Candlesticks are a way of communicating information about how price is moving. Below is a sample of a candlestick chart.
This chart shows price on the right (vertical) axis, and time on the bottom (horizontal) axis.
Moreover, the chart is made of bars that have little lines stemming from the top and the bottom; these
are known as candles. The candle conveys four pieces of information:
- The open price
- The close price
- The high price
- The low price
The horizontal axis at the bottom of the chart can be used to understand
which day corresponds to which candle. Below is an image that illustrates how those four pieces of
information the open, low, high, and close for a given period of time are visualized in the context of
a candle:
The color of the candle is also significant in understanding whether the open price was higher or
lower than the close price. If the candle is red, or denoted as bearish in some other manner, this
means that the open price is lower than the close; and the opposite is true if the candle is green, or
denoted as bearish.
Below demonstrates some of the innumerable patterns formed by candlesticks in the
context of a daily price action chart. These patterns will be discussed and elaborated upon in the
remainder of this guide.
DOJI
This candle has zero or almost zero range between its open and close.
Rather than implying potential reversal or the clear dominance of either bears
or bulls, these candles suggest indecision or balance between the two forces.
Neither buyers nor sellers are fully in control.
A doji that occurs in the context
of a strong trend implies the weakening of the dominant force that resulted in
that trend. A “long-legged doji” has long wicks in both directions, implying strong,
balanced pressure from both buyers and sellers.
GRAVESTONE DOJI
A “gravestone doji” as the name implies, is probably the most ominous candle of all, on that
day, price rallied, but could not stand the altitude they achieved. By the end of the day. They came
back and closed at the same level.
DRAGONFLY DOJI
It depicts a day on which prices opened high, sold off, and then returned to the
opening price. Dragonflies are fairly infrequent. When they do occur, however, they often resolve
bullishly.
HAMMER
A “hammer” is a candlestick with a small body (a small range from open to
close), a long wick protruding below the body, and little to no wick above.
In this respect it is very similar to a dragonfly doji; the primary difference
is that a dragonfly doji will have essentially no body, meaning the open and
close prices are equal.
When a hammer appears at the bottom of a downtrend, its long wick implies
an unsuccessful effort by bears to push price down, and a corresponding
effort by bulls to step in and push price back up quickly before the period
closed. As such, a hammer candlestick in the context of a downtrend suggests the potential
exhaustion of the downtrend and the onset of a bullish reversal.
The “neckline,” often determined
by the high of the previous bar, is the level that price must hit on the next candlestick in order to
confirm the hammer’s reversal signal.
In order for the Hammer signal to be valid, the following conditions must exist:
• The stock must have been in a definite downtrend before this signal occurs. This can be
visually seen on the chart.
• The lower shadow must be at least twice the size of the body.
• The day after the Hammer is formed, one should witness continued buying.
• There should be no upper shadow or a very small upper shadow. The colour of the body does
not matter, but a white body would be more positive than a black body.
HANGING MAN
The hangman candle, so named because it looks like a person who has been executed with legs
swinging beneath, always occurs after an extended uptrend The hangman occurs because traders,
seeing a sell-off in the shares, rush in to grab the stock a bargain price.
In order for the Hanging Man signal to be valid, the following conditions must exist:
• The stock must have been in a definite uptrend before this signal occurs. This can be visually
seen on the chart.
• The lower shadow must be at least twice the size of the body.
• The day after the Hanging Man is formed, one should witness continued selling.
• There should be no upper shadow or a very small upper shadow. The color of the body does
not matter, but a black body would be more positive than a white body.
SHOOTING STAR
This candlestick is simply the inversion of the hanging man: it has a small
body and a long wick protruding above it, with little to no wick below.
The “shooting star” occurs at the height of an uptrend; its long wick implies
that resistance to further bullish movement has been encountered above the
close, and a bearish reversal may be imminent.
In this case, a strong black
candle or a price at the level of the previous bar’s open can act as confirmation
or an entry point. Often, shooting stars are further characterized by a gap
between the previous bar’s close and the relatively higher open of
the shooting star.
EVENING STAR
The “evening star” is the small-bodied middle candle of a 3-bar pattern that can
provide an early indication of a reversal from a bullish to a bearish trend, typically
with an opening price at or a gap above the close of the previous candle
(a gap indicates space between the body of the previous candle and the open
of the consequent candle). The pattern represents a potential top, and therefore
a potential signal to sell.
These are the characteristics of the three candles:
1. A long bullish candle
2. A small-bodied bullish or bearish candle or a doji that opens at or above the close of the previous candle.
3. A black candle that opens at or below the low point of the previous candle’s body and closes at or below the
center of the first candle.
In order for the pattern to be valid, the sequence of candles must be as described above.
Moreover, the pattern should appear in the context of an uptrend in order to signal a reversal and the
start of a downtrend.
MORNING STAR
The “morning star” is the inverse of the evening star, a 3-bar pattern in which
the “star” is a small-bodied candle, typically opening at the close of the previous
candle or opening a gap below it, indicating that a trend is transitioning from
bearish to bullish. The morning star constitutes a potential bottom to the
preceding bearish leg, and functions therefore as a buy signal.
The three candles are as follows:
1. A long bearish candle
2. A small-bodied bullish or bearish candle or a doji that opens at or below the close of the previous candle
3. A white bullish candle that opens at or above the high point of the previous candle and closes at or above
the center of the first candle.
While an evening star pattern after an uptrend signals a reversal, the opposite
a morning star pattern in a downtrend can also signal reversal, and a change in
the balance of
power between bears and bulls.
CHECKMATES
Checkmates occur when price becomes locked in a narrow trading
range preceding a reversal in direction. In a typical bearish
checkmate (right), an uptrend meets a resistance level that is
tested and then rejected due to consequent pressure from holding
the level.
In these cases, the checkmate begins as the first candle
in the range reaches a high that the pressure from bulls is unable
to surpass. Price remains deadlocked in a tight trading range
before the range is broken with a long bearish candlestick,
indicating that the reversal has begun. As an entry signal,
this pattern requires confirmation from one or two strong bearish bars.
In a bullish checkmate (right), the opposite occurs,
typically at a support rather than resistance level. The long
lower wick of the first pin-bar in the red box establishes a
low that the bears cannot achieve; price is trapped thereafter
in a narrow trading range, the checkmate, until bulls
successfully reverse the trend. The tall white bar
immediately after the box confirms the bullish reversal.
In the patterns that have been presented thus far, a simple
concept should be emerging: when a long wick appears in the
context of a trend, it often signals a potential reversal of that trend.
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