A candlestick is a graphical representation of price movement within a specific time frame on a chart. It’s called a candlestick because of its shape, which looks like a candle with a wick at both ends.
Each candlestick shows four key points:
- Open: The price at which the asset opened at the beginning of the period.
- Close: The price at which the asset closed at the end of the period.
- High: The highest price reached during the time period.
- Low: The lowest price reached during the time period.
A candlestick consists of two main parts:
- The Body: The rectangular part, showing the difference between the open and close prices.
- The Wicks (Shadows): The thin lines above and below the body, indicating the price range between the highest and lowest prices.
Basic Candlestick Types
There are two basic candlestick types:
Bullish Candlestick (Green or White):
- This candlestick occurs when the close price is higher than the open price. It indicates upward movement or buying pressure in the market.
Example: A green candlestick might represent a stock opening at $100 and closing at $110, signaling that buyers were dominant during this period.
Bearish Candlestick (Red or Black):
- This candlestick occurs when the close price is lower than the open price. It indicates downward movement or selling pressure in the market.
Example: A red candlestick might represent a stock opening at $110 and closing at $100, signaling that sellers were dominant.
Basic Candlestick Patterns with Examples
1. Doji
A Doji candlestick forms when the open and close prices are nearly the same. It indicates indecision in the market, meaning buyers and sellers are in balance.
- Example: A Doji might appear when a stock opens at $100 and closes at $100. This suggests that the market wasn’t sure whether to move higher or lower during that period.
- Interpretation: A Doji typically indicates a potential reversal or trend pause, but it requires confirmation from the following candles.
2. Hammer and Hanging Man
Hammer: This pattern forms after a downtrend. It has a small body, a long lower wick, and little to no upper wick. It suggests a potential bullish reversal.
Example: A hammer might appear after a stock has been declining, where the price opens at $100, falls to $90, then closes at $105. It signals that buyers are starting to enter the market after the decline.
Hanging Man: This pattern appears after an uptrend and has the same structure as the Hammer. It signals a potential bearish reversal.
Example: After an uptrend, a hanging man may appear where the stock opens at $110, rises to $115, and then falls to $105, closing near $105. It indicates that selling pressure could soon take over.
Two-Candle Patterns
1. Engulfing Patterns
These patterns occur when one candle fully engulfs the previous one, signaling a potential reversal.
Bullish Engulfing: A green candlestick completely engulfs the previous red candlestick. It suggests a shift from bearish to bullish.
Example: If a stock has been in a downtrend, a red candle (e.g., opening at $100, closing at $95) is followed by a larger green candle (e.g., opening at $94, closing at $110). This suggests that buyers have overpowered the sellers, and the trend may reverse to the upside.
Bearish Engulfing: A red candlestick completely engulfs the previous green candlestick. It suggests a shift from bullish to bearish.
Example: If a stock has been in an uptrend, a green candle (e.g., opening at $110, closing at $120) is followed by a larger red candle (e.g., opening at $119, closing at $110). This signals that sellers may now dominate.
2. Piercing Line and Dark Cloud Cover
Piercing Line: This is a bullish pattern that happens after a downtrend. The first candle is a long red candle, followed by a green candle that opens below the red candle's low but closes more than halfway into the body of the red candle.
Example: A stock falls from $120 to $110 (red candle), then opens at $109 and rises to $115 (green candle), closing at $113. This signals a possible reversal to the upside.
Dark Cloud Cover: This is a bearish pattern that happens after an uptrend. The first candle is a long green candle, followed by a red candle that opens above the high of the green candle and closes below the midpoint of the green candle.
Example: A stock rises from $100 to $110 (green candle), then opens at $111 and closes at $105 (red candle). This suggests a potential shift to the downside.
Three-Candle Patterns
1. Morning Star and Evening Star
Morning Star: A bullish reversal pattern after a downtrend. It consists of a large red candle, followed by a small-bodied candle (often a Doji), and then a large green candle. The pattern signals a transition from bearish to bullish.
Example: A stock falls from $120 to $110 (red candle), a Doji forms at $110 (indecision), and then the stock rises from $110 to $120 (green candle). This indicates that the market may have reversed upwards.
Evening Star: A bearish reversal pattern after an uptrend. It consists of a large green candle, followed by a small-bodied candle, and then a large red candle. It suggests a shift from bullish to bearish.
Example: A stock rises from $100 to $110 (green candle), forms a Doji at $110 (indecision), and then falls to $100 (red candle), signaling a potential bearish reversal.
2. Three White Soldiers and Three Black Crows
Three White Soldiers: This is a bullish continuation pattern that occurs after a downtrend. It consists of three consecutive long green candles, each closing higher than the previous one. This indicates strong buying pressure.
Example: A stock falls from $120 to $110, then rises consecutively in three days, moving from $110 to $130. The presence of three consecutive green candles shows buyers are in control.
Three Black Crows: This is a bearish continuation pattern that occurs after an uptrend. It consists of three consecutive long red candles, each closing lower than the previous one, signaling strong selling pressure.
Example: A stock rises from $100 to $120, then declines consecutively in three days, moving from $120 to $100. The presence of three consecutive red candles shows sellers are in control.
Advanced Candlestick Patterns
1. Harami and Harami Cross
Harami: This two-candle pattern consists of a large candlestick followed by a small candlestick completely within the range of the first candle. It signals potential reversal or market indecision.
Example: After a large green candle, a small red candle appears within the green candle’s range. This suggests a slowdown in the upward trend, possibly signaling a reversal.
Harami Cross: This is a variation of the Harami pattern, where the second candle is a Doji. It signals indecision and a potential reversal.
Example: A large green candle is followed by a Doji candle, indicating market uncertainty and the potential for a change in direction.
2. Tweezer Tops and Tweezer Bottoms
Tweezer Tops: This is a bearish reversal pattern formed by two candles with the same or nearly the same high price. It appears at the top of an uptrend, signaling resistance.
Example: A stock rises to $120, then forms two candles with highs at $120, signaling that the market could reverse.
Tweezer Bottoms: This is a bullish reversal pattern formed by two candles with the same or nearly the same low price. It appears at the bottom of a downtrend, signaling support.
Example: A stock falls to $100, then forms two candles with lows at $100, signaling that the market could reverse upwards.
Candlestick patterns are a valuable tool for traders in identifying trends, potential reversals, and market sentiment. From the basics like Doji and Hammer to more advanced patterns like Harami and Tweezer Tops, understanding these patterns can significantly improve your ability to predict price movements.
Also read: Hidden Tricks for Candlestick Patterns: What Most Traders Don’t Know
However, it’s important to remember that no single candlestick pattern is foolproof. It’s always best to use candlestick patterns in conjunction with other technical analysis tools, such as trendlines, moving averages, and volume indicators, to confirm signals and increase the likelihood of a successful trade.