What is a Candlestick?

A candlestick is like telling someone how big a fish is…

Imagine standing around the water cooler on a Monday afternoon after a weekend of fishing. If you had some good luck, you might want to tell your friends about your experience. Describing your catch as being 34 inches long might provide them with the facts. But, it’s hard to grasp what that means with just a number. Instead, you might stretch your arms out and exclaim, “it was this big!” Candlesticks provide that same visual context for how far a stock’s price swung in a day.

In stock trading, a candlestick is an illustration of a stock price’s daily fluctuation. The length of the bar tells you the difference between the opening and closing price. The lines extending beyond the bar, sometimes called shadows, wicks, or tails, show whether or not the price extended higher or lower than the open or close before retreating. The color of the candlestick tells you if the stock closed above or below its opening price.

These candlesticks originated in Japan more than two centuries ago. Munehisa Homma used drawings to indicate how much the price of rice fluctuated during a day. It wasn’t until the 1980s that these drawings became known in the West. Steve Nison introduced them as “Japanese candlestick charting techniques” in a book by the same name. The idea behind candlesticks is that patterns emerge, which a sophisticated trader can spot. Those patterns supposedly signal trends, reversals, and breakouts (prices outside of a normal volatility range) that are about to occur.

Candlestick trading patterns come in many shapes and sizes. The theory is that intraday fluctuations could expose the emotions of the market. Some of the forms within the candlesticks supposedly can indicate a change in momentum and attitude. For instance, after a series of losses, a specific pattern might suggest that the market is moving from fear to hope. If true, the market might soon reverse course and begin a series of gains.

Steve Nison (considered an expert on candlesticks) lists 47 candlestick patterns on his website. The following are some of the more well-known patterns. Note: None of these patterns can be used to reliably predict future stock movements. They are presented here for educational purposes only.

Hammers may happen at the bottom of a downtrend. The candlestick has a small body, with a long lower shadow and no wick at the top. An Inverted Hammer has the same shape but is upside-down. A hammer, or inverted hammer, at the bottom of a downward trend, is considered a reversal signal — Suggesting the price is about to move into an upward trend. Green hammers are generally considered stronger signals than red hammers, but both are considered bullish.

A Hanging Man is a hammer at the top of an uptrend. Likewise, a Shooting Star is an Inverse Hammer at the top of an upward trend. These are bearish reversal patterns, suggesting selling pressure is mounting and the price may fall.

Doji look like a star or a cross, which supposedly display indecision in the market. They happen when the open and close prices are almost the same, meaning the candle doesn’t have a body. Spinning Tops are almost Doji candlesticks, but with a slightly larger body and shadow. When a Doji or Spinning Top appears at the bottom of a downward trend followed by an improvement the next day, it is called a Morning Star and is thought to be a sign of hope. Conversely, a Doji or Spinning Top at the top of a rising trend followed by a decline, called an Evening Star, is believed to be a bad sign.

A Piercing Line is considered to be a bullish reversal pattern. It happens during a downward trend. It begins with trading closing significantly below the open price, creating a tall red candle. Next, the next trading day starts with a gap down, opening below the previous close. Then, the price increases during the day, closing above the midpoint of the last day’s range. This two-day pattern suggests the price is taking a new direction. This inverse of the Piercing Line is called a Dark Cloud Cover, which is believed to signal a bearish reversal.

Engulfing patterns are also two-day sets in which the second day has a higher high and a lower low than the previous day. The color of the second candle, which should be the opposite of the first candle’s color, indicates whether it is a positive or negative sign. If the second day is green, it is considered a Bullish Engulfing pattern. If it is red, it is considered a Bearish Engulfing pattern.

Harami is the opposite of an engulfing pattern. They occur when the body of the second trading day stays entirely within the body of the previous day, and is of the opposite color. A red candle following a tall green candle is considered a Bearish Harami. Likewise, a short green candle following a tall red candle is considered a Bullish Harami.

Some other three-day patterns also emerge. For example, three consecutive long red bars is called a Three Black Crows pattern. It is supposed to convey pessimism in the market, indicating further losses may follow. The inverse, in which there are three consecutive long green bars, is called a Three Advancing Soldiers pattern. It suggests that more gains may follow.

There are numerous other patterns that technical analysts use to predict the direction a stock is heading. These alternative forms of charting are usually longer-term than candlestick patterns, which rely on price changes over several trading days. One popular type of such pattern recognition is called the Elliott Wave Theory, which suggests that stock prices move in a recognizable series of impulses and corrections.

Candlesticks typically create two- or three-day patterns that technical traders analyze. There are a few single candle patterns, but most take longer to form.

Because candlesticks are short-term, they suggest a near-term reversal or continuation of a trend. Candlesticks don’t usually tell you anything useful for more than a few days following a pattern. Therefore, it’s less likely that a candlestick formation will identify a long-term trend that is on the way. It’s considered to be more likely that it can signal changes in momentum, which are probably temporary.

In this way, candlesticks might be more useful in day-trading than long-term investing.

A candlestick theoretically shows the attitude of the current marketplace regarding a stock or other security. A long body (the distance between the opening and closing price) indicates the direction the stock price is moving.

A tall green bar signals that the bulls are in charge, pushing prices up. A tall red bar shows pessimism ruling the market, pulling prices down with bearish sentiment. Short bodies suggest that the bulls and bears are relatively balanced. That could indicate that momentum is slowing down. For example, a short-bodied candle coming after a series of tall green candles might suggest the price is reaching a resistance level.

The shadows (the lines above and below the body) also provide essential information. When a shadow forms, it means that traders tested a higher or lower price, which gets rejected. The length of a top shadow is the distance between the highest price of the day and the closing price. That means that the higher price couldn’t sustain itself, and it fell to the closing price. For instance, a stock price might have gone up to $25 for a few hours, then fell back to $23, leaving a $2 shadow. The fact that the higher price was rejected might convey some important information.

A candlestick chart illustrates several trading days of prices, which you can read with a little bit of practice. A typical line chart might show you the closing price of each day, connected by a line to show the general trend of the stock. Following the line over time can give you an indication of the general price direction. But, there is a lot of information missing from that line.

A candlestick chart provides more than just the closing price. It also gives you the opening price and the high and low prices for the day. You can still get a feel for the general price trend, but you can also see how much intraday volatility was involved in getting to that closing price.

As you look across the time series, the colors of those candles show periods of optimism (green) and pessimism (red). The length of the bars indicates the power of the bulls and bears during a stretch of time. Reading the candlestick chart tells a complete story about how the price moved over the timeframe.

No system can reliably predict the future movements of stocks. However, according to the Encyclopedia of Candlestick Charts by Thomas Bulkowski, the Three-Line Strike is the most reliable candlestick pattern. A three-line strike consists of three consecutive candles of the same color followed by a candle of the opposite color that engulfs the previous three. In other words, if there are three straight days of losses, then the fourth day regains all of those losses, it is a bullish Three-Line Strike.

Although this was the most reliable signal, it was only correct in 67% of bearish signals and 65% of bullish signals. This pattern was also relatively rare, which limits its usefulness.

A trader can start using candlestick patterns by merely looking at the candlestick chart for a stock he or she is interested in buying or selling. Knowing what to look for is a matter of education and practice. However, the stock market is an inherently risky business. No amount of training or education can remove that risk.

It is also worth noting that professional traders may use algorithms to act on reliable signals much faster than human traders can move. Therefore, an opportunity you identify on a candlestick chart will almost certainly close before you have a chance to cash in on it. It is, generally speaking, essentially impossible to beat the market, except by luck. Still, many traders swear by technical analysis and charting, or just thoroughly enjoy the excitement of trading stocks.

*It is not possible to reliably predict the future movements of stocks; all trading entails risk, including the risk of losing your initial investment. Fully research this and other approaches such as fundamental analysis before investing. *