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Candlestick Chart Analysis

 

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Candlesticks Charts

Candlestick charts are on record as being the oldest type of charts used for price prediction. Candlestick charts back to the 1700's, when they were used for predicting rice prices. In fact, during this era in Japan, Munehisa Homma become a legendary rice trader and gained a huge fortune using candlestick analysis. He is said to have executed over 100 consecutive winning trades! This style evolved into the candlestick technique currently used in Japan.

The names given to various candlestick patterns are quite fanciful, and might suggest fortune telling or tea leaf reading rather than a scientific analysis. However, the candlestick is merely another form of the high-low-open-close chart, and the colorful terminology may serve as an aid to the recognition of significant patterns. The effect of the candlestick figure is to emphasize the significance of the range between the opening price and the closing price, called the body of the figure.

Candlestick charts are a useful stand alone tool. They can be merged with other technical tools to create a synergy of techniques. Certain candlestick combinations may imply a period of consolidation; other hint of a forceful price move. They give deep insight into the market conditions.

We have already covered in this course how candlesticks charts are created and look like. Now we can start covering common candlestick analysis terminology and patterns. Please, keep in mind that any analysis tool needs in depth understanding to help you trade profitably and we will cover here only basics that will start you off.

In candlesticks analysis the key role plays the body of the candle and not their shadows or color. Using candle’s body size we can differentiate two candle types full and doji (cross like formation). In doji candles closing and opening prices are very close to each other or sometimes even equal. Below you can see the difference between two types.

Forecasts that are based on candlesticks analysis usually use the combination of 3 candles, where 2 candles form certain pattern and the third one confirms a signal. Nevertheless, the type of each candle plays an important role in analysis as well.

Trend reversal signals is the strongest part of candlesticks based technical analysis. Here, a lot of attention is given to doji candles – candles with small bodies. There is a wide terminology in use, when it comes to candlesticks. For example, doji and small candles get different names. The most important ones you can see on the picture below.

Doji themselves indicate that the market participants are at pause (have not decided yet which direction to take their trades), which is usually seen when there almost equal number of bulls and bears in the market. Almost always dojis are found to be a part of some formation that signals trend reversal and they are less frequently seen when there is a strong bullish or bearish trend in place.

Here is description for some types of candles:

Black Marubozu - The name means close-cropped or close-cut in Japanese, though other interpretations refer to it as Bald or Shaven Head. The Black Marubozu is a single candlestick pattern characterized by a long black body. It does not have any shadows on either end. It is an extremely strong bearish candlestick pattern. A Black Marubozu forms when the opening price is equal to the high price of the day while the closing price is equal to the low price of the day. This shows that the sellers controlled the price action from the first trade to the last trade. When a Black Marubozu day occurs, the day opens and prices continue to move down all day long without stopping. It may show continuation of the downtrend or a final sell off attempt before the bulls regain control.

White Marubozu - The White Marubozu is a single candlestick pattern characterized with a long white body having no shadows on either end. It is an extremely strong bullish candlestick pattern. A White Marubozu simply means that the opening price is equal to the low price of the day and the closing price is equal to the high price of the day. This shows that the buyers controlled the price action from the first trade to the last trade. In a White Marubozu day, the day opens and prices continue to rally up all day long without looking back. The bulls were very strong during the day at such a degree that it caused some concern among the bears and led them to cover their short positions thus adding fuel to the rally.

Bozu - a candlestick with long body (black or white) and a shadow (upper-opening, lower-closing)

Gravestone doji - form when the open, low and close are equal and the high creates a long upper shadow. The resulting candlestick looks like an upside down "T" with a long upper shadow and no lower shadow. Gravestone doji indicate that buyers dominated trading and drove prices higher during the session. However, by the end of the session, sellers resurfaced and pushed prices back to the opening level and the session low.

Dragon fly doji - form when the open, high and close are equal and the low creates a long lower shadow. The resulting candlestick looks like a "T" with a long lower shadow and no upper shadow. Dragon fly doji indicate that sellers dominated trading and drove prices lower during the session. By the end of the session, buyers resurfaced and pushed prices back to the opening level and the session high.

Four Price Doji - is a very rare occurrence and it may be seen only if all the four price components are equal. That is, the open, high, low, and close turn out to be the same. It represents complete and total uncertainty by traders concerning the market direction.

Long-legged doji have long upper and lower shadows that are almost equal in length. These doji reflect a great amount of indecision in the market. Long-legged doji indicate that prices traded well above and below the session's opening level, but closed virtually even with the open. After a whole lot of yelling and screaming, the end result showed little change from the initial open.

Spinning Tops -- candlesticks with small real bodies, and when appearing within a sideways choppy market, they represent equilibrium between the bulls and the bears. They can be either white or black

Lowe and Upper Shadows - upper shadows represent the session high and lower shadows the session low. Candlesticks with short shadows indicate that most of the trading action was confined near the open and close. Candlestick with long shadows show that traded extended well past the open and close.

Inverted Umbrella - is characterized by having no lower shadow and but a long upper shadow. The long upper shadow shows the evidence for selling pressure, but the position of high price indicates that plenty of buyers still are around. Inverted Umbrella is a reversal pattern. Inverted Umbrella indicates that buyers dominated the trading and they were able to drive the prices higher during the day. However, sellers resurfaced by the end of the day and pushed prices back to the opening price level and to the day’s low.

An Umbrella - is a type of a doji characterized with no upper shadow but a long lower shadow. The long lower shadow shows the evidence for buying pressure, but the position of low price indicates that plenty of sellers still are around. Umbrella is interpreted as a reversal pattern. Umbrella indicates that sellers mostly dominated trading during the day and they were able to drive the prices lower during the day. However; buyers resurfaced at the end of the day and they successfully pushed prices back to the opening level and to the day high. 

Just as many traders look to bar charts for double tops and bottoms, head-and-shoulders, and technical indicators for reversal signals, so too can candlestick formations be looked upon for the same purpose. A reversal does not always mean that the current uptrend/downtrend will reverse direction, but merely that the current direction may end. The market may then decide to drift sideways. Candlestick reversal patterns must be viewed within the context of prior activity to be effective. In fact, identical candlesticks may have different meanings depending on where they occur within the context of prior trends and formations. Let us take a look at the most popular and widely used formations and give short description to each.

Hammer - The Bullish Hammer Pattern is a significant candlestick that occurs at the bottom of a trend or during a downtrend and it is called a hammer since it is hammering out a bottom. The Bullish Hammer Pattern is a single candlestick pattern and it has a strong similarity to the Bullish Dragonfly Doji Pattern. In the case of Bullish Dragonfly Doji Pattern, the opening and closing prices are identical whereas the Bullish Hammer Pattern has a small real body at the upper end of the trading range. The overall direction of the market is bearish, characterized by a downtrend. Then the market opens with a sharp sell off implying the continuation of the downtrend. However, prices suddenly turn upwards, the sell-off is quickly abated and bullish sentiment continues during the day with a closing price at or near to its high for the day which causes the long lower shadow. Apparently the market fails to continue in the selling side. This observation reduces the previous bearish sentiment causing the short traders to feel increasingly uneasier with their bearish positions.

Hanging Man - The Bearish Hanging Man Pattern is a single candlestick and a top reversal pattern. It is very similar to the Bearish Dragonfly Doji Pattern. In case of the Bearish Dragonfly Doji Pattern, the opening and closing prices are identical whereas the Bearish Hanging Man Pattern has a small real body. The hanging man is a bearish reversal pattern. It signals a market top or a resistance level. Since it is seen after an advance, a Bearish Hanging Man Pattern signals that selling pressure is starting to increase. The low of the long lower shadow indicates that the sellers pushed prices lower during the session. Even though the bulls regained their footing and drove prices higher by the finish, the appearance of this selling pressure after a rally is a serious warning signal.

Bullish Engulfing Pattern - is a pattern characterized by a large white real body engulfing a preceding small black real body, which appears during a downtrend. The white body does not necessarily engulf the shadows of the black body but totally engulfs the body itself. The Bullish Engulfing Pattern is an important bottom reversal signal. While the market sentiment is bearish; we see some subsided selling reflected by the short, black real body of the first day. Next day shows bull strength with a closing price at or above the previous day’s open. It means that the downtrend is now losing momentum and the bulls started to take the lead.

Bearish Engulfing Pattern - is a large black real body, which engulfs a small white real body in an uptrend (it need not engulf the shadows). The Bearish Engulfing Pattern is an important top reversal signal. Market is in a bull mood. Then we see diminished buying reflected by the short, white real body. This then is followed by a strong sell-off, which lead to a close at or below the previous day’s open. Apparently the uptrend has lost momentum and the bears may be gaining strength.

Piercing Pattern - Bullish Piercing Pattern is a bottom reversal pattern. A long black candlestick is followed by a gap lower during the next day while the market is in downtrend. The day ends up as a strong white candlestick, which closes more than halfway into the prior black candlestick’s real body. The market moves down in a downtrend. The first black real body reinforces this view. The next day the market opens lower via a gap. Everything now goes, as bears want it. However suddenly the market surges toward the close, leading the prices to close sharply above the previous day close. Now the bears are losing their confidence and reevaluating their short positions. The potential buyers start thinking that new lows may not hold and perhaps it is time to take long positions.

Dark Cloud Cover - Bearish Dark Cloud Cover Pattern is a two-candlestick pattern signaling a top reversal after an uptrend or, at times, at the top of a congestion band. We see a strong white real body in the first day. The second day opens strongly above the previous day high (it is above the top of the upper shadow). However, market closes near the low of the day and well within the prior day’s white body at the end of the day. Market goes up with an uptrend. Then we see a strong white candlestick followed by a gap suggesting that bulls retain the control. However, the rally does not continue. Market suddenly closes at or near the lows of the day so the second day body moving well into the prior day’s real body. Longs are shaken somehow and short sellers now have a benchmark to place a stop, which is at the new high of the second day.

 

Morning Star Candlestick Pattern - This is a three-candlestick formation that signals a major bottom. It is composed of a first long black body, a second small real body, white or black, gapping lower to form a star. These two candlesticks define a basic star pattern. The third is a white candlestick that closes well into the first session’s black real body. Third candlestick shows that the market turned bullish now. We see the black body in a falling market suggesting that the bears are in command. Then a small real body appears implying the incapacity of sellers to drive the market lower. The strong white body of third day proves that bulls have taken over. An ideal Bullish Morning Star Pattern preferably has a gap before and after the middle candlestick. The second gap is rare, but lack of it does not take away from the power of this formation.

Evening Star Candlestick Pattern - This is a major top reversal pattern formed by three candlesticks. The first candlestick is a long white body; the second one is a small real body that may be white. It is characteristically marked with a gap in higher direction thus forming a star. In fact, the first two candlesticks form a basic star pattern. Finally we see the black candlestick with a closing price well within first session’s white real body. This pattern clearly shows that the market now turned bearish. The market is already in an uptrend when the white body appears which further suggests the bullish nature of the market. Then a small body appears showing the diminishing capacity of the longs. The strong black real body of the third day is a proof that the bears have taken over. An ideal Bearish Evening Star Pattern has a gap before and after the middle real body. The second gap is rare, but lack of it does not take away from the power of this formation.

Morning Doji Star Candlestick Pattern - This is a three-candlestick formation signaling a major bottom reversal. It is composed of a long black candlestick followed by a doji, which characteristically gaps down to form a doji star. Then we have a third white candlestick whose closing is well into the first session’s black real body. This is a meaningful bottom pattern. Black real body while market is falling down may suggest that the bears are in command. Then a Doji appears showing the diminishing capacity of sellers to drive the market lower. Confirmation of bull ascendancy is the third day’s strong white real body. An ideal Bullish Morning Doji Star Pattern must have a gap before and after the middle line’s real body. The second gap is rare, but lack of it does not take away from the power of this formation.

Evening Doji Star Candlestick Pattern - This is a major top reversal pattern formed by three candlesticks. The first candlestick is a long white body; the second is a doji characterized by a higher gap thus forming a doji star. The third one is a black candlestick with a closing price, which is within the first day’s white real body. It is a meaningful top pattern. The first white body, while the market is in an uptrend, shows the continuing bullish nature of the market. Then a Doji appears showing the diminishing power of the longs. The strong black real body on the third day proves that bears have taken over. An ideal Bearish Evening Doji Star Pattern has a gap before and after the middle real body. The second gap is rare, but lack of it does not take away from the power of this formation.

Shooting Star Candlestick Pattern - Bearish Shooting Star Pattern suggests that prices may be approaching to a top. It looks like its name, a shooting star. The shooting star is a small real body characterized by a long upper shadow, which gaps away from the prior real body. The Shooting Star simply tells us that the market opened near its low, then prices strongly rallied up and finally prices moved down to close near the opening price. In other words, the rally of the day was not sustained.

Inverted Hammer Candlestick Pattern - Bullish Inverted Hammer Pattern is a candlestick characterized by a long upper shadow and a small real body preceded by a long black real body. It is similar in shape to the Bearish Shooting Star. The shooting star appears in a downtrend and thus it becomes a potentially bullish inverted hammer. Bullish Inverted Hammer Pattern occurs in a bearish background. In a day of inverted hammer, market opens at or near its low. Then prices change direction and we see a rally. However the bulls cannot succeed to sustain the rally during the rest of the day and prices finally close either at or near the low of the day. It may not be clear why this type of price action is interpreted as a potential reversal signal. The answer has to do with what happens over the next day. If the next day opens above the real body of the inverted hammer, it means that those who shorted at the opening or closing of the inverted hammer day are losing money. The longer the market holds above the inverted hammer’s real body, the more likely these shorts will attempt to cover their positions. This may ignite a rally as a result of covered short positions, which may then inspire the bottom pickers to take long positions.

It is important to realize that this introduction is just that, an introduction to candlestick chart analysis. After having read this, you will have merely scratched the surface of the many patterns and variables that can go into candlestick analysis. No attempt was made to provide a thorough analysis of each and every pattern. In fact, many formations were left out as they cross the border into more complicated analysis. For a more complete overview of candlestick analysis, it is highly recommended that you read additional literature and practice what you have already learned.

 

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