Understanding Candlesticks: A Guide to Japanese Candlesticks as a Market Indicator
The candlestick chart is one of the most common and popular charting systems for analyzing markets. Whether it’s a forex market, commodities, or even cryptocurrency, candlesticks are extremely useful for finding the current market trend.
However, to use this tool effectively, you need to know how to read candlestick charts. Understanding candlesticks in detail can also help you accomplish much more when using this system.
Below we’ll look at various topics like what a candlestick chart is, where it comes from, and how to read candlestick charts, and we’ll also try to share information that’s useful for understanding candlesticks.
What Is a Candlestick?
A candlestick is a specific type of charting tool used in candlestick charts. These indicators, often referred to as Japanese candlesticks, get their name from their appearance. They resemble candlesticks thanks to their thick body and narrow “wick.”
Each part of the candlestick represents something different, and by learning to interpret these patterns, traders can make accurate predictions of what the market will do next. Each candle represents a time period that may theoretically be as little as one minute or as long as one year. When used for trading purposes, each candle generally represents up to a day in length.
When you know how to read candles, each one will tell you several things about the timeframe they represent. Specifically,
- Did the market price increase (a bullish market) or decrease (a bearish market)?
- Where did the market open and close?
- What were the highest and lowest prices reached by the market?
For these reasons and a few others, the candlestick chart is an invaluable tool for traders who need to accurately analyze market trends.
How To Read a Candlestick
While a candlestick chart can seem complex and hard to understand, it’s generally quite simple once you understand how to read candlesticks.
There are a few main aspects to consider when trying to read a candlestick chart, which we’ll discuss below.
- What color is the candlestick? – Candlesticks may be one of three colors, which gives you your first key to interpreting a candlestick chart. It’s worth noting that the color gives an indication of the overall result rather than indicating any sort of stability. The colors have the following meanings:
- Green – The market was bullish (overall) during the timeframe represented by that particular candlestick. In other words, the price or value of the commodity in question increased during that time.
- Red – The market was bearish (overall) during the time period that the candlestick represents. You could also say that the price or value of the commodity decreased during that time.
- Grey – A gray candlestick is rare and indicates that the market value remained exactly the same during the time period represented by the candlestick.
- Where did the market open? – On a bearish (red) candlestick, you can tell the market’s opening value by looking at the highest point on the candlestick’s body. On the other hand, a bullish (green) candlestick’s opening market value is represented by the lowest part of the candlestick’s body.
- Where did the market close? – On a bearish (red) candlestick, the market’s closing value is represented by the lowest point of the candlestick’s body. On a bullish (green) candlestick, the market’s closing value is represented by the highest point of the candlestick’s body.
- What do the shadows show? – Above and beneath the candlestick’s body are the shadows, thin lines representing fluctuations in the market. Unlike the market’s opening and closing values, these remain constant irrespective of whether the candle is green or red. There are two types of shadows:
- The Upper Shadow – The upper shadow represents any time that the market value traveled over the opening value (in a bearish candlestick) or over the closing value (in a bullish candlestick). The highest point of the upper shadow represents the height of the market value in the timeframe the candlestick represents.
- The Lower Shadow – This shadow represents the times when the market value traveled under the opening price (in a green candlestick) or under the closing price (in a red candlestick). The lowest point of this shadow always represents the lowest price reached by the market during the time period that the candlestick represents.
Now that you understand the basic elements of the candlestick, you understand the elementary steps of how to read candlesticks. Now, let’s take a closer look at how to read candles to provide a detailed insight into how the market behaved during a given time period.
Interpreting Candles to Help Read the Market
Understanding candles properly is key to using them when developing a trading strategy. Each candle has the ability to show you exactly how the market behaved, whether for a whole day or just ten minutes at a time. For instance:
- If a candle is green or white and doesn’t have shadows, you know that the market was highly bullish. Conversely, if a red or black candle has no shadows, you know that the market was highly bearish.
- If a green or white candle only has an upper shadow and it’s quite short, then you know the market was moderately bullish. Comparatively, if a red or black candle only has a short lower shadow, then you know the market was moderately bearish.
- A green or white candle with a long upper shadow indicates that the market was mildly bullish. But, a red or black candle with a long lower shadow indicates that the market was mildly bearish.
- If either a green/white or red/black candle has a short body with an approximately equal upper and lower shadow, then you know the market was either slightly bullish or slightly bearish (as indicated by the color). However, in this case, the market was much nearer to neutral than it was to either extreme.
History of Candlesticks
In Japan, commodities training has been going on for hundreds of years, starting with rice and then moving on to commodities like rapeseed oil and soy. Compared to the West, they started using charts to analyze the markets much earlier.
The first recorded use of charts for analyzing markets in the West was well over 100 years after Japanese traders started using charts in the 1700s. The candlestick chart, in particular, was developed by a rice trader named Munehisa Homma after he realized that the emotions of the traders played a part in the price of rice. However, the candlestick chart remained a Japanese secret until the 1980s, when Westerners were first introduced to this charting system.
How To Take the Most Out of Candlestick Analysis
Now that you know how to read stock candles, it’s time to learn how to maximize candlestick analysis. While the elements mentioned above are an essential part of understanding candlesticks, there’s far more to this technique.
In fact, the candlestick chart is most useful when you use it to study patterns formed by multiple candlesticks rather than the candlesticks individually. You best interpret the candlestick chart By knowing the basic candlestick patterns, so let’s look at some of the most common and significant options.
Falling Three Methods
The falling three methods pattern is characterized by two long candles at the ends and three short candles in the middle. The two longer candles will be red or black, and the three shorter candles will be red or green.
Since three of the candles are bullish, this pattern is a sign of bearish continuation. It tells traders that, though the market is showing signs of becoming bullish, it’s not ready to enter a reversal phase. Therefore, it will likely keep being bearish for the immediate future.
Separating Lines
Separating lines are a type of candlestick pattern indicative of a trend. This type of pattern may be either bullish or bearish and signifies trend continuation. It occurs when the next candle’s body starts on the opening or closing value of the previous time period. In short, it’s a two-candle pattern indicating either a continuing bearish or bullish pattern.
Evening Star
The evening star candlestick pattern is slightly more complex than the patterns mentioned above. It’s a three-candle pattern consisting of one large green candle, one short candle, and a red candle. Generally, this pattern occurs at the top of the chart or at least at the upper end of a bullish trend.
It’s a bearish pattern that indicates trend reversal and which can be used to accurately predict sudden changes in the market.
Morning Star
The morning star candlestick pattern is the polar opposite of the evening star. Where the evening star usually occurs at the top of the chart, the morning star occurs at the lower end of the chart or at the bottom of a bearish trend.
Like the evening star, the morning star consists of three candles. However, in this case, it consists of a long red candle, a short candle, and a green candle. This pattern is also indicative of trend reversal but heralds the reverse. It means that the market is about to shift from a bearish trend into a bullish one.
Rising Three Methods
The rising three methods candlestick pattern consists of five candles. It has two long green or white candles at the beginning and end, with three short red or black candles in between. None of the bearish candles will open at a lower point than the opening value of the first bullish candle.
It takes place when a bullish trend temporarily seems like it may turn bearish. However, the final candle in the set shows a conclusive bullish aspect. It’s usually found at the upper end of a bullish trend and indicates a continuation of that trend.
Three White Soldiers
Three white soldiers is a bullish candlestick pattern that indicates the reversal of a bearish trend.
It is characterized by three green or white candles, with the body of each candle opening at the closing of the previous candle. It may also be that the consecutive candle merely opens above the opening of the previous candle.
Shooting Star
The shooting star is a bearish candlestick pattern consisting of a single red candle. It takes the form of a red or black candle with a long upper shadow and little or no lower shadow. The body is generally short and squat and located near the lower shadow (if there is one).
This pattern is indicative of trend reversal.
Inverted Hammer
The inverted hammer candlestick pattern consists of a single candle and occurs at the bottom of a bearish trend. It is a bullish candlestick pattern that indicates the reversal of the previous bearish trend.
Spinning Top
The spinning top is a single candlestick pattern that may be either bearish or bullish. It has a short real body wedged between long upper and lower shadows.
It is a sign of market indecision and means that either a bullish or bearish trend may follow. However, the trend will often follow the pattern set by the spinning top (become bullish if the top is bullish, or vice versa).
Gravestone Doji
The gravestone doji is a single candlestick pattern that is considered bearish. It occurs when the opening price, closing price, and market low are all very close together and is characterized by a very short body with a long upper shadow.
This pattern characterizes a trend reversal and indicates a coming bearish trend.
Understanding candlestick patterns will help you interpret the market’s support and resistance factors. These are some of the most essential factors when trying to trade successfully.
Why Do Candlestick Patterns Work
Even if you know how to read candlestick charts, it can sometimes be difficult to understand the science behind them. However, a candlestick chart interprets the market based on certain factors likely to affect it. The main influencing factors include the following:
- Market Bias – Market bias refers to the main idea held by the largest group of investors at any time. They may, for instance, believe that a bearish trend is about to start, despite evidence to the contrary. This can have a significant impact on how people trade and, therefore, what happens to the market.
- Market Analysis – Market analysis takes into account real determining factors that affect the market you’re trading on. For instance, if you’re trading on the GBP and the United Kingdom releases a new financial policy, it will almost definitely impact the pound in some capacity.
- Psychology – Whether you’re trading Forex, securities, or indices, psychology plays a fairly important role. Traders look at past trends (market analysis) and consider what other traders and investors think (market bias). However, what they do with that information is based purely on their psychology. Good trading takes into account what traders are statistically most likely to do based on the available information.
Conclusion
A candlestick chart is a useful tool as long as you know how to read candlestick charts. If you familiarize yourself with basic patterns and remember to gauge the market bias when doing market analysis, you’ll do fairly well using this system.
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