Candlestick Charts: The Basics

The candlestick is valuable because it conveys a great amount of information in a relatively simple shape: a triangle with a 'wick' above, below, or on both ends. The same Home Depot chart in candlestick form is shown in Figure below.

[caption id="attachment_12734" align="aligncenter" width="550"](HD) Home Depot (HD), candlestick chart.[/caption]

The features of the candlestick include the real body, which is the rectangle.

If it is white or clear, the session moved upward; is it is black, the session moved downward. The advantage to this feature should be obvious; you can immediately spot trends over a series of sessions when the color of the real body is the same during the period.

The sticks above or below the real body represent the full trading range of the day. The upper and lower horizontal lines of the triangle represent the opening and closing prices; the body itself is the distance between opening and closing. The sticks above and below the real body are the complete trading range for the day. These are called the shadows and are also called tails when exceptionally long, or wicks. The 'tail' form of a shadow often has extra significance because it represents a failed attempt to move price farther than the opening/closing range.

The shadows are given additional names that tell you whether price moved above or below the real body. The upper shadow represents price action that was bullish, or an attempt to move prices higher even though the day's prices closed below that level. The lower shadow is the range of prices below the real body, or an attempt to move prices lower that failed, and with prices returning to the real body before the end of the session.

The complete candlestick shows you not only direction for the sessions, but for a range of sessions. The different segments of the candlestick are shown in Figure below.

[caption id="attachment_12735" align="aligncenter" width="550"]Candlestick segments. Candlestick segments.[/caption]

Referring back to the Home Depot candlestick chart in Figure , how much can you discover from this chart? This period began with a nice uptrend including some gapping patterns. It ended with a middle period of sideways movement, or congestion, in which neither buyers nor sellers had control. This lasted nearly a full month, from the middle of March until the middle of April. The uptrend then resumed.

Key Point

A comparison between the same data on an OHLC chart and a candlestick chart demonstrates the vast diff erence and shows that candlesticks are easier to use and interpret.

Notice the fourth day of the uptrend. It was accompanied by very high volume, confirming the resumption of a bullish trend. Another very clear signal occurred at the very top of the uptrend. The narrow range day (NRD) at the very top is given the name doji in candlestick analysis. The word doji means 'mistake' and it is easy to spot. The distance between opening and closing prices is very small or those levels are identical. So instead of a rectangle, a doji session is a horizontal line.

In the case of Home Depot (Figure ), the doji at the very top of the uptrend was a clear reversal signal. Note the upper shadow, which was an attempt to move price further upward. Its failure signals a loss of momentum and a high likelihood of a reversal and price decline.

While there are dozens of candlestick formations that provide excellent insight into price movement, momentum, continuation, and reversal, following are some of the major ones worth paying attention to. These recur often at key points in a price trend and can be valuable to signal reversal and to confirm what other indicators also reveal.

Key Point

There are so many specific candlestick formations that they are rich analytical tools; at the same time it takes practice and study to master the range of indicators in the form of candlestick sessions.

The first group worth analyzing is the single-stick candle. This is a candlestick of a single day that holds special meaning and also provides valuable insight about the current trend. Single-stick formations include the following:

Long candles. A long candle is any candlestick, white or black, with an exceptionally wide breadth between opening and closing price. A long white candle appearing at or near the bottom of a downtrend is a strong reversal signal; it shows that buyers controlled price action throughout the day. A long black candle showing up at the top of an uptrend has the same meaning, a likely reversal and start of a downtrend.

The long candle may also appear in the middle of a trend. If the color of the candle is consistent with the trend direction (white in uptrends or black in downtrends), it may serve as a continuation day or indicator.

A variation of the long candle is the marubozu. In Japanese, this word means 'little hair.' It is called this because it is a long candle with one of three features: it either has no shadows, or only an upper shadow, or only a lower shadow.

The marubozu with neither shadow is the strongest sign of a bullish trend (white marubozu) or a bearish trend (black marubozu).

The long candlestick types are summarized in Figure below.

[caption id="attachment_12736" align="aligncenter" width="427"]Long candles. Long candles.[/caption]

Short candles. On the opposite side of the scale of single-day candles is the short candle. The extreme version of this is the previously mentioned doji, which comes in several varieties. Every doji consists of a horizontal line instead of a rectangular real body; the opening and closing price for the session is identical or extremely close together. A dragonfly doji has a lower shadow, so it forms a capital letter T. The extent of the lower shadow determines the strength; the lower the shadow, the stronger. If a dragonfly doji shows up at the bottom of the trend, it is extremely bullish because the attempted move downward failed.

The opposite of the dragonfly is the gravestone doji, which has only an upper shadow and looks like a capital T turned upside down. When this appears at the top of an uptrend, it is a very strong reversal indicator.

The short candlestick types are summarized in Figure below.

[caption id="attachment_12737" align="aligncenter" width="550"]Short candles. Short candles.[/caption]

Trend-based candles. Some single-stick candles have a meaning that relies on the current market conditions. These are bullish, bearish, and sideways. So a specific candlestick might appear but its interpretation relies on these conditions.

Key Point

A general observation about candlesticks: exceptionally long and exceptionally short real bodies are probably the most signifi cant signals you are going to see.

The first among these is the long-legged doji, which has exceptionally long upper and lower shadows. The horizontal real body appears closer to the middle of the overall formation.

A long-legged doji showing up at the top of an uptrend signals possible reversal and is bearish; when it shows up at the bottom of a downtrend, it is bullish and may signal a coming uptrend. However, the long-legged doji (like any pattern) may also fail and in hindsight could be a misleading indicator. This is why all patterns in candlestick analysis need to be confirmed before entry or exit decisions are finalized.

Key Point

Some candlestick sessions, like the long-legged doji, may be either bullish or bearish depending on where they show up.

Another candle that depends on where it shows up is the spinning top. This is a candle with a small real body of either color, and long upper and lower shadows. It is similar to the long-legged doji, and like the doji, the spinning top's real body should appear about halfway through the formation.

A spinning top is a buy signal when it shows up at the bottom of a downtrend, or a sell signal at the top of an uptrend. Reversal works in both conditions and the important feature is placement along with shape; the color of the real body is incidental.

Key Point

A spinning top candlestick, like the long-legged doji, may be bullish or bearish. It depends on where it appears.

A final single-stick development that appears a lot is the hammer or hanging man. These both consist of a small real body (color does not matter) and a long lower shadow with no upper shadow. When this shows up at the bottom of a downtrend, it is a bullish reversal signal and is called a hammer. If it shows up at the top of an uptrend, it is a bearish reversal and is called a hanging man.

The trend-based candlestick types are summarized in Figure below.

[caption id="attachment_12739" align="aligncenter" width="550"]Trend-based candles. Trend-based candles.[/caption]

Two-stick patterns. Another group of candlesticks worth noting involves two consecutive sessions. The engulfing pattern consists of a set-up day that has a smaller rectangle on both sides, with the second day's real body extending beyond. The second day's high is higher, and its low is lower than the day preceding. The bullish version consists of a black set-up session and a white second session; the bearish version is the opposite, with a white set-up and black second session.

Another two-stick pattern is called a harami. In Japanese, this word means 'pregnant.' This is the opposite of the engulfing pattern and consists of a set-up day that has a higher high and a higher low than the second day. A bullish version has a black set-up and a white second day; and a bearish version has a white set-up day and a black second day.

Dozens of additional two-stick patterns also can be used for reversal signals, confirmation, and continuation indicators. The preceding are only the most prominent and widely used among them.

Key Point

There are dozens of two-stick candlestick indicators. Some are more subtle than others; they provide excellent forms of initial indicators or confirmation signals.

The two-stick candlestick types are summarized in Figure below.

[caption id="attachment_12738" align="aligncenter" width="417"]Two-stick candles. Two-stick candles.[/caption]

Three-stick patterns. The most complex but also the strongest of candlestick indicators are made up of three consecutive sessions. There are dozens of these and, like the single- and double-stick patterns, the following are only the most easily found and most common of the three-stick patterns.

Key Point

Three-stick indicators are the strongest of all. Because there are three consecutive sessions in each pattern, they serve as a mini-trend of their own.

First is the three white soldiers, which involves three days with all white candles that each move higher. To qualify, the closing price of each session has to be higher than the previous, and the opening price (the bottom of the real body) also has to be higher than the previous day's opening price.

The opposite of the bullish three white soldiers is the bearish three black crows pattern. This is a series of black candles. Each day's opening price is lower than the previous day's open, and each closing is lower than the previous day's close.

Another interesting three-day pattern is the squeeze alert. A bullish version looks like the three black crows with an important difference. All three sessions are black, but each day's range is lower on both sides. Each reports a lower high and a higher low. The bearish squeeze alert is the opposite and it is similar to the three white soldiers. However, each session's high is lower than the previous; and each session's low is higher than the previous.

The three-stick candlestick types are summarized in Figure .

[caption id="attachment_12740" align="aligncenter" width="550"]Three-stick candles. Three-stick candles.[/caption]

Many additional candlesticks are found in the study of charts, and work well to confirm indicated reversal and continuation patterns. The preceding is only an introductory look at candlesticks. The range of possible signals is vast, with more than 100 potential different signals consisting of single sticks or two-day or three-day formations.

Key Point

Candlestick analysis is not a technique you will pick up quickly. The more you study it, the more you discover that a wide range of patterns identifies reversal, momentum, and continuation.

By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2020. Content published with author's permission.

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