Understanding candlestick charts

Introduction

Candlestick charts were first introduced by a Japanese rice trader, Honma Munehisa, in the early eighteenth century. Still sometimes referred to as Japanese candlestick patterns, this versatile charting method has long outgrown its original use in rice futures markets, with candlestick charts now used worldwide to give a clear visual signal of trading session performance in multiple asset classes.

CFD traders use candlestick charts to get a visual idea of past trading sessions, which according to technical analysts can provide a guide to future price moves. Not everyone accepts this, and traders need to be aware markets can move against them, and not always in the way candlestick patterns would imply. Even so, identifying well known candlestick patterns such as the doji star, hammer and pennants is essential for successful technical trading.

Overview of candlestick charts

Candlestick charts are visual representations of price movements in financial markets over a single session. Composed of one or more usually several candlesticks, a pattern shows the user information about market psychology and its effect on price action. There are two key types of candlestick pattern – continuation and reversal. Reversal patterns indicate potential trend changes, signalling shifts from bullish to bearish or vice versa. Examples include the head and shoulders, a well-known pattern that can mark the end of an uptrend, and the hammer, seen as a sign of a potential bullish reversal.

Continuation patterns, on the other hand, imply that the prevailing trend still has momentum and can be expected to continue. The flag and pennant patterns are seen during a brief consolidation before the main trend resumes. Bullish continuation patterns indicate an upward trajectory, while bearish patterns forecast ongoing downward movement. Many chart patterns are reversible, for example the hammer is matched to the inverted hammer, that is simply an upside-down version of the same candlestick. Inverted patterns have the same significance in terms of continuation or reversal, but are bearish instead of bullish or vice versa.

Trading with candlesticks

To generate a useful trading signal, we need to understand whether a pattern is bullish or bearish. Bullish patterns indicate positive sentiment, with buying pressure predominating in the session, while bearish patterns indicate sellers playing the larger role. Traders use these insights to make informed decisions, predicting potential price movements as they happen. Candlestick charting is a broad topic that takes years to fully master, but knowing a few of the most important patterns will help.

1. Hammer and inverted hammer

A hammer is a candlestick pattern that forms after a price decline, so named because it looks like a hammer. The hammer is characterized by a small real body (the body is near the top of the candlestick), a long lower shadow, and little to no upper shadow. The shadow (or wick) is the handle and the body the head of the hammer. This pattern suggests a potential bullish reversal, indicating buyers have regained control after a period of selling pressure. Very similar to the hammer, an inverted hammer appears after a downtrend. It has a small real body near the bottom of the candlestick, a long upper shadow, and little to no lower shadow. The inverted hammer signals potential bullish reversal, with buyers gaining strength and overcoming earlier selling pressure. In both cases the hammer is a classic reversal pattern, and will be used by mean reversion traders as sign of an impending reversal.

2. Doji star

A doji star is a single candlestick pattern that signifies indecision in the market. It is characterised by a small real body that opens and closes near the same price level, creating a thin line. The pattern suggests that neither buyers nor sellers were able to gain control during the trading session. A doji star can indicate a potential reversal or a period of consolidation in the market. Traders pay close attention to market movements following a doji star, as the next decisive break will likely show whether the trend continues or fails.

3. Pennants

A doji star is a single candlestick pattern that signifies indecision in the market. It is characterised by a small real body that opens and closes near the same price level, creating a thin line. The pattern suggests that neither buyers nor sellers were able to gain control during the trading session. A doji star can indicate a potential reversal or a period of consolidation in the market. Traders pay close attention to market movements following a doji star, as the next decisive break will likely show whether the trend continues or fails.

4. Marubozo

The marubozo is a distinctive pattern with a wick / shadow. This candlestick indicates that the session did not trade outside the range of its open and close, and the marubozo is considered a strong single. If the close is higher than the open, the marubozo is bullish, but if the closing price is down from open, bearish. The name marubozo comes from a Japanese word meaning ‘close cropped’, and this is an easy candlestick to identify due to its distinctive and obvious appearance. The market psychology behind the marubozo is a session that involved constant pressure in a single direction, with either buyers or sellers completely dominating price action.

5. Multi-day patterns

Single candlestick patterns such as the doji star or hammer only require one session to form, but there are also multi-day patterns that form over successive trading sessions. Two classic examples are the head and shoulders pattern and evening star. The evening star takes place over three days, with a strong positive session on the first, a weaker one on the second, and finally a large falling candle closing around the middle of the first day, completely erasing the gains of the middle session. Though it requires practice to consistently identify the evening star, it is a powerful bearish reversal pattern, often seen near a key resistance level. Generally speaking, multi-day patterns are harder to identify than single candlestick patterns, and have more potential interpretations.

Confirming trends

Candlesticks often give a warning sign about changes in market direction, but their interpretation is not an exact science. The most sensible strategy is to use candlesticks to confirm your existing suspicions about the market. Say for example you have a short view on USD/JPY and have seen the RSI trading above 80 for several sessions. At that point, a hammer pattern would offer a strong signal the expected reversal is about to happen. Mean reversion traders may then open a short position in USD/JPY or wait until they see decisive downwards price action before joining the market.

CFDs are highly flexible, with forex CFD traders often using candlesticks to identify ideal entry and exit points. You can use candlesticks to identify entry and exit points for trades: often a reversal candlestick will form around a key support or resistance level. Chart patterns also help when deciding when to close an open trade, with a continuation pattern normally seen as a positive side for a (profitable) open position, whereas the appearance of a doji star or reversal pattern like a hammer may be a sign its time to take profit.

Summary

Candlestick patterns form the oldest rational basis for technical analysis, and have been successfully applied to all markets worldwide. ADSS traders, whether they deal in CFDs on equities, indices, or forex, can benefit from understanding candlestick patterns and using them to guide their trading strategies.  The appearance of a bullish pennant or inverted hammer is a clear signal that will be picked up by traders checking charts. Even if you are sceptical about the predictive power of some of these patterns, the mere fact that many traders do use them can result in a self-fulfilling prophecy, where the expected market result is encouraged by traders responding to the pattern. Candlestick charts aren’t without critics – some traders view them as outdated or a relic of the days of single-day, in person trading sessions, and others point to the well-known tendency for humans to see patterns in random noise – but there is no denying they can and do work in some circumstances. The best strategy, as always, is to combine signals from candlesticks with other technical and fundamental methods, following prudent risk-management strategies, and sizing positions appropriately. If you remember these key points, understanding candlesticks is a powerful tool for technical CFD traders in all markets. But you must also appreciate that sometimes markets don’t follow trends, and that could lead to losses.

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