Understand How Candlestick Charts Work
Candlestick charts create formations and patterns that are a type of stock market technical analysis, and are used in stock chart displays. They are able to be used in every time frame, by long term investors to day traders and swing traders. The major benefit with candlestick charts is that they are great at providing you with turning points in the market, and when used properly, can substantially decrease your exposure to risk in the market. With candlestick charts, it’s not a guessing game. Trading blindly is no way to trade. Many are able to read patterns and single candles to determine what will soon follow.
It is even believed by many traders that the news is already worked into the charts. Essentially, news reaches the average trader long after Wall Street. That press release you read this morning may have reached Wall Street a week ago. The end conclusion being that you can, in many circumstances, predict the news (positive or negative) based on chart movements and patterns.
What are Candlestick Charts?
“Japanese Candlestick” charts, named for their resemblance to candles, have been refined after several generations of use in Asia. Today, candlestick charts are used internationally by day traders, swing traders, investors and even Wall Street financial institutions.
Candlesticks are fairly easy to understand. Anyone from a new trader that is just being introduced to technical analysis to the seasoned veteran trader can easily use the power of candlesticks. Candlesticks provide each of us with earlier indications of turning points in the market. They can display reversal signals in just a few sessions, rather than weeks previously needed for a bar chart to display clear reversal signals.
Any technical tool you use can be applied to a candlestick chart. Unlike traditional bar charts and line charts, candlesticks give you trading and timing benefits not otherwise available with other charts. Candlestick charts can be used in all markets from the stock market, futures, commodities, forex and can be a powerful tool when trading options. As a result, the average technical analysis driven trader will much prefer candlestick charts when performing TA or evaluating a security.
The wide part of the candlestick (or the body) of the candle, represents the range between the opening and closing prices of the session (on the daily chart). Same goes for any other time range.
The lines above and/or below the body of the candle are referred to as shadows or wicks. The top of the upper wick shows us the high of the day, while the bottom wick shows us the low of the day.
The color of the candle, and the length of the body shows whether bulls or bears are currently in charge.
Trading With Candlesticks
A very powerful benefit of using candlesticks is that the color and size of the candles can display large volumes of information. A few examples:
- Long green or white candle body confirms bulls are in charge
- Long red or black candle body confirms bears are in charge
- A small candle body (any color) indicates a time that the bulls and bears are in a battle of tug of war and warns you that the current market’s trend momentum may be dying
- As the candle body gets smaller, we essentially end up with a “doji,” a candlestick line that has an identical opening and closing price, and therefore has no candle body.
While the candle body is typically considered to be the most important part of the candlestick, you are also able to gain a substantial amount of information from the position and length of the wicks. For example, a tall wick above the body shows that the market tested and rejected higher prices, while a long wick under the body indicates a market that has tested and rejected lower prices. Candlestick charts will usually provide reversal signals, which traditional bar and line charting techniques are unable to show.
Here is an example of how using candlesticks can help to avoid a losing trades. Exhibit 1 below is a standard bar chart. In the area that is circled on the bar chart, this particular security looks strong, as it appears to be making consecutively higher closes. Based on this aspect (and this chart) alone, this looks like a potentially a winning trade.
Exhibit 2 is a candlestick chart that is analyzing the same stock and time frame used in Exhibit 1.
If you look at the same circled area of the same stock on the candlestick chart, you can easily note the differences. With the candlestick chart, within the same circled area, there are a series of small candle bodies which are referred to as “spinning tops.” Small candle bodies indicate that the previous trend (in this case, the strong rally) could be losing its momentum.
Therefore, while the bar chart in Exhibit 1 makes it look like an attractive trade, the candlestick chart indicates there is a reason for caution when going long. The small candle bodies (spinning tops) illustrate the bulls are losing force. Therefore, by utilizing the candlestick chart, a day trader, swing trader, or even an active investor would more than likely not buy this security in the circled area. Resulting in avoiding a losing trade.
Without a doubt, Candlesticks are the way to go when it comes to charts. The information given by the simple displays are so much more than you get from other types of stock charts. I will follow up this post with additional posts regarding technical analysis, including some of the most common and useful chart patterns to watch for.