Analysis Of Candlestick Patterns In Trading

Last Updated September 21st 2021
7 Min Read

If you have been a trader or are planning to get into trading, you will be familiar with many of the commonly used tools that are indispensable in the field. Among the most used are the various types of charts that depict the price movements in the market. 

These charts can be a gold mine of information that includes trends and patterns that can assist in spotting opportunities in trading. One such chart that has been the go-to option for traders is the candlestick. 

We take a look here at how candlestick patterns help in your analysis as a trader. 

Origins Of Candlestick Charts

The term candlestick is an interesting one, especially in the world of finance and trading, and its origin too is no less fascinating. More so, when we think of a modern-day tool having its history dating back to the 18th century when a Japanese rice trader, Munehisa Homma, pioneered its use. But it was not until the 1990s that its present-day form came into being when Steve Nison adapted it to the times.  

Understanding A Candlestick Chart And Its Patterns

A candlestick chart is a graphical summation of all the relevant information that helps a trader understand an asset’s price movements. It can depict the most crucial data points like the opening and closing price for a day, besides the highest and the lowest recorded. 

The ease of understanding the context and interpreting the variations in price can be attributed to the more visual way of presenting the data. This is especially the case when more than one candlestick pattern has to be referred to and the pattern that emerges makes for a more visual and clearer picture. 

A candlestick chart scores over other conventional forms in its ability to process and present not just the cold numbers but conveys a pattern of the direction in which the asset price is headed. It is possible to even gauge whether a stock or a forex pair is looking bullish or bearish and help form a more decisive strategy. 

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Uses Of Candlestick Charts

Unlike a bar chart, a candlestick chart is more graphic and alive in what it conveys to a trader or an analyst. The very fact that it is more colourful brings an element of emotions that tells the story of how the prices vary in the market. Besides, this also makes for grasping the picture faster with more visual presentation as compared to just numbers on a chart. 

Some of the more specific uses of candlestick charts can be of great help for traders who need accurate information that can be interpreted simply and quickly. Here are a few relevant examples of how these can be useful in actual trading situations.

Identifying and Reading Trends and Patterns: The visual representation of the variation in prices over a range of days, with a clear indication of a sustained period of increase and vice versa, helps identify a forming trend and pattern. This is why traders and analysts prefer candlestick chart patterns over conventional bar charts.

Assessing Support and Resistance: Candlestick patterns can also help in assessing the prevalence of support or resistance in the prices for a period and help base investment decisions on that. With a trend forming in the candlestick across preceding and succeeding trading days, the real picture of support or resistance may not be accurate.  

Spotting Trend Reversals: For those who are into trading based on trends, candlestick patterns can be of particular relevance. If the size of the body is seen to be small or shrinking, it points to a slowdown or end of a trend and the possibility of a new building. Of course, while spotting a trend, it is important to look beyond the current candlestick and check how the next one will develop. 

Interpreting Candlestick Charts And Patterns

The interpretation of a candlestick chart is, typically, picked up from the last trading day’s closing price. This itself updates you with a recap of what happened on the previous day in terms of the highs and lows, opening and closing and so on. It can hold a mirror to what you did and how the asset performed previously such that you can base your new day’s trading on that. 

To be able to analyse the chart itself, it is important to understand the components of a candlestick. The wide part is referred to as the body while the narrow projections on the top and bottom are called the wicks or the shadows. It is the body that is a representation of the variation in prices between the day’s opening and the closing of a certain day’s trading. 

Typically, if the body of the candle is shown in black, this is a depiction of the day’s closing price being lower than the opening’s. Conversely, if the body is shown without any colour or empty, it denotes the closing price ending higher than the opening. 

These colours used may be different and the black and white is just a preference of some. Other combinations used are red instead of black where the trading day ends on a lower price while a green body stands for the closing price being higher. 

When reading a candlestick, it is pertinent to remember that a candle cannot be seen in isolation to interpret it in its fullness. It always has to be seen in context of the preceding and succeeding candles to derive a pattern that emerges from the group. Without the context, it is possible that a wrong or incomplete assessment can be made that results in a wrong interpretation of the situation and, thereby, an erroneous investment decision. 

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Types Of Candlestick Patterns

Let us take a look at a few bullish, bearish and continuation candlestick patterns that are the most common candlestick patterns that you can use to identify trading opportunities and trade the markets.

Bullish candlestick patterns

  • Hammer pattern: When the trades are considerably lower than the opening, you will find that a hammer pattern appears. The hammer pattern is represented by a long lower shadow and a short upper shadow.
  • Inverse hammer pattern: This helps you identify a bullish reversal and looks like an inverted hammer with a short long upper shadow and short lower shadow.
  • Bullish engulfing pattern: When a bearish trend at closing is immediately followed by a bullish trend at opening it looks like the new candle will is engulfing the candle from the previous day.
  • Piercing line pattern: This two-day pattern appears when short-term reversal occurs from a downward to an upward trend.
  • Morning star pattern: This bullish sign has three candles - a tall and black one, a smaller black/white one with a short body and long shadow, and a tall white one - that indicate the start of an upward trend.
  • Three white soldiers pattern: This pattern helps you identify the current downtrend.
  • Bullish Harami pattern: This predicts the reversal in a bear price movement and is a good indicator to enter a long position. 
  • Bullish Harami cross pattern: This appears during a downward trend. 
  • Rising three pattern: A bullish pattern that happens in an uptrend and ends in the continuation of that trend.
  • White Marubozu: This is a single candlestick pattern that appears after a downtrend.
  • Tweezer bottom: Formed at the end of the downtrend, tweezer bottom has two candlesticks – one is bearish and the second one is bullish.

Bearish candlestick patterns

  • Hanging man pattern: This predicts an uptrend and helps traders to enter short trades or exit long trade positions.
  • Shooting star pattern: This predicts a potential price top and reversal. It often occurs after an uptrend and shows that the price may begin to go back down.
  • Evening star pattern: The reverse of the morning star pattern, this pattern is used to decide if a trend is about to reverse and indicates that the price is going to decline.
  • Bearish engulfing pattern: The reverse of the bullish engulfing pattern, this pattern occurs after a price advance.
  • Three black crows pattern: This pattern is used to find the reversal of a current uptrend.
  • Dark cloud cover pattern: A reversal pattern that highlights a shift in momentum to a downtrend following a price escalation. 
  • Bearish harami pattern: This pattern signals that the prices may reverse to a downward trend. 
  • Bearish harami cross pattern: Here the chart pattern forms after an uptrend. 

Continuation candlestick pattern

  • Dragonfly Doji pattern: This predicts a strong signal of a potential bullish bounce to come.
  • Gravestone Doji pattern: Occurs at the top of bullish trends and occurs when a bearish reversal appears.
  • Long legged Doji pattern: It occurs when the opening price and closing price are very close together, but not essentially at an equal level. 
  • Spinning top pattern: This is a sign of neither bullish nor bearish sentiment.

It goes without saying, that you can never use a candlestick pattern, or as a matter of fact, any chart, in isolation. One should always use other technical indicators as well.

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