a bullish trend, the first candle is small and the pattern gets increasingly bigger, which indicates a shift from a bearish to bullish trend and vice versa with the alternating pattern.
For a more in-depth breakdown of different candlestick chart patterns, check out our what are Japanese candlestick patterns guide.
What Are Heikin-Ashi Candlestick Charts?
Above, we have discussed Japanese candlestick charts, what they are and how to read them. However, the Heikin-Ashi technique is another way to calculate candlesticks. Heikini-ashi means “average bar” in Japanese, as such, these types of charts rely on average price data. Whereas traditional Japanese candlestick charts don’t give details as to what happened between the market open and close or which price occurred first, the high or low one, Heikin-ashi can make it easier to spot market trends, price patterns, and possible reversals.
This is why some traders find it useful to use both traditional Japanese candlestick charts and Heikin-Ashi, to get a more overall, well-rounded view of the markets.
Green Heikin-Ashin candles with no upper wicks generally mean a strong uptrend, while their red counterparts that also lack an upper wick often indicate a strong downward trend. However, since this technique of price charting uses average price data, patterns can take longer to develop. These charts also don’t show price gaps.
Final Thoughts
Japanese candlesticks are a very useful tool to dissect both past and current price action on the time frame of your choice. However, it’s important to add some fundamental analysis to your toolkit and look at economic, political, and financial trends that might impact the performance of the asset you’re analyzing.
For example, if a cryptocurrency explodes in value due to an upcoming airdrop or promotional event, it would be irresponsible to buy high and expect the price to just continue going up. Taking a measured approach to day trading and utilizing techniques like dollar-cost averaging (DCA), where you buy at specific intervals, could make all the difference over the course of a month or year.
Ask yourself the question, if you could choose, would you rather earn an extra $10,000 in trading or save $10,000 by eliminating some bad trades over the course of a year? Surprisingly, both yield the same result on your bottom line.
To illustrate this further, let’s once again look at the Land of the Rising Sun. If you’re familiar with Japanese martial arts like karate and aikido, you’ll know that defense is as important as attack. Remember this next time you slide in front of your computer and start drawing lines across those candlesticks!
