Introduction Candlestick Charts
One of the strangest charts used by economists are called candlestick charts. Analysts use them to depict changes in the price of stocks and other investments.
If you don't know how to read a candlestick chart, don't worry - it's not obvious. Read on to find how they work and to learn a skill that will impress your friends!
How to Intepret a Single Candlestick
A candlestick has two components:
- The body - It's a large rectangle that represents the spread between the asset's price as the start and the end of the day. The taller the box, the larger the difference between its opening and closing price. Should the opening and closing price be equal, the box will appear as a thin horizontal line. The boxes are colored to explain whether the closing price was higher or lower than the opening price. If the asset gained in value, it is colored green (or white). If the asset lost value, it is colored red (or black). Every candle in a candlestick chart will have the same width.
- The wicks (also called tails or shadows) - They are vertical lines that extend out of the candlestick body. They depict the highest and lowest prices reached by the asset price during the day. Some candlesticks are missing one or both wicks. Wicks only show up when the asset's price stays between the opening and closing price.
Both bodies and wicks can be described as long or short. If a body is long, it means that there was a big change between opening and closing prices (you'll have to look at the body's color to see if it became more valuable or less). If an uppwer wick is short, that means that the asset's price didn't get much higher throughout the day than the greater of its opening and closing prices. Remember that some investments are more volatile than others, so a shift in price that would be considered long for one asset might be considered relatively short for another.
Reading Multiple Candlesticks
It's very rare to see one candlestick on its own. Investors like to look back further in order to see trends over time.
Take a look at the following chart. What does it tell you?
- All of the candlestick bodies are red - This means the asset price always closes lower than it opens.
- The candlestick bodies keep going lower - This suggests that the people are willing to pay less for the item than they were previously.
It sure looks like this asset is not a very good investment.
Of course, I might be wrong. At some point, traders might decide that the price has dropped so much that it becomes an interesting investment. Or maybe the company's management team is about to announce some unexpected good news.
Candlestick charts don't tell us anything about the company itself or its fundamental value. All it reveals is the company's share price.
Making decisions solely on the basis of changes to share price (technical investment) is a contentious topic. Many investers argue that such actions work because they make use of measures of investor sentiment and those investors have done a lot of research to figure out where to put their money. In other words, technical investors argue that their candlestick charts work because markets are efficienet.
Whether technical investment makes sense or not, its ability to predict market movements can be made manifest, if investors make use of it increases.
What's the alternative? People known as value investors make their buying decisions based upon the relation of share price to the value of the underlying firm. This tends to be a lot of work, so we won't be focusing on value investing in this candlestick pricing guide.
Candlestick charts don't provide any direct information about volume (how many shares are being traded). The fewer the shares traded, the weaker the signals provided, because shifts in price represent the change in sentiment of relatively few investors.
Candlestick charts only provide four data points per day. There's no way of knowing of knowing how prices were distributed over the course of the day. Did the price sink for only two minutes early in the day but spend almost all of the day near the high? There's no way to know.
Directory of Candlestick Patterns
(Patterns with a * contain multiple candlesticks)
- Dragonfly Doji
- Falling Window *
- Gravestone Doji
- Hanging Man
- Harami *
- Harami Cross *
- Spinning Top
- Three Black Crows *
- Three White Soldiers *
A doji is a candlestick with a very short body and wicks of roughly equal length. The legs above and below the body indicate that the market has tested prices for the asset above and below its opening price, but after all has been said and done, the market determined that its opening price was justified.
These are relatively rare for highly-traded assets, which explains why the word was chosen. In Japanese the word doji means mistake, as if to indicate that one should double-check his numbers, if opening and closing prices are approximately equal.
If the wicks are particularly long, the entire shape is referred to as a long-legged doji
A doji on its own provides little in the way of actionable information. The testing of both high and low prices, only to return to an opening price may demonstrate uncertainty, but is otherwise considered a neutral signal.
When it is the most recent candlestick of a larger series that has moved in a single direction, it tends to be seen as a reversal of investor sentiment.
Thus a rising series of candlesticks followed by a doji may lead some investors to believe that the asset's price will soon drop.
The dragonfly doji looks just like a dragonfly - a very small body followed by a long tail.
In other words, there is no upper wick, the short candle body represents the body of the dragonfly, and the long bottom wick represents the dragonfly's tail. The long tail is always below the candle body. In other words, every dragonfly doji points in the same direction.
A dragonfly doji represents a situation in which the asset's high price, opening price, and closing price are very similar, but a significant lower pricing bound has been tested.
In a rising environment, the fact that a price ceiling has been reached, but lower prices have been tested may mean that owners are losing confidence and prices will drop again.
In a falling environment, the fact the prices continued to drop (hence the long tail), may signal that a pricing bottom has been reached, because buyers started buying after the bottom has been reached.
A falling window is a declining trend in which the top wick of a candlestick is below the bottom wick of the previous candle.
Large gaps between candles in a declining pattern tends to indicate a strongly negative sentiment for a given asset. As such, many traders sell when they see the falling window pattern.
A gravestone doji is the exact opposite of a dragonfly doji.
It is characterized by a long upper wick, a short body, and no lower wick.
The long upper wick with a return to opening price indicates a lack of certainty in further price increases. As a result, it may indicate a potential top when it follows a series of price increases.
A hammer is a single candlestick with either a short or completely absent upper wick, a relatively small body and a long tail.
It is sometimes confused with a dragonfly candlestick which features no upper wick and an even shorter body.
It can also be confused with the hanging man candlestick pattern. Hammers always appear after a downward trend in prices, whereas the hanging man always appear after an upward trend in prices.
When preceded by falling prices, it is often a sign of a reversal because lower prices have been tested by market and rejected.
The hanging man is a single candlestick pattern that features a small body, minimal to no upper wick and a relatively long body.
It is always located after a trend of increasing prices. When a similar candlestick appears after decreasing prices, it is known as a hammer.
It typically indicates that a top has been reached, and investors are beginning to lose sentiment.
Red hammers are generally seen as a more bearish signal than green hammers as they demonstrate the (due to the lower closing price) sentiment is not only being tested, it has been lost.
Harami is a multi-candlestick pattern that involves a candlestick with a relatively large body followed by a candlestick with a smaller body of the opposite color that has opening and closing prices that fall within those of the first candle.
It looks like a pregnant woman with an enlarged belly, so it should not surprise you to learn that harami is the Japanese for pregnant.
When the second candle is green (white), it is seen as a positive signal for prices and may be referred to as a bullish harami.
On the other hand, when the second candle is red (black), it is seen as a negative signal for prices and may be referred to as a bearish harami.
A harami cross is a doji that follows a particularity pattern.
First, a series of increasing or decreasing candlesticks must show a definite trend, with the last candle in the sequence having a lengthy body.
The cross itself is simply a doji with a body that is between the opening and closing of the previous candle.
It often indicates a reversal to a trend, though the result is often uncertain.
A candlestick with a long body and no wicks. Its name (marubozu) comes from the Japanese word for bald head, indicating the lack of upper and lower wicks.
If a marubozu is following a trend, either closing higher after a series of price increases, or closing lower after a series of price decreases, the trend will likely continue.
This is because it demonstrates a trend in the same direction with no source of uncertainty, due to the lack of wick.
On the other hand, should it break a trend, it could indicate a significant change in buyer sentiment, for the very same reason.
The spinning top is one of great uncertainty and demonstrates an environment in which investors are unsure as to what the correct price should be.
It features long upper and lower wicks (which demonstrate a wide variety of prices being tested) and a relatively short candlestick body which demonstrates that, ultimately, buyers and sellers were unable to determine a price that differs significantly from where it started.
As with other patterns that demonstrate uncertainty, it often can be seen as as signal for a reversal (whether positive or negative).
Three Black Crows
The three black crows are three candles demonstrating declining prices after a significant run up.
The chart depicts the three black crows as red, rather than black. Many modern resources have replaced the color black with red and the color white with green to increase chart readability, but the old names have stuck.
The occurrence of three price increases in a row may indicate that sentiment is on the upswing and the price will continue to rise further.
Three White Soldiers
The three white soldiers is the name for a pattern that involves three candlesticks.
They are formed when a downward trend is followed by three candlesticks moving in an upward trend.
The three white soldiers will have the following characteristics:
- The first soldier will be smaller than the following two soldiers
- The second and third soldiers will be of roughly equal size
- The third candle will feature minimal wicks, so as to indicate unbroken confidence in the uptrend
Why are we calling white candles green? Remember, back before color printers were common, newspapers had to make due with black and white. They used white to represent increasing prices.
The reverse of the three white soldiers pattern is known as the three black crows.
The three white soldiers is usually perceived as a positive signal of future price increases.