Reading candlestick charts and patterns is one of the most important skills a trader can learn. There are many candlestick patterns. There are single candle patterns, two candle patterns, three, and more candle patterns.
Candlestick patterns have been around for hundreds of years. The popular names for the well-known and lesser-known forms come from Japan and were famously used by rice traders in the 18th century.
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Rather than learning all the multitude of candlestick names and types, it is more important to understand what the candlesticks mean in terms of price movements and what that reveals about the psychology of buyers and sellers in the market.
The parts of the candlestick
Candlestick charts display the prices of a stock or another financial instrument and each candle shows a discrete time period. The easiest period to grasp is a daily period for a stock that trades from the time the market opens to the time the market closes.
Each candle in the chart displays four price points in that daily period:
- the opening price
- the highest price in the day
- the lowest price in the day
- the closing price.
Candlestick charts can be set up to show price movements over different periods, for example, weekly, monthly or shorter periods of hours or minutes during a trading day. But it is easiest to talk here about daily price candles.
A candle is either an up-candle when the closing price is higher than the opening price, or a down-candle when the closing price is lower than the opening price. Different charting sources, websites, or software packages display up-candles and down-candles differently. Some show up-candles as green and down-candles as red.
The standard here is up-candles are shown in white and down-candles are shown as black. Here is what a typical up-candle and a down-candle look like.
In this example the up-candle opened at $320, during the day the lowest price was $315, the highest price was $330 and the price closed at $325 at the end of trading.
Important price points
When we look at a price candle for a particular day, for example, it is good to remember that the closing price is always the most important price. Many orders are executed at the closing price.
If the price closed substantially higher than it opened, then that is a big up day. If it closed substantially lower than it opened, that is a big down day.
If the upper shadow is large, that tells us there was buying pressure in the market for higher prices but some indecision and selling pressure pushed the price to close lower at the end of the day.
Similarly, if the lower shadow is large, that shows some selling pressure pushing prices lower but then buying pressure resumed and pushed the price to close higher at the end of the day.
Let’s dive in and take a look at some major candlestick patterns.
A doji is formed when a trading period closes at or very near the opening price. The sizes of the upper and lower shadows indicate the degree of uncertainty on the upside and on the downside respectively.
Dojis are potentially powerful price trend reversal indicators.
A dragonfly doji at the bottom of a trend is a powerful indicator of a trend reversal to the upside.
A gravestone doji at the top of an uptrend is a powerful indicator of a trend reversal to the downside.
A spinning top doji has large upper and lower shadows and indicates uncertainty in the upward and downward directions and is, therefore, less powerful than another type of doji anywhere in a chart.
Among the strongest trend reversal patterns is the abandoned baby. These can occur either at the top of an uptrend or at the bottom of a downtrend.
For a doji to be an abandoned baby at the top of an uptrend there must be a gap between the previous candle’s high price and the low price of the baby. When the next candle is a large down candle that opens below the low of the doji and the high of that down candle stays below the doji then the downtrend is confirmed.
Similarly, for a doji to be an abandoned baby at the bottom of a downtrend, there must be a gap between the last price low of the previous candle and the high price of the doji. The trend reversal to the upside is confirmed when the next candle is an up candle that opens and stays above the high price of the doji.
The bullish hammer and the bearish hanging man
The bullish hammer and the bearish hanging man look very similar. Each has a small body with a large lower shadow and either a very small or no upper shadow. The close can either be above the open, so using the display format here, the body can be either white or black.
The bullish hammer comes at the bottom of a price downtrend. It is an indicator of a trend reversal in the bullish direction. If the hammer is not at the bottom of a downtrend then it is not a bullish hammer.
The bearish hanging man comes at the top of a price uptrend and indicates a bearish trend reversal. If this pattern happens anywhere else, it is not a bearish hanging man.
Engulfing patterns are two candle patterns. The bullish engulfing pattern occurs at the bottom of a downtrend.
The body of the first candle is completely engulfed by the body of the second candle. It does not matter whether the upper or lower shadows of the first candle are engulfed by the second.
The bearish engulfing pattern occurs at the top of an uptrend.
Bullish piercing and dark cloud cover
There are two piercing patterns, both are two candle patterns. The bullish piercing pattern occurs at the bottom of a downtrend. The first candle is a large down day. The second candle body must open below the closing price of the previous day and then close at least half-way into the body of the previous candle.
Dark cloud cover is the bearish piercing pattern that occurs at the top of a price uptrend.
Like the bullish piercing pattern, the first candle is a large up candle. The body of the second candle has to open above the close of the first candle and close down piercing at least halfway into the body of the previous candle.
Neither of these candle patterns is particularly strong. If the body of the second candle does not pierce halfway, then it is more likely to indicate a trend continuation rather than a reversal.
Morning star and evening star
A morning star occurs at the bottom of a price downtrend.
The star has a small body. There needs to be a gap between the closing price of the previous candle and the opening price of the star. If the body of the next candle is completely above the body of the star then the pattern is a more powerful indicator of a price trend reversal in the bullish direction.
An evening star occurs at the top of a price uptrend.
Like with the morning star, if the body of the next candle after an evening star gaps down from the body of the star then it is a more powerful indicator of a price trend reversal in the downward, i.e. bearish direction.
Shooting star and the bullish inverted hammer
A shooting star occurs at the top of a price uptrend.
The long upper shadow of a shooting star indicates uncertainty in higher prices. It is an indicator that price is likely to trend downwards.
The inverted hammer also has a large upper shadow.
The inverted hammer occurs at the bottom of a downtrend and is not as powerful an indicator of a reversal to price uptrend as a regular bullish hammer.
Harami – mother and child
The harami pattern is a two candle pattern. The body of the first candle, the mother, complete encompasses the body of the second candle, the child. The sizes of the upper and lower shadows do not matter. This pattern is basically a big day followed by a small day.
It is more meaningful in a price uptrend if the mother candle is an up candle, the child candle can be either up or down.
The harami is not a very powerful indicator of the likelihood of a price trend reversal. More usually it tends to stall price. In the example above the harami has the effect of stalling a price uptrend.
In the above example, the harami stalls the price downtrend. Again, whether the child candle is an up candle or a down candle doesn’t matter that much.
When the child is a doji, then the harami pattern becomes more powerful and is more likely to indicate a price trend reversal.
The example above is a harami cross at the bottom of a downtrend.
The harami cross at the top of an uptrend is shown above. That the child candle is a doji makes the pattern a more powerful bearish indicator.
Rising three methods and falling three methods
Rising three methods and falling three methods are examples of three candle patterns. No surprise there.
The main characteristic of the rising three methods is that there is one large body up candle followed by the smaller body candles all of which are contained within the price high and low of the first candle. The next candle that breaks the pattern in the upwards direction should open at least halfway up the first candle, and close above all the previous candles of the pattern. Here is what it looks like
Rising three methods is either the start of a price uptrend after a period of sideways movement, or it is a continuation of a price uptrend.
Falling three methods has the same pattern as rising three methods but in the opposite direction.
Both rising three methods and falling three methods can have more than three candles which fall inside the high to low range of the long body candle.
Three white soldiers and three black crows
The three white solider pattern can happen at the bottom of a price downtrend or at the end of a period of sideways price movement.
The body of each white candle should open inside the body of the previous candle, close above the body of the previous candle, and at or near its high price. So the candles should not have long upper shadows.
If the closing prices of the candles are not progressively higher than the previous candles, then the bullishness of the indicator is not as strong. If the upper shadows are long then it is also not as strong and indicator.
Three black crows is a bearish version of three white soldiers.
All the same considerations apply to the three black crows as the white soldiers but in the opposite sense. Three black crows is an indicator of a price downtrend either after a period of sideways price movement or can be an indicator of a continuing price downtrend.
Differences on the upside and on the downside
Generally, bull markets take longer to form and are slower to happen than bear markets. This is largely because of the psychology of traders. It takes longer for enthusiasm and belief in a bull market to form, than it does for fear to take hold and trigger a bear market.
This is also reflected in how we should read and interpret candlestick patterns. Reversal patterns at the top of a bull market will tend to require less confirmation from other indicators, such as volume, the MACD, the RSI, or the Stochastic oscillator, than will reversal patterns at the bottom of a downtrend.
This means as well that candlestick patterns at the top of an upward price trend do not have to be as strong in themselves to indicate a reversal to a bear market. Conversely, when we see a candlestick pattern at the bottom of a trend and we are looking for an indication of a price reversal in a bullish direction, then we will want to see a strong candlestick pattern for it to start to have validity.
Answers to questions
Q. How do you read a stock candlestick chart?
A. A candlestick chart shows the opening price, the highest price the lowest price, and the closing price of a stock in a specific time period when the price changes in a market.
The highest price is shown by the top of the upper shadow or wick, the lowest price is the bottom of the lower shadow or wick, the top and bottom of the body show the opening and closing price depending on whether the price opened higher or lower than it closed.
When the closing price is higher than the opening price that is considered an up period and the candle will have a specific color either white or green.
When the closing price is lower than the opening price that is considered a down period and the candle will have a different color, either black or red.
Q. Which candlestick patterns are most reliable?
A. Dojis are the most powerful candlestick patterns. Bearish candlestick indicators tend to more readily follow through with price action than do bullish indicators. A gravestone doji at the top of an upward price trend is probably one of the most reliable indicators that a price reversal in the downward direction is likely.
Q. Which candlestick patterns are most bullish?
A. An abandoned baby doji is probably the most bullish candlestick pattern.
Q. Which candlestick patterns are most bearish?
A. A gravestone doji is the most bearish candlestick pattern.
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